Trying times and their effect on insurers

Dear ladies and gentlemen,

It's a pleasure to be speaking at S&P Global Ratings' European Insurance Conference - thank you, Mark Nicholson and Volker Kudszus, for your invitation to today's event. I'm pleased to see a growing interest from different parts of the financial world in insurers, which suggests a clear acknowledgement and appreciation of the sector's power and potential.

The slogan of this year's conference, In The Midst Of The Perfect Storm, is, regrettably, not a flattering one. This is not to say that I'd be putting blame on anyone involved in the naming of this event. The macroeconomic and risk environment is indeed grim and challenging. Challenging for insurers, for other financial service providers, businesses, governments and households.

This bleak situation we're facing now with headwinds of an approaching recession is not something that we expected at the beginning of the year - quite the opposite, actually.

EXPECTATIONS

At the beginning of the year, the evolution of the Covid-19 pandemic dominated the risk environment and it seemed that we were getting the better of the pandemic.

In January 2022, more than 70% of European citizens were already fully vaccinated, fatalities started to fall shortly afterwards and as our societies were developing a measure of immunity, governments opted to ease lockdowns.

The shuttering of business and the curfews had massively disrupted our lives and caused a precipitous drop in economic activity. The crisis, however, was met with generous monetary and fiscal support.

With the pandemic receding and the prospect of further lockdowns and disruptions faded away, we were looking forward to a powerful rebound in 2022.

At the beginning of the year, most forecasters expected the euro area to grow at the pace of around 4% in 2022. There was also the widespread expectation that inflation, which had been climbing up in the months previous, would begin to fall once base effects from a short deflationary period in the pandemic would disappear.

OUTCOME

For a number of reasons that are easier to see with the benefit of hindsight, some of these forecasts did not turn out to be true. Consumers' spending behavior shifted in ways that were extremely difficult to divine beforehand and pandemic-related supply-side bottlenecks proved to be more persistent than expected. This meant that inflation, to a certain degree, was already becoming "sticky" and would take longer to unwind.

Then on Thursday, February 24, 2022, the unthinkable happened. War broke out on the Eastern flank of Europe as Russia started shelling and rolling its tanks into Ukraine.

This hideous and unprovoked aggression and its consequences exacerbated existing inflationary pressures and cast a long shadow over not only European but global growth in 2022.

In two short months, the realistic aspirations that we had for robust growth and a return to price stability in 2022 went up in a puff of smoke.

Today, we are seeing inflation at double digits, depressed growth, higher market volatility and heightened political risks as tensions rise once again amid - one can only hope - exaggerated echoes of the Cold War era.

To curb stubborn price growth, central banks from the Federal Reserve to the European Central Bank have embarked on a tightening cycle after almost a decade of "easy money". This development adds yet another layer to an already challenging environment.

So indeed, as the name of the conference suggests, there's a storm brewing.

In what follows, I would like to review where vulnerabilities may arise from by shedding some light on the impact of these developments on insurers.

INFLATION

Let's start with inflation. Inflation keeps on surprising on the upside in Europe and has recently reached 10%. Even though the central bank is intent on dampening demand with rate hikes, inflation is likely to come down only gradually. The ECB itself is projecting price growth above 5% for next year in the whole of the euro area.

Perhaps the most direct impact of inflation on insurers themselves is via rising claims costs. Higher than expected claims costs due to inflation particularly affect the non-life segments in a negative way rather than life insurers.

Life insurers typically set benefits based on inflation expectations at the point of sale. For this line of business, therefore, higher than expected realized inflation means lower benefits to be paid out to policyholders. Their liabilities sink in relative terms. Non-life insurers, however, are exposed to rising claims costs if inflation exceeds expectations - and this has consequences for their claims reserving.

With sizeable rate hikes already implemented and recessionary signals visible in indicators such as purchasing orders and economic sentiment, there's a growing consensus that inflation is soon to reach its peak. Last week's inflation reading in the United States was a first encouraging sign, but it's too early to jump to conclusions. Even if inflationary pressures were to weaken, we must bear in mind that inflation shows up with a considerable lag for insurers in claims. Inflation therefore remains a force to be reckoned with for the foreseeable future and insurers ought to go about their reserving and pricing accordingly.

Higher claims are bound to lead to rising premiums for policyholders. Nevertheless, lifting premiums while keeping existing customers, let alone bringing new ones in, might not be so straightforward in the current environment.

Price growth over the past year far outstripped wage growth, leaving households with less disposable income. People now on average spend a larger share of their monthly revenues on basic necessities while less is available for savings and investment. Already stretched budgets might mean that policyholders will be reluctant to accept substantially higher prices and instead opt to reduce or otherwise lower their insurance coverage. For this reason, there is a fine line to walk here between justified price rises and potentially losing business.

INTEREST RATES

Another important aspect that is very much linked to inflation is the level of interest rates. The ECB has hiked in three consecutive meetings: in July, September and also at the beginning of this month. The last two meetings each delivered big, 75 basis point hikes and the central bank's deposit facility went from -0.50% in the summer to 1.50% today. After a decade at and below zero, these are forceful moves. Rate-setters have implied that more hikes are in the pipeline although their pace might slow.

So what impact do rising rates to have on insurers in an inflationary environment?

A modest, gradual rise in interest rates is generally good news for insurers. When yields rise in an orderly fashion over time, these new, higher-yielding assets will translate into bigger investment earnings.

The broader answer is also very much linked to the duration gap that individual insurers have between their assets and liabilities This shows a more diverse picture. Here, entities that have a negative duration gap, which would typically be the case for instance with life insurers, are set to benefit the most. For them, inflation and higher rates imply a positive effect on capital as the value of long-term liabilities falls faster than that of assets.

The return of higher-yielded fixed income assets will give insurers some respite after a long period in which yields were difficult to get and this in itself is a positive development. There's likely to be some portfolio rebalancing, with a tilt away from alternative asset classes into more traditional investments.

However, as yields rise, the old assets on insurers' portfolio lose value. The road to having a substantial share of high-yielding fixed-income on insurers' books will be long and will come with its own challenges, but the direction of travel on yields is essentially positive for the insurance sector.

VOLATILITY - LIQUDITY

An assessment of the current environment doesn't stop here. The deteriorating growth outlook, the fraught geopolitical arena, disruptions to Europe's energy supply, uncertainties about the path of inflation and the question of how far central banks are willing to go to dampen demand have all led to an increase in volatility across financial markets.

Uncertainty is high and the questions are plenty. Is an end to the war in sight? Will European countries have enough electricity, oil and gas to keep homes warm and businesses running through the winter? Will China ease its covid zero policy and allay supply hold-ups? Will we see a rise in defaults and unemployment?

The IMF recently talked about a "toxic mix" of high inflation and flagging growth in Europe, cautioning that the region could see a deep recession. The European Systemic Risk Board issued the first general warning of its kind a few weeks back in which it warned that the likelihood of tail risk scenarios materializing has significantly increased over the past months. It called for a heightened awareness of the risks to financial stability in the EU.

Markets are on full alert and on the lookout for any news and events that could jeopardize their positions. While the apocalyptic scenes from the crypto world is a completely different story, we have also witnessed some concerning episodes in genuine markets as well. And I believe there's learnings to be drawn from that for insurers.

Perhaps the most important lesson from the turmoil in the UK gilt market is that if market movements are intense and fast enough, liquidity can indeed be a risk for long-term investors like pension funds and insurers. Insurers and pension funds are exposed to liquidity risk due to margin calls resulting from hedging positions via derivatives. If yields shoot up unexpectedly in a short period of time, causing a corresponding slump in the value of assets, investors might have to resort to fire sales to be able to meet growing margin calls. Forced sales further lower the price of assets, essentially creating a self-reinforcing downward spiral. It took an unprecedented intervention from the Bank of England's Financial Policy Committee to stall this and stabilize the gilt market.

The obvious question on everyone's mind was: Can something like that happen in the euro area?

And the answer is a yes. The risk cannot be excluded. But, importantly, it is not a strong yes. We believe that the materialization of such risks in the EU is much less likely - for a number of reasons.

First of all, the sheer size of the European debt market is a helpful element. Being substantially bigger than the UK market, sudden movements would not be able to sway the market extensively. Secondly, any abrupt repricing of a country's government bonds in Europe would not be fully transferred over into euro swap rates as these are more diversified. The connection between gilt levels and the underlying interest rate swaps that pension funds in the UK use are of a more direct nature. Thirdly, while European pension funds and insurers do hedge against interest rate risks, they tend to do it to a lesser extent than their UK counterparts. We will be publishing an analysis of European insurers' hedging strategies and the liquidity needs connected to these in our forthcoming Financial Stability Report in December.

Even though the above structural buffers would serve to cushion the impact of similar market movements in Europe on insurers' liquidity needs, liquidity management is an important aspect to consider in the current market environment. Besides derivatives hedging, there's another element to liquidity that I would like to briefly touch upon.

This other aspect brings us to the question of lapses. As I mentioned before, inflation leaves consumers with less disposable income. To regain some of their purchasing power in the short term, some people might choose to cut back on their savings via life insurance policies or even reduce the breadth of insurance coverage they enjoy. Lapses may be also motivated by another reason. Traditional savings methods, such as bank deposits, are becoming more attractive compared to insurance contracts signed in an era of ultra-low interest rates. This growing attractiveness could bring policyholders to reclaim their funds and opt for savings options outside the insurance sector.

This means that liquidity can be a concern from market and consumer behavior perspectives alike. There's something to be said about insurers' own risk taking as well with regard to liquidity.

Inflation, especially the level that it reached in the past months, came as a surprise to many. Interest rates are rising, but they follow inflation with considerable delay. The still sizeable spread between inflation and interest rates might motivate insurers to take risks and invest in less liquid assets with higher returns. Given the liquidity concerns amid rising rates that I sketched out before, this could be a source of vulnerability for the sector.

CONCLUSION

The situation, therefore, is highly challenging. There are multiple risk factors at play they cross-influence one another. Are insurers in a perfect storm? Will there be a heavy fallout? It's difficult to judge.

What we know from the context of the pandemic is that insurers have both the space and the toolkit to ride out difficult times. And they do this against the backdrop of a very solid regulatory system that we are determined to keep relevant and up to date. In fact, we have just done an impact assessment for the Solvency II review proposals based on current market conditions as opposed to our original assessment from 2020 and found no material changes that would warrant a reconsideration of our position. The system is holding up well.

Still, as much as it is our intention to go from strength to strength, the world seems to present us with cries after crises. With so many moving parts amid high uncertainties, it very much pays to act prudently - on capital as well as on liquidity. Now is not the time to lower our guards and lower the buffers. They might be needed to help insurers through the trying times ahead.

As the sector is rightfully bracing itself to cope with the current turbulent times, I'd like to leave you with one last message of caution. The economic turbulence we're experiencing today must not lead us to take our eyes off two overarching challenges: digitalization and sustainability, which are just as vital to the health of our industry.

Ladies and gentlemen, thank you very much for your attention. I'm looking forward to going deeper into regulatory topics in the panel discussion that's coming up.

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