Thursday’s rate cut by the European Central Bank highlights the fact that low interest rates will prevail for the foreseeable future, and insurers’ earnings will face pressure as a result, says Fitch Ratings in a new report.
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Fitch says that the 25 basis point rate cut from the ECB “puts into focus the pressure on life insurers’ margins and earnings from low interest rates.” It notes that the ECB’s rate decision means long-term interest rates are expected to remain low, and says this will create challenges for insurers, which are exposed to interest rate risk through investment leverage, product guarantees and policyholder options.
“There has been sustained pressure on life insurers’ profitability for several years as their investment portfolios need to produce sufficient returns to meet the guarantees on their products. This problem is compounded for the majority of life insurers that have reduced the risk profile of their investment portfolios since the start of the crisis,” Fitch says, noting that insurers have increased investments in AAA-rated government bonds and reduced their exposure to stocks.
However, Fitch says that insurers may have to take on additional risk to cope with the effect of low returns. “This could include investing in higher margin instruments, which may lead to deterioration in credit quality and potentially inadequate pricing relative to risk. Alternatively insurers may extend the duration of their asset portfolio. This could lead to asset and liability mismatches that increase liquidity risk,” it suggests.