Interest rate risk, longevity risk and the solvency of life insurers

In this paper I assess the effect of interest rate risk and longevity risk on the solvency position of a life insurer selling policies with minimum guaranteed rate of return, profit participation and annuitization option at maturity. The life insurer is assumed to be based in Germany and therefore subject to German regulation as well as to Solvency II regulation. The model features an existing back book of policies and an existing asset allocation calibrated on observed data, which are then projected forward under stochastic financial markets and stochastic mortality developments. Different scenarios are proposed, with particular focus on a prolonged period of low interest rates and strong reduction in mortality rates. Results suggest that interest rate risk is by far the greatest threat for life insurers, whereas longevity risk can be more easily mitigated and thereby is less detrimental. Introducing a dynamic demand for new policies, i.e. assuming that lower offered guarantees are less attractive to savers, show that a decreasing demand may even be beneficial for the insurer in a protracted period of low interest rates. Introducing stochastic annuitization rates, i.e. allowing for deviations from the expected annuitization rate, the solvency position of the life insurer worsen substantially. Also profitability strongly declines over time, casting doubts on the sustainability of traditional life business going forward with the low interest rate environment. In general, in the proposed framework it is possible to study the evolution over time of an existing book of policies when underlying financial market conditions and mortality developments drastically change. This feature could be of particular interest for regulatory and supervisory authorities within their financial stability mandate, who could better evaluate micro- and macro-prudential policy interventions in light of the persistent low interest rate environment

Assessing Systemic Risk of the European Insurance Industry

This paper investigates the systemic relevance of the insurance industry. We do it by analysing the systemic contribution of the insurance industry vis-á-vis other industries by applying three measures, namely the linear Granger causality test, conditional value at risk and marginal expected shortfall, to three groups, namely banks, insurers and non-financial companies listed in Europe over the last 14 years. Our evidence suggests that the insurance industry shows i) a persistent systemic relevance over time, ii) it plays a subordinate role in causing systemic risk compared to banks. In addition, iii) we do not find clear evidence on the higher systemic relevance of SIFI insurers compared to non-SIFIs

Insurance Activities and Systemic Risk

This paper investigates systemic risk in the insurance industry. We first analyze the systemic contribution of the insurance industry vis-`a-vis other industries by applying 3 measures, namely the linear Granger causality test, conditional value at risk and marginal expected shortfall, on 3 groups, namely banks, insurers and non-financial companies listed in Europe over the last 14 years. We then analyze the determinants of the systemic risk contribution within the insurance industry by using balance sheet level data in a broader sample. Our evidence suggests that i) the insurance industry shows a persistent systemic relevance over time and plays a subordinate role in causing systemic risk compared to banks, and that ii) within the industry, those insurers which engage more in non-insurance-related activities tend to pose more systemic risk. In addition, we are among the first to provide empirical evidence on the role of diversification as potential determinant of systemic risk in the insurance industry. Finally, we confirm that size is also a significant driver of systemic risk, whereas price-to-book ratio and leverage display counterintuitive results

Asset-Liability Management with Ultra-Low Interest Rates

The present SUERF Study includes a selection of papers based on the authors’ contributions to the Vienna conference, jointly organized by SUERF, the OeNB and the Austrian Society for Bank Research. In reply to the financial crisis, the Great Recession and sovereign debt crisis, many central banks have pursued ultra-easy and far reaching unconventional monetary policies for several years. Yields on various bond classes – including euro area sovereign bond yields since the sovereign debt crisis has subsided – have reached extremely low levels. Prices on stocks and real assets have soared. In several countries, markets have been expecting a reversal of the interest rate cycle for some time now. As a result, the risk of – possibly substantial – price corrections in all these asset classes may be seen to have increased

Interest rate risk, longevity risk and the solvency of life insurers

In this paper I assess the effect of interest rate risk and longevity risk on the solvency position of a life insurer selling policies with minimum guaranteed rate of return, profit participation and annuitization option at maturity. The life insurer is assumed to be based in Germany and therefore subject to German regulation as well as to Solvency II regulation. The model features an existing back book of policies and an existing asset allocation calibrated on observed data, which are then projected forward under stochastic financial markets and stochastic mortality developments. Different scenarios are proposed, with particular focus on a prolonged period of low interest rates and strong reduction in mortality rates. Results suggest that interest rate risk is by far the greatest threat for life insurers, whereas longevity risk can be more easily mitigated and thereby is less detrimental. Introducing a dynamic demand for new policies, i.e. assuming that lower offered guarantees are less attractive to savers, show that a decreasing demand may even be beneficial for the insurer in a protracted period of low interest rates. Introducing stochastic annuitization rates, i.e. allowing for deviations from the expected annuitization rate, the solvency position of the life insurer worsen substantially. Also profitability strongly declines over time, casting doubts on the sustainability of traditional life business going forward with the low interest rate environment. In general, in the proposed framework it is possible to study the evolution over time of an existing book of policies when underlying financial market conditions and mortality developments drastically change. This feature could be of particular interest for regulatory and supervisory authorities within their financial stability mandate, who could better evaluate micro- and macro-prudential policy interventions in light of the persistent low interest rate environment

The effects of a low interest rate environment on life insurers : [version july 2014]

Low interest rates are becoming a threat to the stability of the life insurance industry, especially in countries such as Germany, where products with relatively high guaranteed returns sold in the past still represent a prominent share of the total portfolio. This contribution aims to assess and quantify the effects of the current low interest rate phase on the balance sheet of a representative German life insurer, given the current asset allocation and the outstanding liabilities. To do so, we generate a stochastic term structure of interest rates as well as stock market returns to simulate investment returns of a stylized life insurance business portfolio in a multi-period setting. Based on empirically calibrated parameters, we can observe the evolution of the life insurers' balance sheet over time with a special focus on their solvency situation. To account for different scenarios and in order to check the robustness of our findings, we calibrate different capital market settings and different initial situations of capital endowment. Our results suggest that a prolonged period of low interest rates would markedly affect the solvency situation of life insurers, leading to relatively high cumulative probability of default for less capitalized companies

Systemic risk in insurance: towards a new approach

During the last IAIS Global Seminar in June 2017, IAIS disclosed the agenda for a gradual shift in the systemic risk assessment methodology from the current Entity Based Approach (EBA) to a new Activity Based Approach(ABA). The EBA, which was developed in the aftermath of the 2008/2009 financial crisis, defines a list of Global Systemically Important Insurers (G-SIIs) based on a pre-defined set of criteria related to the size of the institution. These G-SIIs are subject to additional regulatory requirements since their distress or disorderly failure would potentially cause significant disruption to the global financial system and economic activity. Even if size is still a needed element of a systemic risk assessment, the strong emphasis put on the too-big-to-fail approach in insurance, i.e. EBA, might be partially missing the underlying nature of systemic risk in insurance. Not only certain activities, including insurance activities such as life or non-life lines of business, but also common exposures or certain managerial practices such as leverage or funding structures, tend to contribute to systemic risk of insurers but are not covered by the current EBA (Berdin and Sottocornola, 2015). Therefore, we very much welcome the general development of the systemic risk assessment methodology, even if several important questions still need to be answered

The Effects of a Low Interest Rate Environment on Life Insurers

Low interest rates are becoming a threat to the stability of the life insurance industry, especially in countries such as Germany, where products with relatively high guaranteed returns sold in the past still represent a prominent share of the total portfolio. This contribution aims to assess and quantify the effects of the current low interest rate phase on the balance sheet of a representative German life insurer, given the current asset allocation and the outstanding liabilities. To do so, we generate a stochastic term structure of interest rates as well as stock market returns to simulate investment returns of a stylized life insurance business portfolio in a multi-period setting. Based on empirically calibrated parameters, we can observe the evolution of the life insurers’ balance sheet over time with a special focus on their solvency situation. To account for different scenarios and in order to check the robustness of our findings, we calibrate different capital market settings and different initial situations of capital endowment. Our results suggest that a prolonged period of low interest rates would markedly affect the solvency situation of life insurers, leading to a relatively high cumulative probability of default, especially for less capitalized companies. In addition, the new reform of the German life insurance regulation has a beneficial effect on the cumulative probability of default, as a direct consequence of the reduction of the payouts to policyholders

Rising interest rates and liquidity risk in the life insurance sector

This paper sheds light on the life insurance sector’s liquidity risk exposure. Life insurers are important long-term investors on financial markets. Due to their long-term investment horizon they cannot quickly adapt to changes in macroeconomic conditions. Rising interest rates in particular can expose life insurers to run-like situations, since a slow interest rate passthrough incentivizes policyholders to terminate insurance policies and invest the proceeds at relatively high market interest rates. We develop and empirically calibrate a granular model of policyholder behavior and life insurance cash flows to quantify insurers’ liquidity risk exposure stemming from policy terminations. Our model predicts that a sharp interest rate rise by 4.5pp within two years would force life insurers to liquidate 12% of their initial assets. While the associated fire sale costs are small under reasonable assumptions, policy terminations plausibly erase 30% of life insurers’ capital due to mark-to-market accounting. Our analysis reveals a mechanism by which monetary policy tightening increases liquidity risk exposure of non-bank financial intermediaries with long-term assets