Protracted low interest rates may place the life insurance industry’s socio-economic role at risk. Mr Daniel M Hofmann of The Geneva Association traces how the current low interest rate environment could place the socio-economic roles of life insurers at risk.
Life insurers deliver three essential services. They protect against the financial consequences of biometric risks such as longevity and mortality; they provide savings and retirement solutions; and as large investors, they channel long-term funds to the corporate and public sectors.
The challenges of longevity risk
When talking about longevity risk, it is important to distinguish between individual and aggregate perspectives. From an individual perspective, longevity risk is defined as the ‘risk’ of a person living longer than the average life expectancy of his or her cohort. Insurers call it a specific risk that they mitigate through pooling and diversification.
From the aggregate perspective (insurers and public and private pension funds), the challenge of longevity risk arises from the potential misspecification of future mortality trends. This is a systematic risk that cannot be mitigated as easily as the specific longevity risk.
Ill-prepared to cope with old age
From the perspective of individuals, the financial predicaments associated with longevity risk are exacerbated by behavioural characteristics that make most people ill-prepared to cope with the burden of old age.
First, most individuals are not saving enough and tend to make poor investment choices. Second, they tend to underestimate longevity risk. Research has shown that subjective life expectations fall short of actuarial expectancies by roughly five and seven years for males and females, respectively. As a result, people tend to overestimate the value of their pension plans. They are under the impression that they are better protected than actuarial arithmetic reveals.
To this we must add the inconvenient implications of low interest rates. Life insurance products alleviate in part or in full the two most important concerns of retirees: first, having enough money to maintain a given lifestyle, and second, ensuring that they do not run out of money in retirement.
In that sense, life annuities are an essential ingredient in an optimal retirement portfolio, and insurers fulfil a critical social function in providing them. However, because customers tend to underestimate longevity risk, the actual demand for annuities keeps lagging behind what might be considered a societal optimum.
It will be a noble challenge for life insurers to help improve financial literacy and make a contribution to mitigating the financial consequences of longevity risk.
Funding the economy
Together with mutual funds and pension funds, insurers are the world’s largest institutional investors. According to the OECD, in 2016 global insurers held US$30.8 trillion in financial assets, of which more than $23 trillion were held by life insurers.
These amounts enable insurers to provide substantial funding to governments and the corporate sector. Moreover, as a result of stable premium cash flows and their long-term, liability-driven investment approach, insurers are a stable source of funding for the real economy. They play an important role in meeting long-term funding needs and, based on stable premium in-flows, their steady portfolio allocations contribute to financial market stability.
Reallocation of investment portfolios
Looking at German’s and Japanese’s life insurers’ investment portfolios, it is noted that the allocation of investment portfolios is fairly stable over the medium term.
However, when one looks further back in history, it was noted from the portfolio reallocation of Japanese life insurers,between 1980 and 2015, the share of loans in the portfolios shrank from 60% to 10%. At the same time, the share of government bonds expanded from 5% to 45%, a growth that picked up sharply after 2000 when the government incurred a swelling debt burden to stimulate the economy.
In insurers’ portfolios, government securities replaced corporate bonds, which is another way of saying that Japanese insurers withdrew from funding the real economy in favour of the government. Also striking is the growing share allocated to foreign securities. This potentially increased foreign exchange risk, although some or all of that risk may have been hedged or (as in the case of unit-linked products) passed on to policyholders.
Similar developments were observed in Germany. The share of government bonds held in investment portfolios more than doubled after the year 2000. This was in some part also the result of solvency regulations that kept capital charges on sovereign debt in EU countries at zero, thus providing an incentive for insurers to hold sovereign debt at the expense of other securities.
The result was the same as in Japan: a declining role of German life insurers in support of private sector activities, as evidenced in the strong decline of mortgage lending and in lending to banks. In other words, the German government was rather successful in displacing or crowding out the private sector.
To the extent that government spending went on consumption, such crowding out may have reduced the long-term growth potential of the German economy. One should also allow for the possibility that some changes in portfolio allocation may be attributed to a search for yield.
In Germany, the allocation to higher-yielding corporate bonds nearly doubled from 2.4% to 4.2% between 2011 and 2015. And Japan entered, and never escaped, the low interest rate environment in the 1990s, which is the time when the allocation to foreign securities began.
Thus, it appears that low interest rates had an impact on the portfolio allocation of Japanese and German life insurers.
Assessment and policy conclusions
The supply of and demand for life insurance products appears to show some degree of interest rate sensitivity.
Low interest rates made the supply of long-term savings products with guarantees an unattractive offer for insurers. They responded by adjusting guarantees on new products to the ‘new normal’ and emphasising unit-linked products.
The emphasis on unit-linked products entails a transfer of investment risk away from insurers to individual policyholders. In the absence of professional support, these individuals are not necessarily well equipped to manage and absorb this risk. This may contribute to policyholder vulnerabilities at some point, which could cause reputation risk for life insurers.
More worrisome is the risk that continued low interest rate pressure could force life insurers to move away from their unique role in the delivery of retirement savings solutions with asset protection. This would open a gap that cannot easily be filled.
In the longer term, the investment portfolios of life insurers appear to have been quite sensitive to interest rates. German and Japanese life insurers allocated a larger share of their portfolios to sovereign debt and foreign securities. This suggests that a prolonged period of low interest rates may, at least at the margin, impair the sector’s ability to provide long-term funding for the domestic economy.
Building blocks for policymakers to include
For the industry to extend its traditional socio-economic role in the future, policymakers must provide a conducive environment. Building blocks of such an environment may include:
- A stable macro-financial and regulatory environment that allows for long-term planning, reduces the risk of disruptive financial crises and promotes long-term savings;
- Regulatory, accounting and risk management frameworks that are viable under many different interest rate scenarios and properly reflect the life insurance business model. It requires in particular acknowledgement that life insurance liabilities are illiquid with very long durations. Insurers are therefore well-positioned to hold assets with a liquidity premium, thereby funding long-term investments in support of economic growth;
- The creation of new asset classes with durations that better match the long liabilities of life insurers. A
Mr Daniel M. Hofmann is Senior Advisor Financial Stability and Insurance Economics at The Geneva Association.