Life insurance companies chasing risky assets in a low interest rate environment need to be closely monitored, the International Monetary Fund says in a new report.
The IMF report labels the issue as the “gamble for resurrection” in response to solvency risk, asset-liability mismatches or diminishing net margins in a low-interest rate environment.
This “re-risking via changes in business models or asset allocation needs to be closely monitored,” the report said.
The report, released Wednesday, said capital shortfalls for life insurers “do not appear to be an immediate risk” as the industry seeks to negotiate the current low interest rate environment because the insurance has increased liquidity and added capital in response to the recent financial crisis.
But, the report warns, “a protracted period of low rates could depress interest margins further and erode capital buffers, potentially driving insurance companies to further increase their credit and liquidity risk.”
At the same time, the report said, “life insurers operate with significant balance sheet leverage and are thus exposed to credit shocks,” thus exacerbating the problem.
In general, the report said, acute risks to the financial system have been reduced because regulators and financial industries worldwide have undertaken a number of steps to shore up the world financial system in the wake of the 2007-2009 severe economic downturn.
But, the report said, further actions are needed to “entrench financial stability.”
The report said global financial stability has improved since its last report in October 2012.
The report said government policy actions have eased monetary and financial conditions and reduced tail risks, leading to a sharp increase in risk appetite and a rally in asset prices.
But, the report said, “if progress on addressing medium-term challenges falters, the rally in financial markets may prove unsustainable, risks could reappear and the global financial crisis could morph into a more chronic phase.”
The report puts insurers in the same boat as pension funds as both have responded to the low-interest-rate environment by increasing their risk exposures.
The issue has been raised by the Federal Reserve Board, which is pressuring insurers to reduce the guarantees they provide on variable annuities sold with commitments to provide a relative high rate of return.
Insurers competed strongly in this market over the past several years, but insurers have been pulling back in that time under pressure from the Fed.
A primary example is MetLife, which in February said it is changing its mix of products in the highly competitive variable annuity that reduces the guaranteed payout promised annuitants.
The report said its concerns about the U.S. life insurance industry stem from the fact that low interest rates mean that insurers face the prospects of investing in lower yielding assets as bonds mature.
“On the liability side, long-term fixed-rate legacy products are costly because minimum guarantee rates cannot be easily reduced,” the report said.
The report said that, “The effect is a compression in net interest margins, that is, a reduction in the difference between returns on underlying investments and rates that insurance companies pay to policyholders.”