Usefulness of the article :this article analyzes the potential impacts of a sustained rise in inflation in France on the business of life insurers.
Summary:
- The COVID-19 pandemic has indirectly caused inflation to rise in 2021, and it cannot be ruled out that this trend will continue for several years.
- A sustained rise in inflation and interest rates could cause disruption, potentially posing risks to life insurance assets.
- Without any « sudden » change in the European Central Bank’s strategy, these risks would remain limited. On the contrary, they could lead to new opportunities for life insurers, who would no longer be hampered by the low interest rate policy that has been in place for several years.
- Other risks (balance sheet imbalances, declining profitability, etc.) may also affect the business of French life insurers, but to a lesser extent.
The decade from 2010 to 2020 was marked by low inflation in all developed economies, particularly in Europe. Despite the multiple monetary measures taken by the European Central Bank (ECB) to stimulate the economy in the wake of the crisis, inflation remained at an average level of 1.1% per year between 2010 and 2020 in the euro zone, compared with 2.1% between 2000 and 2010.
The COVID-19 pandemic that began in early 2020 changed the situation: in December 2021, prices rose by around +5% year-on-year, a 25-year record for the eurozone. They are expected to continue to rise by around 2-3% per year in the coming years, according to the ECB’s « central » scenario. The rise in inflation[1] can be explained by several factors, such as the increase in raw material prices, particularly energy prices, the imbalance between supply and overall demand following the « reopening » of economies and, to a lesser extent, the strength of the dollar against the euro, which is causing « imported » inflation.
Life insurers are closely monitoring inflation trends, as any change in inflation could have a significant impact on both their balance sheets and their income statements. The aim of this article is therefore to analyze the main effects of a sustained rise in inflation in Europe on the business of French life insurers: what are the potential impacts? Is this a risk or an opportunity for them? The analysis will focus mainly on euro-denominated life insurance contracts[2], since in the case of unit-linked contracts[3], the risks are in most cases borne by the insured.
1. The specter of rising interest rates looms over French life insurers
1.1) Risks associated with rising interest rates
A sustained rise in inflation in the eurozone could lead to significant economic decisions, such as a change in the ECB’s monetary policy, which would bring about major macroeconomic changes. If current inflation levels were to persist in the medium term, the ECB would initially be forced to reduce its monthly asset purchases before considering raising key interest rates (refinancing rate, marginal lending facility rate, and deposit facility rate) to maintain control over prices, which is the main objective of its mandate.
For the time being, the Frankfurt-based institution has kept its key rates unchanged, but a first step towards monetary tightening was taken on December 16, 2021, following the announcement of a « gradual reduction in the pace of asset purchases over the coming quarter.«
The potential rise in key interest rates and the end of asset purchase programs could cause a widespread increase in interest rates. Life insurers are very sensitive to such a development because, as the chart below shows, a large portion of their assets are invested in debt securities, whose value decreases when interest rates rise.
Sources: Banque de France,third quarter of 2021
The potential widespread rise in interest rates indirectly caused by the upturn in inflation will therefore have the effect of reducing the value of a large proportion of the assets (or investments) held by life insurers.
This situation could put French life insurers in a difficult position. If interest rates rise, savvy policyholders could be tempted to surrender part of their life insurance policies in order to arbitrage and invest the recovered cash in higher-yielding assets. To ensure the liquidity requested by the policyholder, the insurer will be forced to sell bonds at a discounted price and realize potential capital losses if the value of the bonds held has fallen below the level at which they were purchased. The risk of a sudden increase in benefits payable by the insurer following a rise in interest rates is known as « mass surrender risk. » It mainly affects euro-denominated life insurance contracts which, « unfortunately » for insurers in this context, represent the largest portion of the contracts on their balance sheets.
1.2 ) Risks that can turn into opportunities
However, this « mass redemption risk » on euro-denominated funds following a general rise in interest rates should be put into perspective. Firstly, insurers have currently accumulated a significant level of unrealized capital gains on their bond assets since the introduction of a low interest rate policy in Europe, which has been further accentuated since March 2020 in the wake of the COVID-19 crisis. Consequently, it would take a sudden and « sharp » rise in interest rates to put life insurers in difficulty. This scenario seems unlikely, as inflation levels remain reasonable for the time being and the ECB appears to be moving towards a very gradual rise in interest rates.
Furthermore, since the Sapin 2 law came into force in 2016, redemptions on euro-denominated life insurance contracts may be blocked or restricted by the High Council for Financial Stability, which is chaired by the Minister of Economy and Finance. The aim of this law is to protect financial institutions in the event of panic among savers following a financial crisis.
At the same time, insurers also have certain regulatory « technical provisions » such as the Profit Sharing Provision (PPB), the Surplus Provision (PPE) and the capitalization reserve, which enable them to absorb market shocks and smooth the returns on their assets if necessary.
Furthermore, a generalized rise in interest rates would also help insurers emerge from an even more delicate situation caused by the same low interest rate policy that has been in place in Europe for several years. While this policy has a beneficial effect on asset valuations, it is also a direct consequence of the erosion of returns on euro-denominated funds, as shown in the chart below, which is causing difficulties for life insurers in managing their businesses.
Sources: FFA,
These difficulties may notably materialize in the form of an increase in the regulatory amount of equity capital to be tied up. In order to preserve part of the returns on euro funds in recent years, life insurers have been forced to invest in riskier financial assets. However, since the introduction of the Solvency II Directive in 2016, this situation has required them to tie up a higher amount of capital.
A rebound in interest rates could therefore give life insurers a second wind, both financially and commercially. It would enable insurers to restore the attractiveness of euro-denominated funds at a lower cost of capital. In the long term, it would also ease the commercial pressure that has been weighing on them for several years as they try to convince French people to invest their savings in unit-linked contracts rather than euro-denominated funds. However, the rebound in the yield on euro-denominated funds would be slow and sustained, as insurers have a significant volume of bonds in stock that were purchased at relatively low rates.
Finally, if the insurer is cautious and correctly anticipates macroeconomic developments, the « risk of massive redemptions » can be hedged by strategies involving the purchase and sale of derivatives. The use of call options (caps, swaptions, etc.)[5] to offset the loss in bond capital gains following a rise in interest rates can be an effective hedging solution. However, these instruments must be used with caution and can be very costly, especially if purchased at the wrong time.
The potential rise in interest rates that could materialize in the eurozone following the rise in inflation would pose a threat to insurers if it occurs abruptly. Conversely, it could also be a source of opportunities in the longer term.
2. The potential decline in equity markets: a risk that should not be overlooked
The other key component of insurers’ assets is equity securities, also known as « diversification pockets. » These are most often composed of listed shares, but may also include real estate investments and « unlisted » equity securities. Historically, rising interest rates have very often caused a decline in the value of this type of asset, particularly listed equities, due to arbitrage by investors (divestment of equities, investment in fixed-income products with a more favorable risk/return profile). The chart below shows that there is indeed a decorrelation between interest rates and stock prices (stocks fall when rates rise and vice versa). This decorrelation can be observed in both the United States and the eurozone.
Source: CPR AM
A rise in interest rates could therefore also cause a depreciation in the « diversification » asset class of French life insurers. The depreciation of this type of asset creates several constraints for them:
- On the one hand, in the event of a depreciation of these equity investments, the insurer may have to make accounting provisions (PDD or PRE, for example), which will have a negative impact on the return offered to savers and on its results.
- On the other hand, if interest rates rise and the equity market falls at the same time (without any time lag), pushing all of the insurer’s investments into unrealized capital losses, the insurer will be doubly penalized. Indeed, it will be unable to rely on either its bond portfolio or its « diversification » portfolio to ensure liquidity without realizing capital losses.
The monetary paradigm shift linked to rising inflation therefore not only poses an indirect risk of higher interest rates for insurers, but also a risk of equity depreciation.
Nevertheless, the risk of a decline in the equity market must also be put into perspective. As with bond assets, insurers have also seen the value of their listed shares (equity securities) rise sharply over the past year. It would therefore take a significant shock for them to find themselves in difficulty and obliged to set aside provisions.
Furthermore, since 2015, the decorrelation between the two types of assets has decreased significantly, meaning that a decline in the stock market would be less likely to materialize following an increase in interest rates.
3. Other potential consequences of inflation on life insurance activities
3.1) The risk of asset-liability mismatch on certain pension contracts
For euro-denominated life insurance contracts, it is the policyholders who bear the brunt of the rise in inflation, as the revaluation of their contracts is most often based on guaranteed average rates (GAR) expressed in nominal terms. As a result, the minimum revaluation of contracts will remain as defined at the time of subscription, while the cost of living will have increased in the meantime.
On the other hand, the revaluation of certain retirement savings contracts can sometimes be indexed to inflation. In the event of a sharp rise in inflation, the insurer could find itself in a situation of « asset-liability mismatch, » as the real rate of return on its investments would fall while its commitments to its policyholders would increase. However, this risk is moderate, as inflation-indexed retirement savings contracts are becoming increasingly rare.
In addition, to control this risk of « asset-liability mismatch, » the insurer can link the return on its assets to inflation by investing in inflation-indexed bonds (OATi, for example) or hedge them by negotiating inflation swap contracts with banks.
3.2 Rising structural costs
In addition to balance sheet imbalances, an increase in the general price level would also have potential impacts on the life insurer’s income statement. Indeed, a sustained rise in inflation could lead to a mechanical increase in the insurer’s structural costs (employee salaries, equipment, rent, etc.). This situation could prove compromising if the insurer has underestimated the future amount of expenses it will have to pay, which would result in a decline in its profitability. This problem could be amplified in France, where wage inflation policies are being implemented.
However, this risk must once again be put into perspective. Firstly, because the insurer can pass on the increase in its expenses to the rates offered to customers. Furthermore, in France, wage levels are not indexed to price levels. Thus, a sustained rise in prices would not automatically be reflected in wages, which would help to moderate the increase in structural costs for the insurer.
Finally, even if wage costs were to rise, this could also represent an opportunity for French life insurers, as there would potentially be more payments into savings contracts, which would increase insurers’ income.
3.3) Potential depreciation of the euro
Finally, rising inflation could also have an impact on the international activities of life insurers. Indeed, inflation rates vary from country to country, as does the value of currencies, which depreciate in the event of a sustained rise in inflation. A widespread rise in inflation in Europe would therefore theoretically lead to a depreciation of the euro, a phenomenon that has already been observed in recent months against the dollar, as shown in the chart below.
Euro/dollar exchange rate
Sources: Boursorama
This depreciation could have multiple consequences for European life insurers, but not necessarily negative ones. Due to currency effects, insurers could benefit from higher returns on assets denominated in currencies other than the euro and a potential increase in their competitiveness abroad. On the other hand, the cost of foreign currency debt would increase, but this risk can be hedged using currency options or other similar hedging products.
Conclusion
Ultimately, the impact of a potential rise in interest rates in the event of persistent inflationary pressures remains difficult to estimate. A gradual rise could even provide longer-term opportunities for French life insurers. Conversely, a « sharp » rise could potentially cause them liquidity and solvency problems.
For the time being, the ECB seems determined not to tighten its monetary policy too quickly and plans to raise interest rates gradually from 2023 onwards. However, the European economy is not immune to exogenous shocks (on energy prices, for example) that could force the central bank to raise interest rates faster than expected, thereby exposing life insurers.
References:
http://www.bsi-economics.org/154-les-fonds-en-euros-des-compagnies-d%EF%BF%BDassurance-vie
http://www.bsi-economics.org/531-fonds-euros-risque-assureurs
Combined monetary policy decisions and statement – December 16, 2021
Banque de France: Financial investments of insurance companies –3rd quarter 2021
Economic Bulletin of the European Central Bank – Issue 8/2021
[1] The debate over whether inflation is “sustainable” or “transitory” is still ongoing among European central bankers, even though the temporary nature of inflationary pressures seems to have been ruled out. Ahead of the ECB, the US Federal Reserve announced on December 15 that it would raise its key interest rates nearly three times in 2022.
[2] A euro fund is a secure financial vehicle in which the subscriber to a life insurance policy can invest their savings. It is managed by the insurer and, in most cases, includes a capital guarantee. Euro funds are mainly invested in bonds.
[3] A unit-linked contract is a non-guaranteed financial vehicle, with the investment choice made by the insured. Unit-linked contracts are generally invested in equities or real estate.
[4]For several years now, in order to control interest rates, the ECB has also been using « unconventional » tools such as quantitative easing, which involves buying back assets, mainly government debt, in order to lower interest rates.
[5]Caps and swaptions are options that allow a buyer to protect themselves against rising interest rates in exchange for the payment of a premium.
[6]The provision for permanent impairment (PDD) and the provision for risk of maturity (PRE) are provisions that the insurance company must set aside if the value of an asset recognized as representing the policyholders’ commitments depreciates significantly and permanently (an SLP is set up following a depreciation of more than 20% of the asset compared to its book value for at least six months).
[7] By negotiating an inflation swap with a bank, the insurer would agree to pay the bank a fixed rate (based on a nominal amount) in exchange for the payment of a variable rate by the bank that would be indexed to inflation. This would cover the real return on the insurer’s investment.
