Demand for longevity reinsurance and risk transfer among UK life insurers could rise, as their Solvency II ratios have fallen in the wake of lower investment yields and the fallout from the Brexit vote.
Fitch Ratings highlights the link between investment yields, Solvency II ratios and longevity risk capital charges in a recent report.
“S2 requires insurers to hold a risk margin for longevity risk, a requirement that increases significantly when interest rates fall and an important consideration for annuity business,” Fitch explained.
One of the instruments that life insurers use to manage their Solvency II ratios, related to longevity risk, is longevity reinsurance capacity. Balancing the risks within a life insurers portfolio requires use of both mortality and longevity reinsurance capacity and any increase in demand could result in opportunities for life insurance-linked securities (ILS) funds to participate.
Fitch’s analysis found that in the first-half of 2016 Solvency II ratios among UK life insurance firms declined, driven by the fall in interest rates, and particularly influenced by the Brexit referendum on membership of the EU which saw the UK vote to leave.
The fall in global interest rates, as the world moves increasingly towards negative interest rate policy (NIRP), has had a significant effect on life insurance and reinsurance companies, annuity providers, and pension funds.
Lower yields across the safer assets of the financial markets create great difficulty for insurance and reinsurance companies, which rely on safer, higher rated assets to place premium float into. As rates have declined the asset side of the business has increasingly seen its return drop, lowering the overall returns on equity (RoE’s) of the sector.
For life insurers and annuity providers this can be particularly difficult, as they rely on long-term investments to make the capital required to pay out claims and to keep to the promises made to annuitants.
However, while yields on gilts and other assets continue to decline, Solvency II ratios do remain strong despite the decline in the first-half of 2016, Fitch explained.
But with insurers required to hold a risk margin for longevity risk under Solvency II, any decline means a rethink of the capital requirements and risk margin required.
“Insurers can limit the impact of the risk margin by calculating capital requirements for pre-2016 business using S2 transitional arrangements, and by buying longevity reinsurance,” Fitch said.
So there could be some knock-on effect of lower yields and Brexit that results in a greater demand for longevity reinsurance capacity, a clear opportunity for global reinsurers and also the life ILS funds.
Any increase in demand will be welcomed by both traditional and alternative sides of the market, as an incremental opportunity to deploy capital and capacity into risks.
But even with greater use of longevity reinsurance, Fitch warns that the lower yield world could lead; “Some major insurers to retreat from the annuity market in favour of deploying capital elsewhere.”
Increased demand for longevity reinsurance and risk transfer will likely also be seen in Europe and other markets, as low yields hit life insurers ability to maintain capital and to make the required returns their businesses need.
Capital modelling becomes increasingly important in a market such as today’s, where regulatory and economic pressures threaten traditional insurance and reinsurance business models. Greater and more intelligent use of risk transfer is just one way to adapt to these challenges.
So insurers could face some costs due to Brexit and the lower yield world, with longevity reinsurance provisions one area greater spend may be seen. Fitch remains stable on UK life insurers, saying they should be able to successfully navigate any market challenges.
Hymans Robertson said recently that it believes pensions may be facing up to 50% more in longevity related liability costs, due to lower yields on gilts after Brexit. This is also expected to result in greater demand for longevity risk transfer, meaning that demand for capacity in the reinsurance market for longevity risk could reach its highest levels seen if rates remain low.
View details of many historical longevity swap and reinsurance transactions in our Longevity Risk Deal Directory.