Rising Interest Rates Bear Risks for Life Insurers
Experts Call for a Recalibration of the Additional Interest Reserve
The prolonged period of small returns on assets and the large amounts of legacy contracts which grant a minimum rate of return to policyholders of up to 4% poses a major challenge to European life insurers. Therefore, many of them hope for a near-term reversal in interest rates. However, a sudden rise in interest rates could also entail risks for the insurance industry and thus also for insurance customers. What are the effects of rising interest rates on life insurers’ solvency and liquidity? This question was addressed at the 13th Talk on Insurance and Regulation on May 24 at the Goethe University Frankfurt, organized by the International Center for Insurance and Regulation (ICIR).
Prof. Dr. Helmut Gründl, Managing Director of ICIR, outlined the results of a recent joint research work with Elia Berdin and Christian Kubitza which simulates the effects of a sudden interest rate shock. According to the researchers, a significant and above all rapid rise in interest rates would worsen the liquidity and solvency of life insurers over several years. “Even a gradual increase in interest rates would substantially worsen the liquidity situation and slightly reduce the solvency of the life insurer”, Gründl said.
At first sight, rising interest rates might stabilize the balance sheet of life insurers. However, policyholders may find it more attractive to lapse their contracts and to invest in new saving opportunities with higher returns. In this case life insurer could face a significant outflow of liquidity.
Also, diverging accounting requirements of Solvency II and GAAP would cause frictions, Gründl stated. Under the principle of lowest-value (Niederstwertprinzip), insurance companies would have to swiftly write-off bonds in the trade balance sheet in the case of rising interest rates. At the same time, the value of the obligations on the liability side would even rise in the short term due to additional interest rate reserve regulations, and would only drop thereafter. This would lead to short-term trade losses for the company. In the solvency balance sheet, however, rising interest rates for life insurance companies have a clearly positive effect due to the appropriate market-consistent valuation. The solvency improves. However, cancellations of insurance contracts may have an adverse effect. Due to cancellation fees, cancellations usually result in trade balance profits, while they can contribute to a reduction in own funds in the solvency balance sheet. “In this situation any surrender leads to loss,” Gründl said.
Dr. Frank Grund, Chief Executive Director Insurance and Pension Funds Supervision of the Federal Financial Supervisory Authority (BaFin), agreed to Gründl’s assessment that rising interest rates could bear some risks, however, “there is no need to panic”, he said. Grund pointed out that buffers would mitigate the lapse risk in case of a substantial hike. Not all insurance policies could be surrendered so easily. The surrender charge or the loss of tax incentives and government subsidies for policyholders of Riester contracts provided strong lapse barriers. Contracts with occupational pension funds even could not be mitigated at all.
Grund doubts that an interest rate rise of 5 percentage points in two years, as suggested by Gründl et al., was realistic. Even current stress tests of the European Insurance and Occupational Pensions Authority (EIOPA) were based on a less severe scenario, Grund said.
With reference to the additional interest reserve (Zinszusatzreserve) Grund conceded that life insurers may face diverging effects from financial reporting and prudential regulation. “The problem of the additional interest reserve can only be solved by changing the law”, Grund said. Therefore, he advocated a modification of the actual reserve ordinance (Deckungsrückstellungsverordnung).
In his speech Dr. Klaus Wiener, Member of the Executive Board and Chief Economist at the German Insurance Association (GDV), also called for some regulatory adjustments and pleaded for a recalibration of the additional interest reserve. “The instrument is in principle sensible however, the pace of additional reserve accumulation is way too fast”, he said. Interest rate provisioning already amounted up to 60 billion euros. Even with surging interest rates buffers would further increase.
Wiener pointed out that since the onset of the financial crisis lapse rates have decreased continuously. He considered it unlikely that higher yields would lead to higher lapse rates because a surrender would imply a loss of biometric risk protection for policyholders and surrender charges would apply. Wiener does not expect a rise in capital market yields of more than 3 percent. However, even 3% would not be high enough to trigger a mass termination of life insurance contracts, he stated. “To avoid frictions, surrender values of life insurance policies should be adjusted to changing market conditions”, Wiener suggested.