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Lower for Longer?

Posted September 27, 2016

By David Worsfold

The full reality of a world where returns are going to be lower for longer is starting to cast its shadow across financial institutions, asset managers and regulators.

Last week’s Insurance Investment Exchange seminar in London brought together senior investment professionals from across the insurance industry and threw out the question “Lower for longer or negative forever?” for the first time.

The majority sentiment was negative. Asked to vote on where they thought rates will be in ten years time, over 50% said they believed UK rates would be as they are now or negative. That represents a very sharp pessimistic turn since the hope amongst insurers of rising rates just a few months ago. The full results of the voting will appear next week.

With central banks looking increasingly as if they are boxed into a corner with few viable options left to stimulate economies or respond to economic challenges, the prospect of rates remaining stubbornly low for the medium to long term is now very real. Some research – not least from the International Monetary Fund – suggests that rates could go lower still with a possible floor of -1.5%.

This prospect will start ringing alarm bells in many quarters: life insurers and pensions providers desperate to deliver returns to policyholders, especially those committed to guaranteed returns; general insurers seeing rates squeezed and fearing a long overdue catastrophe draining claims reserves; and, of course, prudential regulators striving to ensure there are no major failures on their watch.

In Europe, the regulators seem to be ahead of the market in their preparation for this low return scenario. Earlier this year, EIOPA (European Insurance and Occupational Pensions Authority) warned in a paper on how Solvency 2 might play out in a low interest rate world that if the low return world lasts for longer than insurers currently assume, as much as 24% of European life insurers could find their solvency margins under pressure.

This paper has not had the attention it deserves. Perhaps some of its conclusions were just too shocking. The various scenarios EIOPA ran through the macroprudential approach it has developed internally pointed to some grave concerns about the stability of insurers in certain situations, such as the sustained low-inflation, low return, low growth reality Japan has struggled with since the turn of the century :

“A low yield module simulating a Japanese-type scenario of prolonged low interest rates was included to assess the scope and scale of the risk posed by such a scenario. According to the results, 24% of insurers in the sample would not meet their Solvency Capital Requirements and certain companies could face problems in meeting their promises in 8-11 years time”.

Since then, the UK has voted to leave the European Union, forcing the Bank of England to cut rates and start a new quantitative easing programme; Italian banks have started showing signs of severe distress; and the Bank of Japan has shown just how bare their policy cupboard is after a decade of ineffective remedial measures. Clearly, things could get worse before they get better.

Alongside, the acceptance that rates will remain lower for longer has grown in the absence of any reliable predictions of just when interest rates might pick up and, when they do, what the peak of the up cycle might be. There is a growing acknowledgement that it will be significantly lower than in previous peaks and that this has important implications. Janet Yellen, chair of the US Federal Reserve, started to outline the options for central banks in dealing with future recessions and inflationary shocks in a speech at the end of August, which immediately unsettled the markets who had been hitherto fighting shy of facing up to this changed reality.

Last week’s Insurance Investment Exchange seminar showed that insurers at least are starting to face the future with a renewed acknowledgement of this reality. The question of what to do now begs the answer.

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