The effects of low interest rates can be broken down into three elements: cashflow effects, reinvestment effects and effects on the valuation of assets and liabilities.
Cashflow effects stem from yield spread compression, as new premiums and maturing investment returns are reinvested at lower yields relative to the yields that insurers have committed to pay. The available margin on this business is gradually eroded by a low yield environment if no action is taken to alter the underlying position. A prolonged period of low interest rates may also have an adverse impact on non-life insurers as low investment returns makes it difficult to compensate for weak underwriting results or counteract the effects of inflation on longer tailed business.
Reinvestment risk arises when maturing investments are reinvested in lower yielding assets. This also exposes the insurer to adverse changes in asset values if market yields rise suddenly.
Valuation effects stem from the adverse effect of a low yield environment on the present valuation of assets and liabilities. Although the exact effects on the balance sheet depends on the valuation method in use, a decline in benchmark interest rates will be reflected in the discount rate applied to liabilities. When the duration of liabilities is greater than that of assets, which is the normal state for large life insurance entities, the outcome is that available net assets to cover solvency would be eroded by a fall in interest rates because the present value of liabilities would increase more than that of assets.
The low yield environment puts pressure mostly on life insurers’ and occupational pension funds’ ability to serve guaranteed rates and maintain strong profitability and financial profiles in the long-run. The impact depends on the prevailing relationship between interest rates, market yields and guaranteed returns, as well as the duration mismatch and composition of the insurer’s and occupational pension fund’s balance sheet. Long term interest rates are of critical importance to life insurers and occupational pension funds, since these institutions typically have long run obligations to policyholders and beneficiaries that become more expensive in today’s terms when market rates are low. Consequently, the financial position of these firms typically deteriorates under such conditions, in particular where the duration of liabilities exceeds that of assets, which is typically the case of life insurers and occupational pension funds. This problem is even more pronounced where guaranteed rates of return have been offered to policyholders or beneficiaries (i.e. defined benefit schemes).