Insurers have faced challenges operating in a low interest rate environment for some years. This blog post picks out some of the key challenges of the low interest rate environment faced by insurers as described in the Milliman paper "The Low Interest Rate Environment: Key challenges for life insurance companies". Challenges also bring opportunities and insurers have proved to be innovators in responding to customer demand by changing product design and but also adapting their own investment strategies and asset and liability management in this environment.

Economic background

Persistent declines in interest rates have been observed in multiple economies from early 1990s to the present. In more recent times, the onset of the Covid 19 pandemic resulted in negative shocks to the demand of and supply sides of worldwide economies. 2021 saw the rebound of gross domestic product (GDP) and inflation which had been kept at bay for many years started rising. There are two main views on whether the inflation we are currently experiencing will persist.

• The first view is that inflation increases are transitory due to temporary demand and supply imbalances because of the reopening of economies
• The second view is that cost pressures on both commodities and wages will lead to prolonged inflation above central bank targets

In the US, the Federal Open Market Committee (Fed) moved to a flexible average inflation targeting approach of 2% average inflation over time. In the UK the Bank of England stated that they will not tighten monetary policy until there is clear evidence of sustainably achieving a 2% inflation target.

The pandemic has also increased levels of government debt as governments provided supports to families. Quantitative easing in the UK led to a lower cost of debt servicing but the shortening of effective maturities leaves public debt vulnerable to increases in interest rates.

Other things equal, if increases in inflation persist, it is more likely that interest rates will rise and if inflationary pressures reduce, interest rates may retain their current levels. Central banks have a mandate to target inflation but also allow to support the real economy. This may indicate an appetite to keep rates low in the short and medium term to support economic recovery. As there are large levels of uncertainty around interest rate drivers, there may be an increase in the volatility of interest rates going forward.

Complexities on interest rate management

Different interest rates being used across the financial and solvency reporting bases to value long term liabilities makes managing interest rate hedging complex. On the regulatory side, Solvency II values liabilities using discount rates based on the risk-free curve extrapolated to an ultimate forward rate. Economic valuations may use discount curves based on market rates and finally, there is the IFRS 4 balance sheet, where the liabilities are calculated using a fixed interest rate. Low interest rates have widened the gap between the reporting regimes but the introduction of IFRS 17 to replace IFRS 4 which will use market consistent discount rates instead of fixed interest rates should partially close that gap.

Lower interest rates have had a negative effect on IFRS income statements. Assets have lower durations than liabilities and when they matured the proceeds were reinvested at lower interest rates. Insurers moved to asset allocation to a wider asset range, but improved investment return is booked immediately under IFRS4 while the operating return is spread over time.

In Japan, interest rates have been low for over 20 years, so the country makes a good case study for analysing the impact of low interest rates on actuarial assumptions. Guaranteed interest rates on policies have been falling as a result of low interest rates and lower lapses and surrenders have been observed as in-force polices have higher guaranteed rates than those offered to new business. Policies incepted prior to 1996 place a large burden on profitability and contribute to declining lapse and surrender rates. Policies written after 2000 have lower guaranteed rates and are more susceptible to lapse and surrender risk due to interest rate fluctuations. The use of dynamic lapse and surrender rate functions are low as Japan has been in a prolonged low interest rate environment for some time and it is difficult to calibrate models based on actual experience rates. As the post Covid 19 future remain uncertain and the possibility of interest rates rises has begun, the use of dynamic lapse and surrender rate functions may need to be examined. The accuracy of the duration and convexity of liabilities of the liabilities to be hedged is critical.

Other challenges on investment and ALM strategies

Government and corporate bonds make up an important part of the asset portfolios used by insurers to back liabilities from non-linked insurance products with guarantees. Such policies are largely closed to new business in European and UK markets. Lower yields on bonds caused a drag on profits leading to insurers to search for yield elsewhere. This has led to a trend in moving investment towards non-publicly traded debt and investing in foreign currency assets to back domestic liabilities. Investing in privately traded assets requires specialised investment knowledge and involve complex asset structuring. Due to illiquid and idiosyncratic nature of the assets, they can offer investors attractive returns.

Investing in foreign currency assets can offer diversification benefits and additional yield albeit with extra hedging costs to manage currency risk. This search for yield comes at a cost. Hedging costs and extra collateral may be needed and the liquidity profile of the insurer can change.

Product development

Low interest rates have also influenced features of life insurance and pension product design in many countries. In Japan, there has been a marked shift between savings type products with guarantees to more protection type products that are less impacted by guarantees. Prior to the 1990’s there was a large endowment and whole life market. In the 1990’s with low interest rates, savings products shifted to be more protection like such as term products with riders. In the 2000s, medical insurance, variable annuities and single premium whole life products sold through bank channels became more popular. Since 2010s after the financial crisis, variables annuities have waned in popularity and increasing sales of foreign currency denominated annuities and whole life insurance have become popular.

A major trend in product design has been shifting investment risk from insurers to customers by removing products with guarantees from the markets. Less with profit style products which insulated customers from market volatility are being sold and products that allow more investment freedom are more popular. In the UK, with profits business has declined and although not solely due to lower interest rates, these have been a contributary factor. This has led to a growth in unit linked business allowing the customer to freely choose investments. Private pensions have moved from defined benefit to defined contribution which are similar to unit linked savings products. This change can lead to a diversion of outcomes for individual customers due to small differences in timing of their investments.

The low interest rate landscape has also affected the asset allocation of with profits business where equity backing ratios where in excess of 50% in the late 1990s and have reduced to around 30% since 2010s. This shift was due to capital pressures from the transition to mark to market valuations and the rising cost of guarantees as interest rates declined.

Low interest rates have also put charges levied by insurers into the spotlight. Charges reducing the returns to customers are more tolerable when yields are high but less tolerable when returns are low. In the UK, there are two caps applied to charges on stakeholder pensions and auto-enrolment pensions.

Cost vs value for money and the road ahead

The insurance industry has many strengths in adapting and surviving the low interest environment. The shift in product offering shows willingness of insurers to adapt to changing customer needs. Insurer’s ability to offer guarantees is a clear differentiator from competitors such as asset managers. External incentives also exist such as tax advantages for buying an insurance policy or compulsory insurance products. Insurers have strong existing infrastructures and relationships for building on their customer base.

With strengths, there are also weaknesses that may limit innovation and undermine the industry’s future role. Regulatory regime changes such as the introduction of IFRS 17 and Solvency II have increased implementation costs and increased capital requirements on some products. Legacy products and systems can be costly to maintain. Criticisms round customer communications on product benefits and limitations have been directed to insurers in the past and effective communication will likely be a key driver for success. As there has been a shift to products offering simpler products, insurers may need to compete with large asset managers whose scale mean that they can offer their products at lower cost. The shift from complex to simpler products may lead to reduced innovation of insurance products. With the growing popularity of customers investing in passive funds, this also opens up the potential for growing systemic risk as many funds need to execute similar trades when markets move.

There are many opportunities for insurers in this environment. Aging populations may mean a greater demand for insurance and pension products. The growing use of big data is helping insurers to understand their customers better. Customer awareness of environment social and governance issues has never been higher and offers a great opportunity for insurers to incorporate “green” or “sustainable” criteria into investment strategies.

There are challenges that insurers will need to navigate. Populations seem likely in the long term to decline. GDP growth has been stagnant in many countries leading to less ability of customers to pay for insurance products. Increases in inflation may make consumption more attractive at the cost of reducing savings. There may be government policy changes that shift advantages of insurance products to banks or other financial institutions.

Regardless of the road ahead, courageous decision making from insurers in navigating this environment will be required.

Milliman research paper

The full research paper can be found on Milliman’s website. The paper describes the economic background of low interest rates using US, UK and Japanese markets as examples. It also details the impact low interest rates have had on asset management, investment strategies and the evolution of product design. Finally, the paper discusses the road ahead for insurers including opportunities for growth.