A rising interest rate environment tends to have a positive impact on insurers. However, the recent rate increases have not benefited all insurers equally. The new regime presents both opportunities and challenges, which we have outlined below.
Asset-liability mismatch is more punitive
For insurers with tight capital budgets, asset-liability matching (ALM) policies are coming under increased scrutiny. Further, when interest rates are higher, both standard formula and internal model approaches generally involve higher rate volatility projections, so each year of duration mismatch is likely to require more capital.
Consider the recent example: the five-year EIOPA risk-free rate increased from -0.35% to 3.13% between end-June 2021 and end-June 2023. The corresponding increase in capital required for being two years short duration (five-year asset duration vs. seven-year liability duration) has increased by c.7%. Solvency II interest rate risk stresses are multiplicative (with a 1% floor on rates up)1, so given the significant increase in interest rates over the period, at the five-year point they are c.86% higher than one year ago.2
The expectation of rising rates has been on insurers’ agendas for several years. Those engaged in tactical positioning have tended to be short duration, to potentially reinvest at higher yields.
As we potentially near peak rates – combined with the more punitive ALM mismatch capital charges – insurers are likely to revert to more neutral positioning. This seems sensible as rate decisions appear increasingly finely balanced.
However, regardless of their macroeconomic views, we expect fewer insurers to tactically position for falling rates. While holding long duration bonds when rates fall would result in a capital cost, the potential for divergence between the base rate credit cycle and longer-term rates means there is an added element of risk.
EIOPA risk-free rates and 5-year interest rate charges
Unrealized losses and restriction on active management
Rising rates have left many insurers with significant unrealized accounting losses. Due to these losses, combined with the P&L implications of realizing them, insurers have placed realized loss limits on their matching portfolios. To stem further accounting losses, insurers are increasingly transitioning their total return mandates to benchmarked-constrained (or book yield focused) mandates.
When transitioning a matching portfolio, insurers need to reconsider their manager selection process and appropriate fees. Transitioning to a benchmark-constrained mandate degrades manager’s ability to generate alpha so a passive approach may be more appropriate (with care to avoid ALM mismatch).
As the shift is also likely to place greater pressure to generate alpha on the surplus portfolio, it is a good time for insurers to reassess and amend mandates to ensure the fees are appropriate for the level of active management of each mandate.
The low nominal rate and benign default environment of the past few years has limited opportunities for active fixed income managers. The dispersion of managers’ returns had been compact pre-2022. The graph below shows the wider dispersion of returns for European fixed income managers in 2022 vs previous years. Today, 10-year German bunds are yielding c.2.6%3 and investment grade credit has returned 2.2% year-to-date, after returning nearly -17%4 in 2022. Sharp yield rises were generally absorbed by investment-grade corporates, with rating agencies increasingly cautious on speculative-grade credit and commercial real estate debt.
We expect insurers with predictable liabilities to opt for a hold-to-maturity approach (especially at the shorter end), with matching assets benefiting from hold-to-maturity accounting. Higher base rates and borrowing costs have vastly improved the value proposition for credit investing and managers with more constrained mandates could capture additional alpha, in particular within investment-grade.
While needing to be balanced with turnover and loss realization restrictions, the anchoring effect of higher base rates means alpha-orientated strategies within the surplus portfolio are poised to deliver a welcome additional contribution. Some insurers have used this opportunity to refine mandates, which also helped facilitate the discussion around restructuring to incorporate more ESG-focused mandates.
While this environment presents fixed income opportunities, some insurers have also increased strategic holdings of cash as of Q3 2023. Fixed income offered returns above 3% in Europe, while providing flexibility and the prospect of higher reinvestment rates if there is higher than expected inflation. Cash can also act as a useful war chest to acquire attractive private market secondaries without committing unconditionally.
During the low-rate era, many insurers extended into less liquid investments to counter low investment returns. This has undoubtedly eased with recent rate increases, so insurers are re-examining their illiquidity budgets and allowances. Meanwhile, the increased income generated has naturally increased income distributions and could be an opportunity to adopt a higher risk tolerance for illiquidity, especially in the surplus portfolio.
The current rate environment is presenting a new set of challenges and opportunities for insurers. Navigating this new regime will require them to re-think fundamental portfolio positioning, performance and products as they prepare for the future.
1 Current interest rate stresses as specified in Commission Delegated Regulation (EU) 2015/35. Note that changes are proposed as part of the Solvency II 2020 Review.
2 Source: EIOPA: Based on RFP curves over the period 30/06/2022 to 30/06/2023.
3 Source: Bloomberg as at 08/09/2023.
4 Source: Bloomberg. All returns are shown in US Dollar terms. Investment grade credit represented by the Barclays Global Investment Credit Index.
5 Source: MercerInsight as at 30/06/2023. Based on Mercer defined universe of Fixed Income Manager within the Government & Non Government Universe. Benchmark shown as Bloomberg Euro Aggregate.
Senior investment consultant