Address by Head of Life Insurance, Mark Burke, to the 3rd Annual Best Practice in Managing Insurance Assets

27 September 2013 Speech

A regulatory perspective on the challenges posed by a changing interest rate environment

Good morning ladies and gentlemen. It gives me great pleasure to be able to speak to you this morning and to offer you my own perspective, from a regulatory lens, on the challenges posed by a changing interest rate landscape. The prospect of a prolonged period of low interest rates poses particular challenges for the insurance sector. In some cases, these challenges will necessitate only a tweaking of a firms investment strategy and perhaps some cost optimisation. In other cases, the challenges are more fundamental in nature and may require original thinking to overhaul the firm’s business model. The business models most vulnerable to the impact of a prolonged period of low yields and low interest rates are those that are long-tailed, perhaps those with investment guarantees, or those dependent on investment returns to maintain profitability. This covers life assurance investment guarantee business as well as some non-life business lines. There is also the impact on the reinsurance market where excess liquidity in the capital markets is chasing yields in uncorrelated asset classes, thereby exerting significant downward pressure on reinsurance rates which would otherwise harden significantly. The impact of a prolonged low-interest environment very much depends upon how a variety of factors interact with one another, such as interest rates, asset returns, guaranteed returns on the historic portfolio, as well as any duration mismatch between assets and liabilities. We recognise that the interaction of the above will give rise to a different impact for different insurers and we have framed the supervisory response accordingly.

Over the course of the next half hour or so, I would like to highlight some of the more significant issues we have seen in the Irish market and comment on how we have amended the supervisory strategy and engagement philosophy accordingly. To help streamline the discussion, I will examine these issues from the perspective of each of the areas of life insurance initially, and then non-life insurance & reinsurance.

Observations from a Life Insurance perspective

The negative effects of low interest rates on insurers appear slowly because only current premium income, a fraction of total investments, is invested at current market yields. On the one hand, this delayed impact on the investment portfolio gives insurers time to react but, on the other hand, it can also tempt insurers to wait, delaying the required actions as they hope for a reversal in interest rates. The exact timing of when these effects are recognised will depend to some extent on accounting conventions. Where a market value method is used, the impact is observed very rapidly since any decline in interest rates is reflected in the rates used to value liabilities. If historic cost accounting is used, the impact on an insurer’s balance sheet appears much more slowly as the business runs off the books. The implementation of Solvency II would see a move to a more market consistent valuation and a risk based solvency requirement that would explicitly calculate a capital charge for the embedded guarantee. Indeed, the implications of this aspect of the Solvency II regime has been the source of much debate and criticism, but it is important to recognise in this context that a market consistent valuation is merely the messenger in terms of making an underlying risk visible at an early stage.

In many respects, the issue unfolding in some European markets is not dissimilar to the types of challenges faced by the Japanese life insurance industry in dealing with the challenges it faced in the last two decades. It is useful to spend some time examining how that market dealt with its challenges as there may be a useful read-across to some of the issues faced in European markets where similar exposures exist.

The fundamental issue faced by Japanese writers was dealing with spread compression initially and ultimately a negative spread. The spread is simply the difference between the rate of guaranteed returns on the products sold over a number of years and the yield on the underlying investments. A negative spread implies that the firm is not earning enough on its investments to support the guarantees provided on previous years’ new business. The problem in Japan would have been exacerbated by the long duration of the business, relatively rigid guarantees, and policyholder options which included the possibility of withdrawing money without penalty, increasing payments or sums insured at original terms, or extending the term of policies. All of these factors increased the interest rate sensitivity of the products.

How have the industry and regulatory authorities dealt with these challenges?

The solution certainly involved a lot of patience. The first step was to reduce the guarantees offered to new policyholders in an effort to eliminate the negative spread problem and restore profitability of new business. As historic business matured and increasing amounts of the overall book were written on more favourable terms, the spread gap reduced. However, this was a journey that took well over a decade owing to the relative size of the historic book. Insurers also redesigned their product portfolio. This included a move towards products that were less risky for the insurer and included those that were less capital intensive. Where providers continued selling guaranteed products, the features of the products were adjusted to limit the risk to the insurer. Providers also embarked on numerous initiatives to streamline their operational costs, optimise their asset management and hedging strategies for the historic portfolio as well as introduce enhancements to the area of enterprise risk management. Regulatory authorities also played their role. The facility to amend the terms on existing business was introduced where some writers encountered real difficulties. The solvency position was also amended to include a forward looking component which allowed writers take credit for future profits on new business. The aim was to incentivise and accelerate the shift towards profitable new products.

From a prudential regulatory perspective at the Central Bank of Ireland, we have amended our supervisory and engagement philosophy with a few key themes in mind: capital adequacy for the historic book, robustness of the business model regarding new business, and strengthening the enterprise risk management framework. While the significant majority of the pensions and savings business written in Ireland is unit-linked in nature and so the investment risk is borne by the policyholder, there are a number of variable annuity firms domiciled Ireland selling into a variety of European markets. A number of years ago, we set up a specialised supervisory team to supervise these firms. This coincided with the introduction of a new capital standard for this business. We also hold quarterly meetings with each firm to understand the performance of their hedging strategies during the quarter.

From a risk governance and product strategy perspective, the firms impacted have made significant changes and enhancements and adopted a pro-active stance in dealing with business model challenges. The following slide provides some details of the extent to which the product features have been amended. Guarantee fees have been increased; benefit richness has been reduced; the fund platform has been overhauled with more passively managed funds and funds that are more easily hedged; modelling capabilities have been enhanced; perhaps most importantly, the product design process has become much more dynamic and integrated with the rest of the business. The proactivity on firms' part to deal with these business model challenges upfront is very much welcomed and indeed, is absolutely necessary if these products are to remain profitable for the insurer going forward.

Earlier this month, we launched a stress testing exercise which will help us assess balance sheet resilience to a variety of different stresses and scenarios. The exercise is primarily directed at those providers of investment guarantee business. The exercise will help us examine the preparedness of these firms for the potential impact of a prolonged low interest rate environment and to better understand the degree of planning around potential management actions. The results of this exercise will help inform any future policy decision making and our supervisory engagement going forward.

I don't intend to discuss the precise particulars of our individual stresses, but I am happy to speak to the types of issues one might wish to explore with typical firms selling investment guarantee business.

If we take a look at the evolution of interest rates throughout the last century, we can see that many different scenarios are possible. These include prolonged periods of low interest rates and periods characterised by interest rates fluctuating around long-term averages with intermittent spiking of rates, driven by inflation. Throughout this period, expectations of the long term average will also vary in line with long term economic fundamentals. More recently, unconventional monetary policy has also played a role. It is also important to note that the changes from one interest rate regime to another present challenges for insurers. Insurers portfolios tend to be dominated by fixed-income investments, and once rates go up, the unrealised gains of yesterday accrued during the low-interest rate environment become the unrealised losses of today.

In this regard, it is incumbent upon insurers to be mindful of the impact of a sharp rise in rates on their solvency position. A sharp rise in rates can also give rise to challenges for insurers depending upon the policyholder behaviour in the face of a changing interest rate landscape. Many of these products with investment guarantees are long term policies and the interest rates credited to these policies will reflect the expected yield on the underlying investments over that same long term. Hence, a sudden spike in interest rates can make the products appear unattractive relative to other products in the market, at least in the short term. This is due to the averaging effect where rates of return credited to policies reflects the average interest rate rather than the current interest rate. Policyholders may have to balance their desire to switch to potentially more attractive new products with the surrender penalties they would incur should they choose to en-cash existing ones. The likelihood of such a scenario will very much depend upon the individual circumstances of a given insurer, the maturity profile of their portfolio and the prevalence of surrender penalties. However, the potential impact on an insurers' portfolio can be significant, and it is important that Boards have fully investigated and are aware of the potential impact of various scenarios.

There is also the more general issue of the 'search for yield'. In an effort to boost returns, some insurers have moved away from sovereign bonds into corporate bonds, while others have moved some assets away from investment grade bonds into sub-investment grade bonds or more illiquid assets. Given that many firms are undertaking a shift at a similar time, it is important that the yield on the underlying investment reflects an adequate premia for the risks it entails. Corporate bonds as an asset class have rallied strongly in recent years, which is more reflective of increased demand rather than an improved credit outlook. As a result, a spike in credit spreads today similar to that of three years ago would result in a much greater impact on insurers' balance sheets given the shift in asset allocations that has taken place. There is also the issue that some of these investments may not be very liquid. No doubt, these are the types of issues that are occupying the minds of many investment and risk committees, but it is useful to bear in mind that insurers are paid for their expertise in managing insurance risk, not their investment expertise.

Coming back to the stress testing framework we have launched in Ireland, a key output of the scenario testing for us will be a better understanding of the resilience of balance sheets to a period of prolonged low interest rates and rational policyholder behaviour. In a period of prolonged low rates, guaranteed products written in previous years become more 'in-the-money' and hence policyholders are more likely to retain these products. We have seen big adjustments being made by many US firms as they refine their lapse and policyholder behaviour assumptions for variable annuity portfolios, in an effort to improve the robustness of their risk models. We have not seen this type of behaviour yet in the European variable annuity market as the business is much less mature.

The other consideration to be mindful of is the length of time it can take to rebalance the portfolio where there is a 'negative spread' issue on the in-force book. I noted earlier that in the Japanese scenario, it took well over a decade for this rebalancing to take place. During this time, the Japanese stock market suffered some significant shocks as well as two natural disasters. This points to the need to be wary of the diversification credits given in a model when such a scenario is modelled. It is something that we are mindful of in the calibration of our own scenario testing.

I noted earlier that the quantitative results of the stress testing exercise, as well as the qualitative commentary around management actions will help inform any future policy decision making and our supervisory engagement going forward. In keeping with the lessons learned from the Japanese scenario, we will also be pushing the development of more sophisticated enterprise risk management and modelling capability. It is important that firms models do not only look at short term solvency positions, but also have sufficient regard to the need for longer term economic capital modelling capability so that firms being to adjust their product propositions at a sufficiently early stage going forward.

With this in mind, we will be launching a market risk monitor which variable annuity companies will be required to complete on a regular basis. Variable Annuity writers’ business models are inherently exposed to market risk arising from constantly evolving market conditions and are reliant on sophisticated hedging programmes. The aims of the project are to have standardised and consistent exposure data across the industry, to have a forward-looking assessment of exposures, and to have framework which can facilitate regular industry-wide stress testing. From a modelling sophistication standpoint, we acknowledge that some firms will be more prepared than others to implement the requirements immediately and in some cases, it will be necessary to engage in a dialogue with firms to tailor the adoption of the requirements initially, depending upon where their modelling capability is along the continuum of sophistication.

The need for innovation

At this stage, I would like to spend some time discussing one of the more fundamental challenges posed by a low interest rate environment - that is the need for product innovation. It is my opinion that life insurers need to envisage strategies that go beyond re-pricing policies and adjusting guarantee levels. The fundamental challenge posed by a low interest rate environment is how the economic costs of guarantees offered compare with policyholders’ willingness to pay for them.

New life insurance products need to be designed in a way that the guarantees offered to consumers are attractive, meet a genuine consumer need, offer good value-for-money, and also, are profitable for the product provider.

Policyholders would like to have guarantees for as many years as possible, and would also like other features such as generous surrender options. However, such guarantees and options come at a cost that is borne either by the policyholder or the insurer. The challenge is to strike a balance between the benefits and the attractiveness of the guarantee to the consumer on the one hand, and their cost to the product provider on the other hand.

As a first step, insurers need to be honest with themselves about the costs of such guarantees. The cost of investment guarantees is becoming more transparent owing to the greater emphasis on enhanced risk management, and the growing prevalence of the use of economic balance sheets and market consistency. The second component is a more evolved communications strategy with the consumer.

When customers are presented with the price tag of some commonly granted embedded options at the point of sale, how do they evaluate the value of the guarantee or would it be dismissed as a “nice to have”? This would suggest that guarantees that are difficult to hedge, yet create little value for customers at the point of sale, should be removed from the product suite. The current low interest rate environment provides the opportunity to address these issues and create a win-win situation for both insurers and policyholders, ensuring that the needs and expectations of all parties are met.

This points to the need for more product innovation, and more flexible guarantees. The economic cost of more flexible guarantees tend to be lower, they are more easily hedged, and they are better positioned to cater with the implications of changing macro-economic conditions. This can also be in the consumers' best interests. Can we say that a product with long term embedded guarantees purchased today will be attractive in say 15 years’ time? Could the interest rate environment be such that the consumer would want to switch to a product with higher guarantees in 15 years’ time? What about the costs associated with such a switch? It cannot be about headline sales figures, it must also be about a product which caters for consumers needs in the face of a future macro-economic outlook which may be less predictable going forward.

So, the need for innovation and flexibility is clear. But so too is the need for a more evolved communications strategy on the part of the product provider. We have seen intense competition in the marketplace in recent times. A natural consequence of intensive competition in the marketplace is the preponderance of complex and multi-dimensional products as product providers try to differentiate their products from the competition. Complex products bring with them complex and multi-dimensional price structures. This creates a dilemma for consumers and their financial advisers. It can be very challenging for consumers and their financial advisers to fully understand and explain the detail and the implications of these complex product design and price structures. It would be unfortunate if the end result was just a cohort of consumers getting increasingly frustrated with the sales process and thereby electing not to purchase the necessary insurance coverage. In that regard, product providers need to avoid the temptation of increasing product complexity and thereby avoid the risk of disenfranchising the customer base. Navigating a path through these challenges will require some original thinking. However, the opportunity and reward also exists for a win-win scenario for those insurers who consider a more evolved communications strategy underpinned by principles such as product simplicity and transparency.

I have spent a lot of time discussing the life insurance industry perspective. I would now like to briefly turn my attention to the non-life and reinsurance markets. The low interest rate environment also impacts these markets, albeit from a different perspective.

Observations from a Non-Life and Reinsurance perspective

The low interest rate environment is impacting the non-life and reinsurance business models in both an expected and unexpected manner. Non-life business is short-tailed relative to life business, thereby greatly reducing the interest rate sensitivity of the business. Even the interest rate risk inherent in the longer-tailed non-life business can be mitigated by prudent asset-liability management, leaving aside the exposure to unexpected claims inflation on some lines. Reduced investment income and the reduced premium income which will typically accompany a subdued economy will also place pressure on firms' business models. In that regard, we would expect to see an appropriate emphasis placed on cost optimisation programmes; we would be mindful of the temptation for firms to alter their strategic asset allocations in a 'search for yield'; We would regard continued underwriting discipline and improved risk management practices to be of paramount importance in dealing with the low interest rate challenges. We would also be mindful of the temptation which exists to pursue headline premium growth and market share in response to these challenges. The supervisory engagement model will be tailored accordingly where we see indications that such a strategy is being pursued.

The unexpected consequence of the low interest rate environment has come in the form of an influx of alternative capital into the reinsurance market particularly. This is the result of significant excess liquidity in the global financial system searching for better returns on uncorrelated asset classes. This influx of capital is having a major impact on current reinsurance market dynamics and has particularly pressured property catastrophe pricing. While sidecars and the insurance-linked securities market has been around for years, the nature of the current influx of capital represents a significant strategic challenges to the business model of reinsurers.

To take an example, 2011 featured $110bn of insured losses through various catastrophes. Reinsurers have taken $50bn of those. One might have assumed that this would have been a sufficient catalyst for reinsurance rates to harden. These rate increases did not materialise. It turns out they were the wrong kind of losses; too many, and too spread out. A single event causing more than $100bn of losses would probably have led to a change in behaviour, but a series of events in Australia, Japan, New Zealand, Thailand and the US were not sufficient in themselves.

It also appears that positive momentum in reinsurance pricing is difficult to maintain. While there were some rate increases in 2012, the capital markets appear to move very quickly to take advantage of opportunities, preventing rates rising by much. This is reflective of the nature and the scale of quantitative easing in recent years. With the influx of capital into the reinsurance markets, the traditional reinsurers are finding the going very tough and unable to push through the rate increases they might otherwise like to.

This isn't limited to just reinsurance markets. The Lloyds market has seen external sources of capital enter the market and partner with existing writers. The advent of 'blind underwriting' as it has been referred to, has raised concerns in some quarters and this will need to be monitored closely.

So, to summarise, the Property & Casualty business model is not without its challenges and many would argue that the industry now needs to target a combined ratio in the low to mid 90s to have a chance of delivering adequate returns. This leaves insurers with two choices: either continue doing business as is and lower target shareholder returns or bring their underwriting discipline to a new level and try to maintain the current targets.

In our business model discussions with firms, we have noted some recurring themes when speaking to them about their strategies and the challenges facing their businesses. I’ve noted a few of them here regarding the need for greater underwriting discipline going forward.

  • The need to get smarter at capital allocation – market dynamics require firms to invest more in sophisticated capital modelling and risk governance, leading to smarter capital allocation, clarity around risk appetite resulting in better underwriting, pricing and entry and exit decisions as profitable opportunities are more easily identified;
  • Avoiding the temptation to significantly increase risk on the asset side of the balance sheet and remembering that the client is buying the insurer’s underwriting expertise, not their investment management expertise;
  • The need to take greater control of pricing strategies: underwriting cycles in different lines and geographies are less correlated than they used to be, meaning that it is increasingly difficult to use exceptional losses from one event to justify raising prices in unrelated classes or geographies;
  • The need to recognise that the underwriting cycle may not be as pronounced as it has been historically due to the influx of alternative capital; and
  • The need to make the most of data – the real competitive advantage exists for those companies that can capture and analyse data to get a more sophisticated view of the business they are writing.

From the prudential point of view, we continue to pay close attention to firms' underwriting discipline. A continually soft market with lower investment returns with over-capacity reflects a new norm for insurers and reinsurers. Insurers and reinsurers alike recognise the need for greater discipline, but may find it difficult to adhere to that discipline in the face of the challenges of the soft underwriting cycle and their desire to maintain volumes and market share. It goes without saying that a focus on reserve adequacy is a critical part of the supervisory strategy in normal times for a non-life or reinsurance company. However, in light of the above, we will be amending our supervisory strategy to place a greater emphasis on reserve reviews and pricing adequacy. This programme will be rolled out in the remainder of 2013 and will continue into 2014.


At this stage, I would like to conclude my presentation. I have spoken at length about the many different ways in which the low interest rate environment is impacting firms' business models and how our supervisory strategy and engagement philosophy has been amended. The key messages that I would like to leave the audience with are as follows:

Ensuring that sufficient work is undertaken within your firms to deal with the challenges of a low interest rate environment;
Ensuring that pricing strategies reflect current market realities;
Ensuring that the implications of changes to asset allocations are fully understood both from the perspectives of credit quality and liquidity and the potential impact of a sudden spike in credit spreads;
Recognise early the need for some original thinking and product innovation, particularly in the areas of savings and retirement solutions. The rewards are there for product providers that pursue a strategy of product simplicity and flexibility, and give sufficient consideration to transparency and to their communications strategy; and
Finally, as we begin to move towards the implementation of Solvency II, to avoid the temptation of 'shooting the messenger'. The path to Solvency II implementation has not been without its twists and turns, but we need to recognise the benefits of its market consistent approach in increasing the transparency of the costs of investment guarantees in life assurance products, particularly those provided over long periods of time.
Thank you for your attention this morning.