Sven Giegold

Low interest rates: turning a blind eye is not a solution either

Low interest rates are having an increasingly dramatic impact on insurance policies. In early August, the German Federal Financial Supervisory Authority (BaFin) published up-to-date figures on the solvency of German life assurers. Twenty-five percent of the firms concerned now do not meet Solvency II’s capital requirements. Four of the 84 firms examined have no or negative own funds. Only by making use of the EU Solvency II Directive’s transitional provisions, according to the BaFin, are assurers keeping their heads above water.

In reality, however, many life assurers are in an even worse position: Solvency II’s capital requirements do not reflect the real risks. Regardless of the financial circumstances of states and local or regional authorities, risks from OECD countries’ sovereign bonds are ignored in the regulatory capital requirements.

Most significantly, however, the long-term risk-free interest rate – or, in EU-speak, the ‘ultimate forward rate’ (UFR) – has been set unrealistically high. Using the UFR, the BaFin stipulates that very-long-term investments can generate a risk-free yield of 4.2% in the euro zone, of which 2.0% is accounted for by the inflation target set by the European Central Bank (ECB). That is much more, however, than is assumed by the market. If the UFR is set too high, life insurers have to set aside too little capital for their liabilities vis-à-vis their policyholders. Since, given the optimistic assumption underlying the UFR, funds to cover liabilities vis-à-vis clients cannot be earned on the market through investments. That is a high-risk wager, however, since a fundamental turnaround regarding low interest rates is not in sight. The assumption by ever more economists is that this is the ‘new normal’. Investment impetus in western industrialised countries is not sufficient to absorb all the capital in search of investment. More and more financial actors do not know what to do with their money. Unless a determined, internationally coordinated approach is taken, low interest rates are not going to go away: they are by no means solely the result of Draghi-style loose monetary policy; rather, they stem to a large extent, at the very least, from macroeconomic imbalances which the ECB, too, does no more than react to.

Solvency II requires the European Insurance and Occupational Pensions Authority (EIOPA) to put the methodology for determining the UFR on a better footing. In that connection, the EIOPA submitted a proposal in April 2016; a decision should be taken shortly. Under that proposal, the mean of interest rates observed since 1960 (!) would be calculated in order to derive the UFR valid for a given period. For the euro zone, that would produce a UFR of 3.7% for 2019, i.e. markedly lower than the 4.2% assumed at present. The annual UFR adjustment would be limited to 0.2%, meaning only slow convergence with market realities, i.e. 4.0% in 2017, 3.8% in 2018 and 3.7% in 2019.

The new EIOPA methodology is still optimistic: in view of current high capital stock levels, there is little reason to believe that, in the foreseeable future, interest can again be earned risk-free at 1960s levels. Accordingly, it is much more realistic for the Netherlands’ pensions supervisor to assume a UFR of 3.0% for the euro zone; and the rate assumed by the International Association of Insurance Supervisors (IAIS) is only 3.5%.

Within the EIOPA, there was a broad majority in favour of the new UFR calculation rules. The EIOPA has shown considerable consideration for the industry’s difficulties: Article 47 of the Solvency II implementing provisions stipulates that the UFR must be determined “in a transparent, prudent, reliable and objective manner that is consistent over time”. The EIOPA proposal fails to comply with that prudence-based stipulation: in the circumstances, and given market expectations, factoring in interest rates from more than 55 years ago can hardly be regarded as prudent.

The German Insurance Association (GIA) and the BaFin are nonetheless fighting tooth and nail, in a joint campaign, against the new rules. In support of its resistance, the BaFin cites the procyclical effects of lowering the UFR. Accordingly, if the UFR falls, even more insurers will push into longer-term investments, bringing about even more of a fall in market interest rates at the long end of the interest rate curve and subsequently, in turn, a further fall in the UFR, and so on and so forth.

The BaFin’s argument would initially appear to be logical, but it is ultimately absurd: on the basis of that logic, the UFR ought to remain unrealistically high at all times and ought never to be lowered. That was not the intention of the law makers, however, which wanted to ensure that life assurers would be sufficiently capitalised. In the meantime, the Commission has betrayed the EIOPA and is openly threatening to reject the new UFR calculation rules in order to guarantee stability.

Ultimately, however, any political cover-up of the industry’s solvency problems will be counter-productive, given that it is doubtful whether that will strengthen customer confidence in what is a product for the long term: endowment life insurance. Regrettably, the German industry-average own-funds figure of about 1.5% of life assurers’ balance sheet assets is far from reassuring. In the final analysis, then, changing calculation rules in firms’ favour is to do assurers a disservice: in the short term, it will ease the pressure; but, in the long term, it will make problems worse and cause more harm.

What would actually benefit the industry is an economic policy that boosted investment impetus in Europe overall. Only then will interest rates rise, providing the ECB with scope for a policy reversal on interest rates. Cheap money ought to be invested now in the future. Accordingly, governments must create the right environment, e.g. for rigorous ecological modernisation, education and digital infrastructure investment. The associations representing banks working for the real economy, together with endowment life ensurance, are the victims of low-interest-rate policy; but I have heard virtually nothing from them in terms of backing for such an economic policy turnaround. And that’s a shame and against the interest of their own business model!

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