DNBulletin: Stress test shows vulnerabilities of European insurers
Dutch insurance groups are relatively sensitive to further decreases in interest rates compared with average European peers. By contrast, they are less sensitive to a sudden rise in interest rates combined with falling asset prices. Also, they are resilient to several catastrophe scenarios. This is apparent from the results of a new stress test published today by EIOPA, the European supervisory authority for insurers and pension funds. The Dutch insurance groups’ high sensitivity to lower interest rates is due mainly to their relatively concentrated exposure to long-term life insurance policies.
Stress test looks at three scenarios
Stress tests have evolved into an indispensable instrument for identifying risk. Supervisory authorities are increasingly turning to stress tests, and are using them in more and more areas. Stress tests aim to reveal vulnerabilities in a financial institution or the financial system before they materialise. The two-yearly EIOPA stress test for insurers also serves this purpose. Specifically, it aims to establish the sensitivity of insurers to extreme scenarios and analyse its impact on financial stability. This means insurers were not assessed to see whether they passed or failed a specific test. Forty-two European insurance groups took part, including Aegon, NN Group and Achmea. At our request, a.s.r. and Vivat also took part in the stress test at national level. The test looked at the sensitivity to three different scenarios. The first scenario combines a drop in interest rates, including an immediate downward adjustment of the ultimate forward rate (UFR) – something which is unlikely to happen in practice – with an increased longevity risk. It is the combination of these shocks that makes this a severe scenario. The second scenario, which is more likely to materialise given current economic conditions, assumes a rise in interest rates, a fall in asset prices and an increase in lapse risk. The third scenario involves various catastrophes, such as windstorms and flooding. To assess the insurers’ vulnerability to the scenarios, their financial baseline position at year-end 2017 was compared with their post-stress positions. One indicator that illustrates the impact on an insurer’s own funds is the asset/liability ratio. Figure 1 shows this ratio, both for the five Dutch participating insurers on an aggregated basis and the European average, in the baseline and post-stress situations.
Dutch insurers are particularly vulnerable to further interest rate decline in combination with longevity shock
The results show that the average ratio is above 100%, both before and after stress scenarios were applied. At the same time, it becomes clear that Dutch insurers are particularly vulnerable to the scenario involving a decrease in interest rates combined with rising life expectancy (scenario 1). In that scenario, market interest rates fall even further from current levels, and the ultimate forward rate, which is the rate at which liabilities with duration exceeding 20 years are valued, is assumed to fall to 2.04%. The figure shows that this scenario has a substantial impact on own funds. Also, the impact is larger than on the European average for the insurers participating in the stress test. The impact is especially large if the mitigating effect of the long-term guarantee (LTG) measures, which reduce the sensitivity of Dutch insurers’ balance sheet to market movements, is disregarded.
Figure 1 - Asset/liability ratios for the five Dutch insurers (weighted on the basis of total assets) in the baseline position and following application of the three scenarios. In addition to the LTG measures, the right-hand bar is also adjusted for the Solvency II transitional measures. The latter is relevant because Dutch insurers hardly apply these.
Figure 2 shows the underlying causes of the stress impact in the first scenario on the aggregated balance sheet of the five Dutch insurers. Falling interest rates push up asset prices as prices of bonds and loans go up. However, the value of the liabilities increases much more sharply due to the combination of lower market rates, an immediate downward adjustment of the UFR and the longevity shock. The Dutch insurance groups are sensitive to this scenario due to their concentrated exposure to long-term liabilities under life insurance policies and defined benefit pension products. This implies that the results for the Dutch insurance groups, viewed in relation to their European peers, are caused mainly by the nature of the shock and their business model. Therefore, they do not necessarily mean that Dutch insurers are in worse condition. As intended the LTG measures partly mitigate the impact of stress scenarios.
Figure 2 - The impact of falling interest rates, a lower UFR and increased longevity risk on the asset/liability ratio in scenario 1. The adjustment for LTG measures includes the impact of transitional measures.
Additional sensitivity to combination of rising interest rates and falling asset prices
Dutch insurers appear less sensitive to the scenario of a sudden rise in interest rates, falling asset prices and an increased lapse risk (scenario 2). In contrast to the first scenario, the assets side of the balance sheet is hit particularly hard under this scenario. The impact of this scenario is lower (see Figure 1), but the stress test shows that insurers must also take into consideration a scenario in which interest rates go up sharply and asset prices fall. This scenario could be more probable then one involving further rate declines, given that the accommodative monetary policy is currently expected to be phased out and financial conditions may tighten.
Relatively high resilience against catastrophes
The stress test's results also revealed that the Dutch insurers are relatively resilient to the catastrophe scenario (see Figure 1), which sees the asset/liability ratio drop to a limited extent. This is in line with the findings from an analysis (available in Dutch) that we performed earlier among non-life insurers.
A European recovery and resolution framework is needed
The results confirm the challenging conditions in which insurers operate and the urgency with which they need to continue making the sector more future-proof. Dutch insurers generally acknowledge this and have made good progress. In addition, it is as important as ever that insurers consider in their capital and dividend policies the low interest rates and the mitigating impact of the UFR and the LTG measures. Lastly, the results testify to the importance of introducing a European recovery and resolution framework for insurers. In the Netherlands, the Senate recently adopted a national framework.
