A sharp jump in interest rates after a prolonged period of ultra-loose monetary policy could trigger solvency and liquidity problems at insurers and pension funds, the Bank for International Settlements has warned.
BIS, which promotes financial stability through the cooperation of global central banks, further warned that the resulting distress or failure of insurers and pension funds could permeate the wider economy.
Low interest rates in the aftermath of the global financial crisis have put pressure on firms' profitability and financial strength. In a July 5 report, the BIS's Committee on the Global Financial System said higher interest rates would improve the financial position of insurers and pension funds, because they suffer from so-called negative duration gaps — low discount rates triggered by low interest rates boost the valuation of liabilities to a greater extent than assets.
But, it said, gains from an interest rate snapback could be cut or eliminated by efforts insurers have made to counteract the effects of prolonged low interest rates, such as lengthening the duration of assets and making riskier investments. Although riskier assets generate higher returns when rates are low, they result in larger losses if rates spike.
Furthermore, a jump in interest rates could mean more people cancel, or surrender, their life insurance policy, because surrender options built into some policies would become more attractive following a sudden snapback of interest rates. This would drain insurers' liquidity, and companies could also face additional collateral demands driven by losses on derivative positions, BIS said.
Distress at, or the actual failure of, particular insurance companies and pension funds could be transmitted to the broader economy through financial sector counterparties such as banks and/or stakeholders in the non-financial sector such as households.
Furthermore, troubled firms urgently seeking liquidity could amplify falling valuations through fire sales, it said.
The BIS report examined the financial stability implications of prolonged low interest rates, and compared this to a scenario of prolonged low rates followed by a sudden snapback.
Such a snapback could be challenging for all financial institutions, not just insurers, the report said.
Banks would likely face valuation losses on long-duration assets and credit losses on loans. Those in emerging markets could face "even greater challenges" if sharply higher interest rates in advanced economies triggered a reversal of capital flows and a sharp sell-off in emerging market assets, BIS said.