The factor battering insurers’ balance sheets

IAG chief executive Peter Harmer. (Norm Oorloff)

The QBE and IAG results this week provided a local insight into an escalating and destabilising global issue.

While the banks’ response to the Reserve Bank’s latest rate cut has stirred controversy, the impact on insurers of the global low-rate environment — in some parts of the world a negative-rate environment — tends to get underplayed.

Low rates are compressing bank interest margins. For insurers, there’s an element of margin squeeze because of the impact on their investment earnings but there’s an additional balance sheet effect.

Not only do they generate less income from their shareholder capital and the reserves that support their claims liabilities, but they also suffer a balance sheet effect from the falling discount rates used to value those claims liabilities.

The balance sheet effect showed up most clearly in the QBE interim result, with the group disclosing a $US283 million “adverse discount rate impact” on its results. Its investment income actually rose, but that was due entirely to favourable currency movements.

IAG, in its results on Friday, cited a “significantly lower” contribution from investment income on its shareholders funds as a factor in the 14 per cent decline in earnings. The income generated by that shareholder capital slumped from $223m in 2014-15 to $97m, while investment income from its technical reserves fell from $562m to $463m.

Both insurers have shifted their investment portfolios around during the past year, slightly dialling up the levels of risk. It was notable that QBE lowered its holdings of short-term money market securities and government bonds, while increasing its exposures to corporate and infrastructure debt.

Insurers traditionally have invested predominantly in low-risk, high-quality fixed interest securities, with big weightings to government and AAA-rated corporate bonds, where yields are now either negligible or negative.

The flattening of global yield curves means that duration — buying longer-term bonds — doesn’t solve the dilemma they face in trying to match their assets and liabilities, indeed it could entrench it.

As QBE said, an environment where global risk-free rates continue to slide to the point that 77 per cent of global sovereign bond yields are below one per cent and 40 per cent are negative, challenges insurers.

They aren’t, of course, the only sector challenged by the unprecedented low-rate environment.

A year ago Larry Fink, chief executive of BlackRock, the world’s largest asset manager, warned that low interest rate policies were threatening insurance companies and pension funds and destroying their value and viability.

This week, writing in the Financial Times, bond market guru Bill Gross said there was now a global store of about $US13 trillion of negative-yielding bonds and argued that near-zero and negative policy rates were putting the historic business models of insurers and pension funds, with long-tail liabilities, increasingly at risk.

This would flow into job cuts, higher insurance premiums, reduced pension benefits and increasing defaults and had the potential to turn a once-virtuous circle into a “cycle of stagnation and decay,” he wrote.

The IMF and OECD have both warned of the threat to solvency posed by ultra-low rates to insurers and pension funds with long-tail exposures and the pressure they were facing to chase yield by taking on higher-risk investment strategies.

Germany’s financial regulator has referred to the “seeping poison” of low rates. The impacts are insidious because a very protracted period of low rates has a creeping long-term undermining effect rather than dealing a sudden shock to the system.

The issue is of particular relevance in Europe and the US, given that they still have very large defined benefit pension fund systems, where the combined effect of low rates on near-term investment earnings and actuarial calculations, using falling discount rates, of their long-term liabilities creates an exaggerated negative outcome.

European banks, who are being charged an annualised rate of 0.4 per cent by the European Central Bank for deposits held with the ECB, are reportedly considering storing their cash in their vaults rather than accept a negative return, as have some insurers.

The profitability of banks globally, but especially in Europe, is being drained by the impact of the low-rate environment on both sides of their net interest margins and the continually increasing levels of capital and liquidity they are required to hold — which are generating negligible, if any, returns.

It is also, obviously, having a major adverse impact on their depositors and on the banks’ ability to attract and retain deposits, which is why the Australian banks — big and small — raised term deposit rates while only passing on a portion of the RBA’s latest rate cut to borrowers.

The hollowing out of banks, insurers, pension funds and individuals’ savings are among a wide range of unintended consequences that have been flowing from the unconventional monetary policies that the US Federal Reserve Board pioneered in 2009 and that have been adopted enthusiastically and with increasing aggression (albeit with questionable success) by the Europeans and the Japanese.

The more obvious and well-recognised consequence, intended but perhaps not to the degree to which it has occurred, has been to significantly inflate the price of risk assets while reducing risk premia.

Ultra-low and negative rate policies haves forced investors, whether institutional or individual, from insurers and pension funds to self-funded retirees, to accept ever-rising levels of risk for ever-diminishing levels of return.

Central banks, of course, have only one relatively blunt tool with which to respond to shifts in economic circumstances, which is why they (including the RBA’s Glenn Stevens in his final public address as the bank’s governor last week) have been increasingly urging politicians to share the burden and add carefully targeted fiscal policy to the mix.

The monetary policies central banks have pursued since the financial crisis — for nearly eight years — were designed to protect real economies.

One could argue about how effective they have been as they have shifted into increasingly unconventional settings. There is an obvious and growing concern, however, that in seeking to protect real economies, the over-reliance on monetary policies is creating continually increasing levels of risk within the global financial system.

Central banks and governments have virtually exhausted their reserves of monetary and fiscal policy ammunition with which to respond to another financial system — or financial markets — shock. In the meantime, the unintended consequences continue to flow.