The funding position of insurers and pension schemes across Europe has been hit by plunging sovereign bond yields as anxious investors seek safe havens in the wake of the UK’s Brexit referendum.
Ten-year UK bonds have skidded below 1% for the first time. German 10-year bonds have hit a negative 0.11%. Real yields on longer-dated bonds have fallen to unprecedented levels, with the German, Dutch and Italian 30-year bonds on 0.38%, 0.54% and 2.39% respectively. Yields on French 50-year bonds have fallen by a fifth to 1.4% since March.
Yields at these levels throw up “duration mismatch” problems for insurers whose liabilities stretch further into the future than the maturity of their bond portfolios. This means when insurers need to buy new bonds, their yield could be too low to fund the firms’ future outgoings. Life insurers who have marketed guaranteed products to their clients are facing particularly severe problems.
To make their funding positions look better, many insurers in continental Europe chose to discount their liabilities beyond 20 years through the “Ultimate Forward Rate” of 4.2%, which significantly reduces their funding gaps.
Independent analyst Ned Cazalet calls this measure the “Unbelievable Fantasy Rate”, warning that it will lead to complacency: “The discount rate used by many life insurers bears no resemblance to the yield generated by their portfolios.”
Cazalet, who has served as an adviser to HM Treasury on life assurance issues, said the UFR camouflaged funding gaps which were under great strain following the European Central Bank’s attempt to stimulate the European economy through a negative interest rate policy: “Brexit-inspired heightened risk awareness exacerbates the problem.”
He added that any further measures to “ease tensions” could in fact throw more fuel onto the fire, not least because of the negative impact on banks, whose bonds are held by eurozone insurers. Bank stocks have slumped since the referendum, with Barclays down 20% and Royal Bank of Scotland 19%, although European banks have also fallen but not as far.
The European Insurance and Occupational Pensions Authority is reviewing UFR methodology. In a statement, Eiopa said it was based on long-term average real returns, providing a way to put together a funding framework in the absence of market-based evidence.
The Dutch central bank has demanded reform. In a May statement it said: “The impact of the current low interest environment on insurers is only partly visible in their financial reports and means the solvency position of insurers gives too optimistic a picture of their financial position.”
An executive at a German-based insurer said he understood reasons for concern, but he pointed out current market distortions were abnormal. Asset manager Twelve Capital said in a statement it believed insurance sector fundamentals were robust, but added: “We believe it is natural for investors to raise questions over the financial health of insurer balance sheets.”
The share price of UK insurer Aviva has fallen 8.4% since the Brexit vote. It rushed out a statement stressing that Brexit would have no significant operational impact on its business, pointing to the strength of its balance sheet.
JP Morgan Asset Management bond manager Prashant Sharma said the funding positions of insurers would vary widely: “Brexit is likely to mean lower-for-longer fixed income yields, a factor the insurance industry is already dealing with given negative rates in Europe. The extent of the insurer impact will depend on their ALM mismatch and guarantee rates. Expect renewed focus on the theme of insurance companies searching for opportunities to increase risk-adjusted yield.”
Aberdeen Asset Management’s head of fixed income products, Andrew Harrison, said: “Brexit has made liability matching for insurers even more challenging in this lower for longer interest rate environment. An obvious response is to diversify into less liquid credit markets, but these are becoming increasingly crowded.”
Eiopa said in a stability report published on June 21: “If low interest rates persist long enough, certain types of insurance products may experience profound changes, possibly leading to sector consolidation.” It warned that profitability was under “severe pressure” pointing to low yields and the danger that insurers could be taking more risks to achieve the yields they needed.
David Rae, Russell Investment’s head of client strategy and research, said insurers and pension schemes were both facing funding challenges. He said: “In aggregate schemes could be looking at a 10% hit to funding levels, depending on the level of liaibility hedging.”
He said it was hard to find investment opportunities to plug the increase in funding gaps, due to the inflated value of assets. He added that schemes would also need to keep a close eye on the strength of sponsor covenants, particularly if Europe fell back into recession.
Swiss Re is concerned that low or negative bond yields have led to financial repression, depressing returns for insurers and pension schemes. In a pre-Brexit policy note it said: “Turn off the money tap – our economy is drowning. Prudential regulations for both banks and insurance companies that favour sovereign bonds only add fuel to the fire.”
But Tanguy Le Saout, head of European fixed income at Pioneer Investments, does not see an end to repression. He said in a strategy note: “With the economic growth outlook deteriorating and monetary policy remaining accommodative, pressure on bond yields is likely to remain to the downside. Bond yields will remain lower for longer.”