3. ANALYSIS ON PROFITABILITY
The low interest rate environment is, in principle, expect-
ed to impact both the balance sheet (i.e. solvency) and
profitability position of insurers. The implications on sol-
vency will be discussed in the next chapter. In terms of
income prospects, if market bond yields remain at very
low levels for asignificant period of time, this will have
an impact on insurer’s profitability in the medium to
long-term horizon. In fact, given that insurers hold fixed
income investments to alarge ex tent, significant amounts
of earned coupons and redemptions from matured bonds
will be reinvested at lower rates.
The eect of the income channel is magnified in the case of
life portfolios with high guarantees stemming from prod-
ucts sold in the past, as they require higher yields in or-
der to meet promises made during dierent market (yield)
conditions. Insurers have typically negative duration gaps
(i.e. longer duration for liabilities than for assets) and fac-
toring in the reinvestment at lower rates as well the eect
of high guaranteed rates due to old products, considera-
ble strain might be put on their profitability. Insurers hold
assets, bought in the past, yielding high coupons which
might compensate to acertain extent the overall eects
of low interest in the short to medium term, but because
of the negative duration gap surely not in the long term.
Understanding insurers’ future profitability is key because
once the expectation of a“low for long ” scenario is an-
chored there will be immediate eects on their net worth,
but also on their investment and underwriting behaviour.
This chapter discusses the eect of low interest rate envi-
ronment on insurers’ profitability, focusing mainly on life
portfolios. Amodel projection capturing reinvestment risk
with implications on profitability is analysed, under the
assumption of a“low for long” scenario, with the focus on
studying the convergence of the profitability of insurers’
fixed income portfolios towards yields currently observed
in the market. In addition, the extent of guaranteed rates
and the yields of insurers’ portfolios are discussed. Finally,
this chapter presents the additional challenges caused by
Covid-19 on the profitability of insurers.
Figure 3.1 shows that 5.94% (or 6.06%) of the government
bonds portfolio will reach maturity in 1 year (2 years) and
that in 10 years’ time insurers will replace approximate-
ly 60% of their government bonds portfolio. In Q4 2019,
bonds held were yielding, averaging across maturities,
acoupon of 3. 24%. The maturing bonds will have to be
replaced with new ones that will yield (YTM based on
market rates) very low rates; for example, bonds with 10-
year maturities will yield approximately 0.5% and bonds
with 14-year maturities approximately 1% . This could be
translated into the risk that investment yields fall below
guarantees for insurers causing lo sses and ultimately de-
cline in capital.
In the case of corporate bonds (Figure 3.2), 7.75% of these
will reach maturity date in 1 year. These bonds were yield-
ing acoupon of 2.72% and will have to be replaced with
bonds, which will yield (YTM current market rates) amax-
imum of approximately 1.5% for the longest maturity.
Based on the information presented in Figure 3.1 and 3.2,
it is possible to project insurers’ future bonds portfolio
cash-flows. The following are the simplifying assumptions
made in order to have atractable approach:
a) The market yields will stay as in Q4-2019 for the
next ten years. Additionally, other market conditions
such as credit spreads are assume d unchanged.
b) Every year the cash-flows generated (earned cou-
pons and bond redemption amounts) by the portfo-
lio are reinvested with maturities matching the cur-
rent maturity structure. As an example, if in Q4-2019
15% of the portfolio of government bonds has the
maturity above 14 years then the reinvestment will
be done accordingly.
c) Capital gains on bond positions are not realised.
d) The generated cash-flows are not distributed as
profits to shareholder s.
e) These are reinvested in the same asset class (e.g.
not in equity or others).
f) The focus is only on the financial aspect of the
profitability and potential gains stemming from in-
surance contracts are not taken into account.
g) Premium inflows are not considered.
IMPACT OF ULTRA LOW YIEL DS ON THE INSURANCE SEC TOR, INCLUDING FIRST EFF ECTS OF COVID CRISIS