What a difference a year makes. Just 12 months ago, most market participants, including S&P Global Ratings, were cautiously optimistic that the global economy would continue its recovery and that interest rates would begin the long journey toward normalization as central banks signaled or even took initial steps toward tightening monetary policy.
Alas, rate normalization appears to have suffered a false dawn; central banks have reversed course. The U.S. Federal Reserve has cut rates three times so far in 2019. The European Central Bank, meanwhile, announced a third round of targeted longer-term refinancing operations (TLTRO) in March and then cut rates and resumed its bond-buying program in September.
At the same time, trade tensions between major global economies such as the U.S., China, Europe, and Japan have continued to escalate, while domestic tensions such as Brexit and the impeachment process in the U.S. sowed further uncertainty.
The global economy therefore appears less resilient to financial shock than it was 10 years ago. The risk of recession in the U.S. has risen to an estimated 30%-35%, from 15%-20% this time last year. As we look to 2020, insurers face low interest rates, by now a familiar foe, for the foreseeable future.
In our view, credit fundamentals for rated European insurers remain strong and support our stable outlook on the sector. In particular, our ratings are still supported by insurers' robust capital positions. We expect these to be replenished by strong, diversified earnings, despite the increased pressure caused by low or negative interest rates. We anticipate that the pressure on earnings will gradually ease as long durations and the actions of insurers' management teams mitigate the effect of low interest rates.
For those insurers that can manage the low-rate pressure, the ongoing transition of the global economy presents a tremendous opportunity for the industry to demonstrate its value; but this would not be without risk. As the composition of the economy shifts from manufacturing companies to services and tech firms; from tangible assets to intangible ones, such as R&D and intellectual property; and as digitalization changes the way business is done, the nature of risk and the types of protection demanded from corporations and individuals will change. The advent of the sharing economy, the internet of things, and driverless cars are all examples of how insurers must rethink their products to evolve with the market.
Similarly, as the economy must shift toward a more environmentally friendly and sustainable version from carbon-intensive production and consumption, insurers should continue to act as investors and underwriters of this transition to help mitigate any potential volatility.
Global Credit Risks Weigh On Insurers
We believe that some of the top risks to global and regional credit conditions, particularly the implications of accommodative monetary policy in many major economies (see "Credit Conditions EMEA: Lingering In The Lowzone," published on Sept. 30, 2019) will erode profitability, largely by weighing on investment returns. European insurers should also see slower premium growth and penetration growth in 2020. (A country's insurance penetration is measured by dividing its gross premium written by its GDP.) Although it is not our base case, should a recession or a sharp turn in the credit cycle materialize, we expect insurers' balance sheets to feel the pain through asset price volatility (see table 1).
Macroeconomic Risks Top The List For Insurers
Global summary: Rising political tensions and heightened uncertainty weigh on business and consumer confidence and risk undermining global growth prospects. The lengthening list of disputes includes the U.S.-China trade-technology war, Brexit, delayed ratification of the U.S.-Mexico-Canada agreement, U.S.-Iran tensions, recent attack on Saudi oil facilities, and the Japan-Korea technology dispute.
Insurance summary: Trade wars and slower growth are unlikely to have a significant direct effect on insurers, other than those with a heavy presence in marine and trade credit lines. However, slower economic growth, which we forecast for all major economies, is one of the factors contributing to our expectation that both insurance premium and penetration will see little growth in European insurance markets.
Mature markets negative feedback loop
Global summary: We anticipate that renewed monetary policy stimulus in the U.S. and Europe and continued accommodative policy in the U.S. and Japan will likely prevent a global recession, but the risk is on the rise. We now estimate the likelihood of a U.S. recession at 35%, up from 20% in 2018, and we believe that markets that rely heavily on trade with the U.S.--such as the U.K., Europe, and many emerging markets--will suffer if the U.S. economy sees a prolonged downturn.
Slowing global GDP growth, inverted yield curves, and our expectation of low interest rates for the foreseeable future continue to sow the seeds for the next financial crisis as investors hunt for yield. Credit spreads may not reflect the true risk of assets, leading to overvaluations and further debt accumulation.
Insurance summary: Low interest rates, tight spreads, and inverted yield curves eat into insurers' profitability and increase asset-liability mismatches, particularly for life insurers. Ratings suffer in volatile markets--a recession or rapid turn in the credit cycle that causes asset volatility can impair balance sheets.
Global summary: Environmental risk factors related to greenhouse emissions, water, and waste have become more urgent global issues. The challenge, from a credit viewpoint, is how to manage the asymmetric risks and related costs attached to climate change and regulation.
Global summary: Climate change presents both a threat and an opportunity to insurers. The main risk for the insurance sector is that more claims will follow the increasing severity and frequency of natural disasters. The industry also faces indirect exposure through its investment activities, balanced against its low use of physical infrastructure and facilities. That said, through their roles as investors, risk managers, and risk carriers, insurers can play an important role in helping to mitigate the impact of climate change and supporting the global economy's transition to lower carbon emissions.
Global summary: Increasing technological dependency, global interconnectedness, and rapid technological change means that cyberrisk has systemic dimensions.
Global summary: Cybersecurity also poses a threat and opportunity to insurers. Companies bear the risk of incurring cyberattacks, particularly because of the amount of personal health and financial information they hold on their policyholders. On the other hand, with economic losses from cyberattacks totaling more than $600 billion in 2018, there is huge demand for protection from cyberrisk. Although this pool of risk represents an opportunity for a significant new line of business for insurers, the nature of the risk is hard to define and constantly evolving. Insurers must tread with caution here.
Familiar Pressures Are Persisting
Low interest rates are here to stay. Both the U.S. Fed and the ECB reversed course in monetary policy terms during 2019, which came as an unwelcome surprise to many market observers, including us. Instead of beginning the long road to interest rate normalization, we now expect rates to remain low for several years. For example, we forecast that German long-term yields will stay negative until 2021.
Insurers in European markets have varying degrees of exposure to the risks presented by prolonged low rates, which include interest rate risk, asset-liability mismatch risk, and longevity risk. Exposure is influenced by the absolute level of rates and yields in each market. In addition, the insurance product structures on offer, the composition of insurance groups, regulatory behavior, and policyholder demands will differ from market to market (see table 2).
Life Market Characteristics
Risk levels differ between markets due to variations in product characteristics
|Life guarantees and IICRA||Guaranteed rate back book||Maximum guaranteed rate on new business||Average return on investment (all in)||Average reinvestment yield||Share of traditional life reserves||IICRA|
|U.K. With Profit||3%-4%||N/A||3%||2%||28%||Low|
|*2.2% indvidual, 2.6% group life. §2.8% excl. ZZR. †0.25% for non-mandatory group life.|
Since 2009, when interest rates in Europe fell following the global financial crisis, life insurers in the region have been making strategic decisions intended to enable them to withstand the pressure. Table 3 lists the strategic options available to insurance management teams aiming to address their exposure to low interest rates.
Life Insurers Have Levers To Pull
|Mitigant||Benefit||Risk / Limitations|
|Lower guaranteed rates on new business||- Lowers future obligation and average guarantee of back book||- Slow to realize the impact - Less competitive guarantee rates reduce the attractiveness of the product, increasing lapse risk|
|Lower crediting rates (on top of guaranteed minimum) on in-force business||- Reduces current and future obligations||- Benefit slow to materialize, though faster than above - Reduces customer loyalty - Increases lapse risk when yield environment improves|
|Shift asset allocation to generate excess returns||- Can boost profitability / ability to cover future obligations - Investing in longer duration assets can help reduce asset-liability mismatch||- Increases risks in other areas, e.g., credit, liquidity, or FX - Incurs higher capital charges - Limited by depth of capital markets|
|Disposal of back books||- Reduces future obligations and significant capital requirements - Immediate impact||- Sale valuation may be unattractive, possibly leading to loss upon disposal - Reputational risk - Some regulators are reluctant on disposals, limiting buyer pool|
|Diversify life insurance product offerings and/or stop writing any traditional type products||- Diversifies earning streams away from reliance on investment returns toward fees - Transition of savings policies to unit-linked and protection can reduce future obligations and capital requirements - Certain products can share potential losses with policyholders||- Policyholder appetite for different products may be limited - Protection and unit-linked space overcrowded|
|Diversify outside of life (e.g. health, P/C, asset management)||- Diversifies earning streams away from reliance on investment returns to fees (AM) or underwriting (health, non-life)||- Brings competition from incumbent players who often have better scale and expertise - Slow to build significant operations that diversify the life risk - High cost of entry to new lines or sectors|
|Boost policyholder or regulatory reserves (e.g., PPE, ZZR)||- Stores buffer to stabilize balance sheet - Can help smooth crediting rates to policyholders||- Burden to current year profit|
|Adjust hedging strategy||- Can reduce exposure to interest rate or spread risk - Can reduce asset-liability mismatch - Can reduce foreign exchange exposure||- Cost of hedges can be prohibitive in unfavorable markets - Creates dependence on being able to roll hedges - Increases profit and loss volatility in adverse markets|
Insurance companies have been using many of these options, in one combination or another, to insulate themselves from the effect of low rates. Low investment returns have also forced non-life insurers to focus on lowering expenses and push for adequate technical pricing. This has helped to support operating performance in Europe. We also believe it has helped to solidify reserves, especially given that local inflation has been depressed over the same period.
Life insurers in all markets are taking active steps to shift their portfolio of insurance products away from rate-sensitive guarantee business. Most life companies have made significant cuts to new business guaranteed rates--a trend that began over a decade ago, in some countries, like France.
Other measures to accelerate portfolio shifts include actively offering customers that have traditional products the opportunity to switch to a unit-linked product, as in some Nordic markets. Others have allowed old books of business to be sold or to go into run-off, as in Germany or the Netherlands. Insurers are also increasingly comfortable with offering asset management type products--a shift that is most pronounced in the U.K. Others offer savers a guarantee of 0%, and may offer that on only part of the paid-in premium, typically 80%-90%. For savers facing negative interest rates, a guarantee that they will retain at least 80%-90% of their paid-in premium may be sufficient.
In 2011, the German government introduced an additional reserving requirement (ZZR) which acts to enforce the prefinancing of future guarantee payouts. This had a material effect on the remaining burden for life insurers (see "Proposed Reform Makes ZZR A Less Bitter Pill For German Life Insurers," published on Oct. 8, 2018), but should help to protect policyholders. The ZZR has had quite an effect on insurers: The average guarantee in the back book in Germany has fallen to 1.9% today, from about 3% just four years back.
Despite these actions, low interest rates remain a risk for insurers. Average coupon rates on bonds are still declining by about 20 basis points per year in many markets, further undercutting insurers' returns on investment. We anticipate that our rated universe will generate a positive investment spread over the next three-to-four years (that is, returns on investment will be greater than guaranteed obligations on insurance policies. We see this as an important lead indicator for our ratings. However, we cannot rule out the risk of negative spreads further down the line, if insurers cannot shift their profiles quickly enough.
Earnings Still Reinforce Stable Ratings
We anticipate that premium growth and insurance penetration will both remain largely flat in Europe through 2020. In large part, we attribute this to the mature nature of these insurance markets, and our expectation that economic growth will stagnate. In most European markets, non-life premium growth is likely to outpace the growth of life premiums.
Despite slower growth in the top line, we anticipate that earnings in EMEA will remain positive and will help to sustain insurers' robust capital positions, which in turn supports our ratings, especially on non-life insurers.
Non-life insurers feel the pinch
Although low rates will hit non-life insurers' investment returns, this has merely sharpened their focus on profitable underwriting. Given that most lines of business have seen a rise in premium in 2019, a trend that should continue in 2020, we expect combined ratios to remain below 100% in EMEA. (Lower combined ratios indicate better profitability. A combined ratio of greater than 100% signifies an underwriting loss.) We forecast that in many markets, combined ratios will be about 95%, or even lower, in 2020. We also assume that technical margins will remain very healthy in 2020, except for in the extremely competitive U.K. P/C market.
Life insurers feel a hammerblow
Life insurers, by contrast, will find that low interest rates and investment yields put their earnings under significantly more pressure. Those that have a large savings business will be hit particularly hard. Even though low interest rates will eat into investment returns for life insurers, we still expect returns to outpace policy obligations and that return on equity (ROE) will be 7%-11% in 2020. The squeeze on earnings will unfold at a slow pace over the duration of life liabilities; in many cases, this means it will take decades.
Diversification offers a cushion
Many of Europe's largest life insurers actually benefit from the more favorable operating environment in the non-life segment--most life insurers are composite players that write both life and non-life insurance. Chart 4 demonstrates the benefit offered by being a composite company, compared with being a pure life insurer.
Regulatory And Accounting Changes Demand Further Attention
Regulators and accounting standard setters continue to shift the ground on which management teams are supervised and reported. Insurance management teams face significant developments to Solvency II, and the implementation of the International Capital Standard (ICS) and International Financial Reporting Standards (IFRS) standards 17 and 9 in the next 24 months. They will have to allocate significant time and attention to ensuring a smooth transition.
Solvency II gets an update
At year-end 2018, the median Solvency II ratio for all types of insurers (life, non-life, and composites) stood above 200% according to the June 2019 financial stability report from the European Insurance and Occupational Pensions Authority (EIOPA). In addition, the interquartile range for all types of insurers stood above 150%. This denotes a generally healthy backdrop. Nevertheless, it could come under pressure through a combination of lower interest rates and more-restrictive regulatory guidelines following the 2020 review of Solvency II.
On Oct. 15, 2019, EIOPA published a request for comment on proposals on a number of Solvency II assumptions, of which the most significant are:
- Change in the way companies determine the ultimate forward rate (UFR), the discount rate used to value insurers' liabilities;
- Change in the calculation of the volatility adjustment (VA), which is used to mitigate temporary market price volatility;
- Increase the calibration of the interest rate risk shock, in line with EIOPA's previous proposals laid out in 2018;
- Introduce macroprudential policy tools for national regulators to better apprehend systemic risk; and
- Establish a minimum harmonized resolution and recovery framework for insurance.
It is too early to anticipate the potential impact of the combination of the proposed changes. Nevertheless, in 2018, EIOPA provided some insights into its new proposal for the interest rate risk submodule, known as the shifted approach, in which it assumed stress scenarios would include negative interest rates. It estimated an average reduction for life insurers of 14 percentage points, using the Solvency II standard formula.
The impact of this calibration does not seem to be material on average, given the current starting point of Solvency II ratios. That said, we expect that this potential recalibration, combined with the proposed changes to UFR and VA, could have a more severe impact on life insurers in Northern Europe that typically have long-duration contracts (see table 1). We won't know the extent and materiality of changes to the Solvency II framework until the end of 2020, when the European Commission (EC) has given its opinion on EIOPA's final recommendations. EIOPA is due to publish its final recommendations by June 30, 2020.
Confidential reporting for ICS 2.0 starts soon
In addition to the update to Solvency II, there is a long list of internationally active insurance groups domiciled in Europe, which might be on the list of the International Association of Insurance Supervisors (IAIS) for the ICS. We expect IAIS to pass ICS 2.0 in November 2019, during its annual conference in Abu Dhabi. ICS 2.0 will then undergo five years of confidential reporting, during which it will not be a prescribed capital standard. We do not expect it to increase the capital requirement for the insurers we rate (see "G-SII Regulation: For Global Insurers, A Long Tunnel With Dim Light Ahead," published March 16, 2016). ICS 2.0 is most likely to cause issues if it does not move in tandem with Solvency II, and we have yet to receive further clarification on the use of internal models under ICS 2.0.
The rating impact of the changes to Solvency II and ICS is likely to be minimal. However, regulatory and accounting updates will absorb management capacity, carry material costs, and might indicate inconsistent messages to external stakeholders. Solvency II and ICS may yet move in different directions.
The EU has yet to endorse IFRS 17
The International Accounting Standards Board (IASB) has now completed its consultation on the IFRS 17 amendments, which had an original implementation deadline of 2021. This marks another important step in insurance accounting. It is not yet clear what the EC will decide regarding endorsing this standard within the EU. The EC's view could set the timeline for many other regions globally, although the standard might be applied as soon as 2022 or even earlier in some regions within Asia-Pacific.
Insurers' level of preparedness for IFRS 17 varies sharply. Some are well advanced and would have been ready for the original 2021 deadline; other projects are somewhat immature and will need more time to arrive at a fully compliant state.
Despite the material investment accounting and IT required, we do not expect IFRS 17 to have a direct impact on any of our insurance ratings. Nevertheless, a significant amount of management capacity is bound in this project, and again there are some open questions with regards to the transition process (see "IFRS 17 Highlights How Low Interest Rates Hurt Insurers," published on Sept. 18, 2019).
Insurance Can Make A Crucial Contribution In ESG Terms
Over the past 12 months, we have a seen a sea change in attitudes toward environmental, social, and governance (ESG) factors. The topic has become mainstream, with investors, the media, regulators, and the general public taking more interest in the subject.
Although they do not typically label their activities as ESG, insurers have always worked on understanding environmental risks, which form part of their pricing for natural catastrophe exposure. They also incorporate social factors like demographics, longevity, and mortality in their planning, and under prudent regulation display high standards of governance. In their public disclosures, many insurers stress how they incorporate ESG factors in their investment activities. Some have developed a consistent view of ESG factors in their insurance operations, but not all.
We consider ESG factors relevant for insurers and our ratings on them (see "The Role Of Environmental, Social, And Governance Credit Factors In Our Ratings Analysis," published Sept. 12, 2019). From time to time, ESG factors have led to rating actions (see "How Environmental, Social, And Governance Factors Help Shape The Ratings On Governments, Insurers, And Financial Institutions," published Oct. 23, 2018).
Many insurance companies have responded to the mainstream interest in ESG by publicly bolstering their ESG credentials by announcing moves such as:
- Amending their investment and underwriting exposures to the coal sector or other carbon-related industries;
- Signing up for the UN's Net-Zero Asset Owner Alliance; or
- Committing to becoming carbon neutral by 2050.
To be fair, many companies have viewed ESG factors as part of their investment and underwriting operations for some time; they just haven't made major announcements about this aspect of their operations.
In our view, the insurance industry is uniquely placed to influence understanding of and response to ESG factors, not only through the roles they play as employers and investors, but also through their positions as risk carriers and risk managers. Insurers could help in understanding the economic exposure and how to appropriately mitigate and manage those risks.
The industry's intrinsic exposure to environmental and social risks is relatively limited, especially compared with other corporate sectors that have more significant carbon footprints or need to manage greenhouse gas emissions or the social implications of their products. That said, insurers have a role as risk carriers and investors in many of these industries. Therefore, they assume their counterparties' exposure to these risks through their investment portfolios and insurance liabilities.
Mind The Gap
As the world's wealth grows, so does the amount of insurable assets. Insurance penetration, however, has lagged behind. The underinsurance has created a protection gap, estimated by the Geneva Association, an insurance think tank, at over $100 trillion. This presents a clear opportunity for insurers to exploit their roles as asset owners to support investment in reducing the gap and, as part of their role as risk carriers and risk managers, to help bring insurance thinking and solutions to help close the gap.
One of the most obvious ways that insurers can take advantage of the growing opportunities presented by ESG factors is to build on their social responsibility to help close the gap. This can be achieved by helping to develop financial solutions, such as risk pools or catastrophe bonds, that provide protection to individuals and organizations and mitigate the financial and economic impact of significant loss events. Insurers can also play a role by investing in infrastructure that builds a community's resilience to extreme climate events, thereby mitigating the impact. There are some great examples of these solutions in action, but more can be done to bring insurance to the forefront of the minds of policymakers. Success in this arena will not only help to build societal resilience, but will also benefit insurers' reputations and bring new opportunities for other business as economies grow.
Opportunities Are Hiding In The Low Interest Rate Cloud
Interest rates will afflict the European insurance industry for some time to come. Insurers, particularly those with significant life insurance operations, will have to reassess their strategy and composition to withstand this continued challenge. That said, we anticipate that European insurers will display solid performance and maintain strong balance sheets and capitalization for the next two years. Over the longer term, persistent low yields could cause downgrades if management teams don't take the proper action today.
Management will also have to adapt to costly changes such as the move to IFRS 17 and ICS, but these are unlikely to have a direct rating impact. For those that can adapt, there are ESG and other opportunities to seize. New risk pools and changes in the way consumers demand protection and advice could make the longer-term future bright.
This report does not constitute a rating action.
|Primary Credit Analysts:||Dennis P Sugrue, London (44) 20-7176-7056;|
|Volker Kudszus, Frankfurt (49) 69-33-999-192;|
|Secondary Contact:||Simon Ashworth, London (44) 20-7176-7243;|
|Additional Contact:||Insurance Ratings Europe;|
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