The resurgence of inflation risks and central banks’ response to rising prices has decidedly reversed a four-decade-long trend of falling interest rates, placing pension funds and life insurance companies in a challenging position when it comes to lliquidity and investmetn income.
According to the European Insurance and Occupational Pensions Authority’s (EIOPA) December 2023 Financial Stability Report published today, while higher interest rates hold the promise of increased investment income for insurers and pension funds in the long term, they also entail coping with losses on existing fixed income portfolios in the short term.
Life insurers, in particular, may also face higher surrender rates and lower new business as consumers may opt for non-insurance investments with higher perceived returns, the report noted.
The combination of geopolitical uncertainties, higher refinancing costs and reduced disposable household income due to inflation might tip the EU economy into recession in the coming months, it added.
“It sometimes feels like we are living in a period of permanent crisis,” said Petra Hielkema, EIOPA’s chair.
“Geopolitical tensions are at a level not seen for many years. We now have two wars, one in Ukraine and the other one in the Middle East, leading to suffering and uncertainty,” she said, adding that the recent pandemic also added to an increased fragmentation and polarisation of the European Union member states.
She also noted that inflation had reached “levels many knew only from books and interest rates rose with unprecedent speed while the outlook for economic growth is overshadowed by poor demographics and a winding back of globalisation”.
EIOPA’s Financial Stability Report takes a close look at several topics, including liquidity risks for the insurance sector, portfolio rebalancing after monetary normalisation, liquidity needs of occupational pension funds on interest rate derivatives, and the impact of past recessions on insurers and lessons for the future.
Globally, interest rates were in a downward trend since the early 1980s. This trend has now decidedly reversed – yields for 10-year German government bonds rose swiftly from -0.18 % at the beginning of 2022 to 2.56 % at the end of that year and to 2.84 % in early October 2023, according to the report.
This has been mirrored by an increase in the EIOPA Risk Free Rates which have a significant impact on the value of technical provisions and therefore the own funds of insurers.
The 20-year Risk Free Rate for the euro increased from 0.46 % at the end of 2021 to 2.77 % at the end of 2022 and to 3.21 % in September 2023. The spreads on EU sovereign bonds expanded in 2022 but have not changed much since then, it added.
Based on the euro yield curve, markets do currently not expect a return to the period of low yields. The exit from the long period of low rates means also heighted uncertainty about their future path.
“It is hard to overstate the importance of the changing interest rate environment for insurers (particularly life) and pension funds. Interest rates define the time value of money and the insurance and pension business is about paying premiums and contributions now to receive claims and benefit payments in the (sometimes distant) future,” the report stated.
The new environment affects insurers and pension funds through different mechanisms, EIOPA said. Insurers and pension funds are large holders of fixed income instruments. In the longer term, higher interest rates are positive for them as funds can be invested with higher returns. But in the meantime, insurers and pension funds have to digest substantial losses on their existing fixed income investments, the report continued.
“The complex and volatile environment poses challenges for the people working to reduce the risks to financial stability in the European Union. I think two elements can help us to cope with these challenges: first, we have to constantly monitor new and emerging risks and can never take things for granted,” Hielkema said, giving the example of the Silicon Valley Bank in the first months of 2023.
Another case were the events around LDI funds in the UK in 2022 where the volatility in the sovereign debt market reached levels that are more typical of a developing country. Finally, there are geopolitical tensions which might break out at any moment in unexpected areas, she explained.
“Second, we have to take a broad, holistic perspective on risks to financial stability. An example are protection gaps. Climate change may make certain risks uninsurable. But this is not only a consumer protection concern but might also have impacts on the wider economy and thus on financial stability if uninsured losses after a natural catastrophe inhibit the reconstruction,” Hielkema continued, giving pension gaps as a second example.
“Savings products with exorbitant fees are not only a concern from a consumer protection perspective. The resulting lower wealth of future retirees increases also the risk of conflicts about the distribution of resources and thus the risk of societal and political instability,” she said.
”So far, the insurance and pension funds sectors in the EU have proved to be quite robust. We do not have a crystal ball to know whether this will remain the case in future. But you can be confident that we will continue to pursue with all our energy our mission to preserve a robust insurance and pension industry to the benefit of all European citizens,” Hielkema said.
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