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Low interest rates have created a hostile environment for Europe's traditional life insurance industry. Although insurers have responded well, forthcoming changes to Solvency II will make things even tougher. Our report with Morgan Stanley looks at the key issues, exposure of the industry, and potential responses.

As low interest rates look likely to remain for some time to come, the European life insurance industry remains under significant pressure. In recent years, insurers have used some of the obvious levers to stay afloat, such as realizing hidden reserves. To withstand continued low yields, insurers now need to analyze and plan for another set of mitigating actions and make some tough decisions. 

The impact of the Solvency II review on insurers

While the sector has responded through reducing guarantees in new business and tightening its asset liability mismatch (ALM) management practices, the problem arising from low interest rates is aggravated by several factors. First, elements in the Solvency II (SII) framework that have softened the impact of marking liabilities to market are wearing off. For example, the ultimate forward rate used in extrapolating the SII discount curve is steadily reduced, and the effect of transitional measures also decreases over time. 

Second, changes to the SII framework as proposed by the European Insurance and Occupational Pensions Authority (EIOPA) in their SII review will increase the impact of low interest rates. Specifically, this is driven by changes to the extrapolation approach for the SII discount curve, which brings it closer to market rates at the long end as well, and a harsher interest rate shock under the Standard Formula, which allows for negative interest rates in stress scenarios. 

Low interest rates and European insurers

These changes and impacts apply across Europe, but not all geographies are equally impacted. Germany and the Netherlands are most affected given the long duration of their liabilities and interest rate sensitivity of their traditional life insurance books. In the Netherlands, insurers are relatively well prepared as the local regulator (DNB) has required them to perform a market-consistent economic capital calculation in parallel to the SII calculation since the inception of SII.  

Our model shows that if the changes to the SII framework were applied today, in today’s market environment, the solvency of German life insurers would on average decrease by 60 percentage points or more, meaning that more than one third of German life insurers would have a solvency ratio below 100% without transitional measures. 

Actions European insurers should take in a low interest environment 

To stay above water in this challenging environment and withstand low yields, traditional life insurers should:

  • Further optimize their approach to asset liability management (ALM), hedging and cashflow matching and reassess their investment strategies
  • Perform a structural review of modelling choices and actuarial assumptions to bring them in line with the revised Solvency II framework
  • Tighten their back book management practices, for example with regard to crediting rules
  • Further accelerate the transition to products with lower guarantees
  • Further increase the operational efficiency of their business