Analysis on profitability

• Author: European Insurance and Occupational Pensions Authority (EU body or agency)
• Pages: 25-30

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 asignif‌icant 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 alarge ex tent, signif‌icant amounts

of earned coupons and redemptions from matured bonds

will be reinvested at lower rates.

The eect 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 dierent 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 eect

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 acertain extent the overall eects

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 eects on their net worth,

but also on their investment and underwriting behaviour.

This chapter discusses the eect of low interest rate envi-

ronment on insurers’ prof‌itability, focusing mainly on life

portfolios. Amodel 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,

acoupon 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 acoupon of 2.72% and will have to be replaced with

bonds, which will yield (YTM current market rates) amax-

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 atractable 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

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