The Costs of the Financial Crisis for Policyholders

By Daniel Haefeli and Dr. Kai-Uwe Schanz | December 16, 2011

When examining the consequences of the financial crisis on the insurance industry it is important to differentiate between direct and indirect effects on one hand, and short- and medium-term ramifications on the other.

Insurers were directly and immediately impacted by write downs on their investment portfolios. The subsequent economic slowdown had a further adverse impact on equity markets and credit quality, impairing the insurance industry’s massive corporate bond portfolios.

Indirectly, insurers were heavily hit by the economic slowdown that followed the turmoil in financial markets. In 2009, developed countries experienced the worst recession in 80 years. The ongoing sovereign debt crisis in Europe — accelerated by the financial crisis — conjures up the spectre of a double-dip recession. In response, households and firms cut insurance budgets and premium volumes contracted sharply.

Life insurers continue to feel the pinch as interest rates head for record low levels, making companies struggle to meet guaranteed policyholder returns.

Yield Curve

The ultra-loose monetary policies of central banks have resulted in a positive yield curve, with a sizeable differential between short- and long-term yields. Banks are benefiting from this constellation, generally tending to prefer low interest rates to reduce funding costs whereas insurers benefit from higher rates as their inverse business cycle (collect premiums first, pay claims later) makes interest income a key pillar of their business model. Leveraging the current shape of the yield curve, banks borrow at low cost and lend longer term at attractive margins. Ultimately, insurers are made to pay the price for recapitalizing banks.

This price is a heavy one: Global insurance assets amount to about US$24 trillion, more than 10 percent of total global financial assets. A yield reduction of as little as 100 basis points would result in a loss of investment income of approximately US$240 billion, more than three times the total costs for Hurricane Katrina every year. A lasting negative impact on investment income would be a particular challenge for non-life insurers with low or volatile underwriting results and life insurers who have entered into contractual minimum yield obligations.

Investment returns are a key input to pricing insurance contracts. To make up for lower returns insurers would have to raise premium rates for non-life and life insurance policies and reduce the returns they can offer to life policyholders.

Challenges Ahead

The challenges ahead of insurers are compounded by impending regulatory changes. The global trend towards risk-based capital regimes — with Solvency II arguably being the most complex framework — reduces insurers’ freedom when investing their assets. Going forward, market risk (e.g., the risk of changing interest and foreign exchange rates) has to be underpinned by more risk capital, making investments in higher-yielding asset classes potentially uneconomical. This reduces the capacity of insurers to act in a counter-cyclical manner. Regulators, therefore, run the risk of weakening the stabilizing role insurers traditionally play within the financial markets.

Insurance-related changes to the International Financial Reporting Standards compound this as the market-to-market principle fails to properly reflect the long-term character of insurance liabilities and corresponding assets.

Sovereign bonds carry the lowest risk charges under Solvency II, incentive for insurers to invest more heavily in this asset class. However, as a consequence of current monetary policies top-rated fixed-income securities yield at record-low levels, and sovereign bonds are no longer considered as fail-proof. Insurers, therefore, are caught in an uncomfortable dilemma: Either accept low-yielding investments in government bonds or engage in higher-risk asset classes which carry significant or even prohibitive capital charges and imply a much higher volatility.

High Price to Pay

Lawmakers may want to acknowledge that insurance policyholders are paying a high price for restoring the balance sheets of those financial services players who were instrumental in causing the financial crisis in the first place — higher premium rates primarily in non-life business and lower guarantees and profit participation on the life side.

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