Address by Director of Policy and Risk Patrick Brady to the Society of Actuaries conference on ERM: Insights for Insurers

25 September 2013 Speech

Implications of sustained low interest rate environment

I would like to thank the Society of Actuaries for inviting me to speak here today at this conference on Enterprise Risk Management: Insights for Insurers. The challenge when speaking on a subject that most of the audience are only too well aware of is to set a context. So, it may be a case of less insight and more about reminding ourselves of what is all too obvious, if misunderstood. It may also be the case that we are at the beginning of the end of the low interest rate environment, but that should not dissuade us from confronting the stark reality of what we have been experiencing for the last years.

Low rates – Historical context

For much of our adult lives the primary trend exhibited by interest rates in the world’s major economies has been one of relentless decline. Globalisation, competition and the vigilance of central banks have mitigated the inflationary pressures of the 1970’s.

In response to the global financial crisis in 2007/08, nominal interest rates across much of the developed world have tested the zero bound and have remained low. During this period of time, negative real interest rates have been a regular feature.

It is appropriate to question just how unique the present interest rate environment is. The use of the word sustained is important – it gives us a clue that this is not a sudden move. In 1980, the median base rate for G7 nations plus Switzerland was approaching 14%. By 1990, that rate was approximately 10%, 4% in 2005 and today it is barely 0.5%.

The study of economic history allows us to survey the past so as to gauge the relevance of the present. In terms of bond yields, the longest time-series of data available is that of the Netherlands. In the past year, the Dutch 10 year bond yield traded at a 5 century low of 1.49%. It is not unique in this. Notwithstanding the recent snap back rally in bond yields, the US 10 year Treasury bond traded at 1.396% during the summer of 2012 and has since rallied to 2.82% (3 Sept). Since records began in 1790 these levels are truly unique in terms of interest rates.

Data from the Bank of England on the base rate reveal that UK official interest rates are at their lowest level since 1694 and that the present rate of 0.5% is 150bps lower than previous historic lows. That this level has been sustained for almost four years speaks to the gravity of the situation that faces major economies today.

At the shorter end of the yield curve, 2 year yields across ‘core’ European economies turned negative in 2012. Never before has history recorded such low yields that have been co-ordinated across so many jurisdictions for so long. Western economies have had many episodes in the past when interest rates were deemed as being low. However, interest rates have not been this low across so many economies at any previous time in history for such a sustained period.

With Central Banks aggressively cutting rates in response to the global financial crisis, the psychological limit of the zero lower bound in nominal interest rates has necessitated increasing usage of what is termed “unconventional” policy tools. Large scale asset purchase programmes have been pursued on a global scale by the major central banks.

Yield compression across many asset classes is as a direct result of asset purchase programs. So, while G10 government bond yields in recent times have rarely in history been lower, the yields on corporate bonds, asset backed securities, equities and property have seen significant compression as a consequence of financial markets that are flooded with cheap liquidity.

During 2009, the yield of major investment grade corporate bond indices was in excess of 6%. Following a significant liquidity driven rally and the search for yield, that figure today is approximately 3%. The move in high yield corporate bond markets is more significant – yields in excess of 15% during 2009 have narrowed to barely 5% currently.

Since 2009, the European equity market has rallied 53% while the S&P500 Index is up 83%. Liquidity and the search for yield have spread into the domestic commercial property market. According to CBRE, investment into commercial property has risen from approximately €70m during 2009 to €550 million in 2012. At the end of the first quarter of 2013 investments totalling €350 million have poured into the sector. Yields, particularly for prime office real estate, are likely to compress as a result.

Unique is a word often misused. The present interest rate environment is unique in the true meaning of that word – it has no precedents in economic history.

The risks

The policy response from many central banks has been designed to mitigate risks posed largely by an imploding banking bubble. To the extent that insurers will generally have a negative duration gap as opposed to a positive gap at banks it is fair to say that ultra-accommodative monetary policy is not particularly accommodative for all insurers. This has prompted some in the insurance industry to question whether banks were rescued at the expense of the insurance industry?

I should say at this point that the Central Bank is wholly aware that interest rates impact on insurers in different ways to that of banks and is sympathetic to that fact.

We have to deal with the realities of the current environment and the insurance industry can do little to change that. Interest rates and market yields, while an essential component of the profitability of insurers, are a variable over which insurers have no direct control.

This brings to mind the well-worn example of the failure of several high profile Japanese life insurers in the mid to late 1990’s. Their failure was not exclusively brought about by low interest rates but rather due to inappropriate business strategies coupled with management and board complacency. A prolonged period of low interest rates served to expose these underlying weaknesses.

To build a business model that is crucially dependent on one and only one interest rate outcome or financial market environment is foolhardy at the very least. History reminds us that resilient firms in any industry are not simply lucky; they are robust to an evolving and uncontrollable external environment.

The Central Bank is of the view that business models and strategies of supervised firms must be robust to an environment over which firms have little or no control. Firms cannot change the external environment but can adapt to how it will impact on them. Firms are responsible for the choices they make and indeed, avoid making.

The persistency of low rates is the key risk faced by many insurance companies in that both sides of the insurance company balance sheet can be adversely impacted. While these risks are doubtlessly understood by the actuarial profession, it is worthwhile giving the view of the Central Bank in terms of the risks that we consider in our supervisory engagement model.

Domestic Life Insurance

The structure of the domestic life insurance industry where firms predominantly engage in the sale of unit linked business with little exposure to guaranteed products leaves the life insurance industry in Ireland significantly less exposed by the low rate environment relative to the life insurance industry elsewhere and the variable annuity (VA) industry in Ireland.

The significant lengthening of liabilities and contracted cash outflows associated with having a large book of guaranteed business is much less of a risk for the domestic life insurance sector. There are risks, particularly surrounding persistency and the cost base – but these are more significantly influenced by domestic economic factors as opposed to global interest rates.

Insofar as the low rate environment and unconventional monetary policy have supported asset prices, then the value of unit linked funds should have risen in tandem with financial markets over the past two years. To the extent that this may help investor confidence should be welcomed by insurers.

Domestic Non-Life insurance

Given the general tendency for non-life insurers to be more exposed to short tail liabilities relative to life insurers, the impact of low rates on the non-life insurance sector is often downplayed. With the domestic life industry having a relatively small exposure to guarantees then the impact of sustained low interest rates is arguably more keenly felt in the domestic non-life sector.

The well-worn rule of thumb is that for a 1% decline in investment income a general insurance company must improve the combined ratio by 3 percentage points in order to generate the same return on equity. This underscores the importance to have control over what can be controlled.

The Central Bank takes a dim view of the strategy of regulated firms that place an emphasis on market share to the detriment of profitability. With investment income under pressure, insurers need to be more responsible in terms of pricing policies. Market share does not compensate policy holders or shareholders in the absence of underwriting profitability. We remain highly vigilant to the pricing and competitive strategies of firms in the industry. If the industry is serious about the risk that persistent low rates have on profitability, then that fact should underscore a firms underwriting strategy as well as the approach to investments. In time, prudently managed insurers will continue to focus on profitability and long term resilience over and above market share.

An aspect of the risk posed by low interest rates to non-life insurers that gets less exposure is the interplay between interest rates, inflation and reserves. Low rates will typically impact firms underwriting long tail risks more than those firms underwriting short tail risks as they are more likely to have more pronounced risks regarding portfolio interest rate sensitivity and claims inflation risk. If inflation expectations increase beyond the estimates used in reserving models and interest rates do not shift accordingly, then future claims may not be adequately covered by investment income. A high degree of sound and prudent judgement is required on your part and, perhaps, some luck!


An internal study conducted by the Central Bank of Ireland has analysed the asset allocation and investment returns of the global reinsurance industry. The yield on fixed income investment portfolios has declined from 2.6% in 2011 to 2.3% in 2012. At the same time, portfolio duration has increased marginally (2.9 years from 2.8). The asset allocation shift has been gradual, with slight decreases in the exposure to government bonds being offset by an increase in exposure to corporate bonds and cash.

The continual search for yield that is associated with this period of low rates has attracted increasing amounts of capital from alternative providers into the reinsurance industry. The resulting excess capacity is exerting downward pressure on insurance pricing. Guy Carpenter estimates that approximately 14% of global P&C reinsurance capacity is via alternative capital – this figure was 8% in 2008.

John Nelson, the chairman of Lloyds of London, fired a timely reminder to us two weeks ago when he said: “We all vividly remember the systemic problems which arose in the banking industry . . . where capital became detached from the underlying transaction of risk.”

Following on from a weak April renewals, in the recent July renewals round, pricing pressure was reported across a wide degree of reinsurance lines. The latest reinsurance industry gathering in Monte Carlo would seem to suggest that pricing continues to remain weak.

The most recent Aon Benfield study of reinsurer profitability reveals that the Accident Year Combined Ratio has declined year on year. The resulting increase in profitability has, fortunately, more than offset the decline in investment income (from 3.8% in H12011 to 3.4% in H12013). This is certainly a welcome development and the industry should seek to build on that where possible.

Variable Annuity

Of all the sectors that we supervise at the Central Bank the VA sector is the most adversely impacted by the interest rate (and financial market) environment. The provision of long term guarantees is significantly more expensive when rates are low. While this is well known, we feel that it is neither fully accepted nor understood sufficiently by all in the industry.

Let me preface my following comments by saying that I am speaking at some remove from direct supervision.

The business models and pricing strategy of some VA entities are questionable in terms of vulnerability to external risks. I understand that at least one firm has increased the minimum guarantee and reduced the cost of the policy in order to grow the business aggressively, despite the current, persistent low rate environment. I find this behaviour deeply troubling and, in my view, it points to a lack of coherence in strategy – where growth and long term profitability are not considered in an holistic fashion. It strikes me that this is growing a loss making business in the hope that rates in the future will be substantially higher than prevailing today. It is the insurance equivalent of pretend and extend in the banking domain. Hope is hardly a strategy. So, instead of mitigating one risk, low interest rates, a different risk is being created, strategic risk. Interestingly, this is one of the key risks identified by the US Comptroller of the Currency only two weeks ago, where he expressed concern that some banks were venturing in to new lines of business to generate higher profits but that were beyond their technical competence, risk tolerance and capital adequacy.

The interest rate and market environment can have a much more direct impact on the balance sheet of VA writers than more traditional lines of life insurance; hence this sector requires a considerable level of monitoring and supervision.

The Central Bank of Ireland supervises a total of ten entities involved in the production and sale of variable annuity and is therefore the leading regulatory authority for VAs in Europe. Of those ten VA entities, four are closed to new business. The industry here is responsible for approximately €18bn of Assets under Management and generated close on €4bn of premium income during 2012. These firms predominantly serve a client base in the UK, Continental Europe and Japan.

It is worth reminding ourselves simply how fragile this industry is. During 2008, as equity markets tumbled and the banking crisis began to snowball Central banks began aggressively lowering interest rates in response. Losses in the global VA industry began to mount as hedging strategies proved ineffective. In the US, hedging losses exceeded $4bn in September and October of 2008 alone.

The high volatility associated with a shift in rates and collapsing financial markets increased market volatility which in turn increased the cost of hedging significantly.

As interest rates remained low, the cost of providing the VA guarantees began to climb substantially. We now see the double knock-out blow in action – the asset side of the balance sheet diminishing at the same time that liabilities expand. The combined result of losses, increasing cost of guarantees and falling profitability was the depletion of capital in the industry.

During 2008 one of the leading VA producers in the US incurred losses that obliterated much of the previous four years profitability. By 2009, losses at this firm doubled from 2008 levels and they tripled in 2010. How robust is an industry where financial market events can destroy a generation’s worth of profitability?

The VA industry – and here let me emphasise I am referring to the global industry - has consistently told the world that hedging strategies have been improved, that they have been strengthened to cope with an ever changing set of financial circumstances. But those same strategies have been shown to be ineffective whenever the industry has been faced with major shifts in rates, yield curves and underlying financial markets.

If the hedging strategy is fully effective then profitability is likely to be minimal due to the cost of hedging. If the VA producer runs at less than 100% hedge effectiveness then they are taking on the cost of guaranteeing financial markets onto their balance sheet – hardly a prudent or far-sighted strategy.

The Central Bank engagement with the VA industry is conducted under our PRISM supervisory model. This is not a model in the sense of a set of inputs and outputs rather it is a supervisory tool underpinned by a judicious philosophy of supervision. A key component of the PRISM approach to supervision is an in-depth analysis of firm business model and how that model reacts and is shaped by internal factors and the external environment. Each sector undergoes an environmental analysis in order to identify and rank plausible external threats.

As part of our engagement model, a specialist team of supervisors is responsible for the supervision and oversight of VA undertakings. During 2011, this team rolled out new reserving standards for the industry that significantly raised the capital requirements of VA undertakings in Ireland. Since then, our supervisors have worked closely with the industry with a view to conducting stress tests assessing what the impact on solvency from a sustained low rate environment would be. I want to recognise the good relationship between industry participants and supervision staff and express my gratitude for the cooperation that we have received.

Indeed, building on that cooperation, the VA supervision team, in coordination with VA writers, has developed a framework for the quantitative assessment of the scope and scale of the risks posed by a prolonged low interest rate environment and firms’ preparedness for such an environment. This framework has focused on closer scrutiny of interest rate risk and critical assessments of firms’ product offerings in the marketplace.

To further combat the risk of low interest rates, the VA team has recently launched a stress testing framework across the industry in Ireland. During the second half of 2013, this will be used to test the resilience of firms’ business models under a range of scenarios incorporating sustained periods of low interest rates in combination with other market risks.

The Central Bank will remain vigilant with regard to this sector. Given that the majority of the firms are subsidiaries of parent companies that are headquartered in continental Europe we know that the eyes of other regulators and the industry are watching our approach closely.

With the benefit of experience, the data that we have accumulated, the insight of the PRISM engagement model and, some might say, hindsight, it is difficult to say had we had all that information and experience when these firms sought authorisation that those authorisations may have been less forthcoming or potentially more onerous.

Investment Strategy

Recognising that there are some restrictions relating to asset classes within Technical Provisions, I want to say a bit about investment strategy, more particularly investment strategy that is robust to the financial market and interest rate environment.

A recent study by EIOPA into the asset allocation of insurers in Europe has revealed that insurers in Ireland have a markedly different asset allocation compared with their peers across Europe. Irish regulated companies have amongst the highest exposure to nominal assets such as cash and fixed income. This strategy is perceived as a low risk investment strategy which is only partially correct. Investment portfolios that are highly concentrated in government bonds and cash should exhibit lower volatility than a portfolio that contains corporate bonds, equities, commodities and property – but that does not mean they are without risk.

Such a portfolio is significantly more exposed to interest rate risk and the risk of a sudden change in inflation expectations. It strikes me that the investment approach favoured by many in the insurance industry is reactive and passive – mitigating yesterday’s risks today. Given how fundamentally vital investment is to insurers surely the industry could do more to be proactive and, perhaps, consider a potentially counter cyclical approach to investment strategy.

At the risk of being accused of having 20/20 hindsight (again!) I watched with interest over the past five years how insurers sold out Irish government bonds at the most inopportune time only to load up on negative yielding short term bonds issued by core economies. This behaviour is deeply ironic when one considers the inherent exposure of Irish insurers to the Irish financial system via the significant deposits held in the Irish banking sector.

There is little that entities can do to influence the rate environment. There is much that they can prudently do to improve core underwriting profitability and generate reasonable investment income. By way of example, the dividend yield on the MSCI World Index is well in excess of the yield available on 10 year government bonds issued by core economies, yet the equity allocation of Irish insurers is at their lowest in several decades. There is a shortage of acceptable office property in the central Dublin area – what are insurance companies doing with present property exposure to take advantage of this? While not recommending that firms bet the company’s balance sheet on a highly volatile asset class, maybe a greater allocation than minimal is warranted.

The present asset allocation strategy does provide entities with the flexibility to deploy cash resources prudently to take advantage of underlying asset volatility in order to generate a yield. This being the case, it was disappointing to witness the increase in investment in holdings of corporate bonds by entities after one of the most significant rallies in corporate bonds in recent history. The industry has a history of investing in yield producing assets after yields have already compressed. Given the amount of actuarial talent and investment expertise in the industry this should be addressed by company executives.

An interesting aspect of the low rate environment has been that equity investors have increased investment flows into the stocks of insurance companies. In a low yield environment the dividend yield available in the quoted insurance sector has been superior to that available generally in the equity markets. The dividend yield on the pan European insurance sector is estimated to be 4.5% for 2014 versus a broader market yield of 3.5%. These inflows have propelled the quoted insurance sector to one of the best performing equity sectors globally in the past year.

Solvency II

Just a very few words on Solvency II.

From an asset point of view, at last market risk is explicitly recognised in the Solvency Capital Requirement. Firms should appreciate how these rules are likely to impact their balance sheet strength and review proposed investment strategies with the new rules in mind.

Separately, the low interest rate environment was undoubtedly a major factor in the delays concluding Omnibus 2 negotiations. EIOPA has proposed a potential package of solutions following the LTG Impact Assessment work and this has formed the basis for current negotiations. The proposals under discussion in Trilogues attempt to find solutions which permit deviations from discounting at pure risk free (low) interest rates in specified circumstances through matching adjustment, volatility adjustment and special transitional measures. While this continues to be a very sensitive subject, it is to be hoped that we will have an agreed workable outcome and both Parliament and the Council can finally sign-off on this long anticipated project.


Monetary policy can, if successful, buy time to address the broader systemic issues of excessive leverage but we cannot know for how long the present environment will be sustained.

This point is significant given the recent snap back in treasury yields on both sides of the Atlantic. During August this year, yields in 10 year benchmark bonds issued by core economies increased by 10 to 30 basis points. Market expectations are for rate increases in the next 12 months on both sides of the Atlantic notwithstanding the non-activation of the much anticipated tapering by the US FED. The European rate curve has become highly correlated with the US rate curve. This may be explained by rising rate expectations due to tapering of the QE programme allied to an improvement in economic data in the United States, France and Germany.

This snap back in yields poses short term risks for the investment portfolios of firms, particularly those with longer duration assets. It exposes investors to mark-to-market losses on bond portfolios. The Central Bank estimates that a 1% sudden increase in interest rates would reduce (in the short-term) the average solvency margin of non-life High Impact companies by 36 percentage points due to declines in the market value of investments (average solvency could fall from 240% to 204% - a still healthy level but a significant potential drop nonetheless). As benchmark yields have risen, equities and emerging market currencies have declined. This volatility is to be expected. The market would now appear to be anticipating much tighter liquidity conditions in the future. To the extent that this would result in higher interest rates would be welcomed by the insurance industry and savers alike.

Much of these market expectations may be unwarranted. The improvement in economic data in France and Germany is likely to have been driven by one-off factors. Inflation expectations in Europe are well anchored below 2%. As Mario Draghi reminded us on September 5th, the green shoots of recovery, if evident at all, are still very green.

Insurance companies must be mindful that the recent rise in yields is not necessarily signalling that we will move toward a higher interest rate. Because we cannot know with certainty, we must take steps to ensure that the threats to the stability of the financial system and the consumer are minimised. Insurance companies should take steps to ensure that products and business models are robust to the uncertain environment so as not to jeopardize policy holders and shareholders through the pursuit of reckless growth.

The low interest rate environment provides insurers that are significantly adversely exposed to interest rates an opportunity to address this issue.

Where permissible, insurance entities must use this opportunity to amend pricing and policies that are inconsistent with robust long term profitability and stability.

Thank you and I hope you enjoy the rest of your conference.