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Japan Credit Spotlight: Falling Rates Are Risky Business For Life Insurers

Japan Credit Spotlight: Falling Rates Are Risky Business For Life Insurers

(Editor's Note: This article is part of the "Japan Credit Spotlight" series, which discusses major credit trends for issuers and structured finance products in the country. )

Main Risks

The main risk factors companies in Japan's life insurance sector face continue to be market risks such as interest rate risk and equity risk.

S&P Global Ratings observes that some life insurers are purchasing super-long-term domestic bonds while selling mid-long-term domestic bonds to lengthen their asset durations to reduce interest rate risk.

To maintain their investment yields, on the other hand, life insurers need to convert some of the cash inflows they get from bond redemptions and coupon income from yen-denominated fixed investments to shorter-duration foreign bonds (see chart 1).

Thus, we believe interest rate risk is unlikely to improve in the short term.

In our view, exposure to equity risk will neither decline nor increase significantly given life insurers have not greatly increased holdings of domestic equities. This is despite the necessity of such holdings for general business needs and to maintain a certain amount of investment yield.

Declining yields on foreign bonds as Europe and the U.S. lower interest rates could gradually increase risks life insurers normally shun, such as credit risk and illiquidity risk.

The U.S. Federal Reserve Board cut its policy rate at its Federal Open Market Committee (FOMC) meeting in July because of fears of a recession. In addition, the European Central Bank's governing council in September signaled a resumption of quantitative easing, also due to concerns about a recession in the Eurozone economy. Amid such conditions, it is probable yields on foreign bonds will fall further as interest rates in Europe and the U.S. decline.

In our view, Japan-based life insurers will decide whether to increase their open positions in foreign currency-denominated bonds or hedge them after assessing the market and their investment yields minus hedging costs (see chart 2). We consider it probable that their foreign currency risk could increase temporarily.

To date, we have yet to see a sufficient-enough increase in alternative investments--such as speculative grade bonds, infrastructure fund investments, collateralized loan obligations, securitized products including bank loans, and real estate for investment--as to influence creditworthiness.

However, when life insurers see a further decline in investment returns from Europe and the U.S., where domestic life insurers have allocated funds, they could have no choice but to reallocate even more of their money to such asset classes.


Insurance-related margins underpin life insurance profits.   In our view, mortality and morbidity margins from stable policies in force will continue to underpin life insurers' profit bases. Comparatively high-yielding domestic public and corporate bonds bought in the past are maturing at a time when yields on European and U.S. bonds, as well as those on domestic bonds, are under downward pressure. Reinvestment of redemptions in this environment will squeeze investment yields.

On the other hand, average guaranteed rates of interest on policies in force have been declining, which will alleviate constricted investment margins due to lower investment yields.

All in all, insurers will continue to accumulate retained earnings after payouts to policyholders and dividends to shareholders, supported by stable insurance-related margins and still-positive though pressured investment margins, in our view.

A growing likelihood of an economic value-based solvency regime in Japan is driving insurers to strengthen their capital bases.   The Financial Service Agency's (FSA) fourth field test of an economic solvency ratio in June reaffirmed that the ratio is highly sensitive to market variables such as interest rates and stock prices. Moreover, discussion about the future introduction of a regulatory framework to recognize the solvency of insurers based on economic value continued to advance with an expert council holding its first meeting on the topic. The FSA's fifth field test is set to occur this year.

Amid these circumstances, Japan's life insurance sector continues to strengthen its capital base through accumulation of internal reserves and issuance of subordinated bonds in preparation for the future introduction of rules on economic value-based solvency. We see this trend continuing in the medium to long term.

Chart 1


Chart 2


This report does not constitute a rating action.

Primary Credit Analyst:Eiji Kubo, Tokyo (81) 3-4550-8750;
Secondary Contact:Toshiko Sekine, Tokyo (81) 3-4550-8720;

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