Wanted: New management instruments
The historically low interest rates – together with the arrival of Solvency II – now leave little room for active balance sheet management. The need to meet partially conflicting requirements creates a problem for life insurers.
The market-consistent discount rate under Solvency II can result in substantial increases in their reserves, but generally the growth in the market value of their investments often does not fully compensate for the increase. At the same time, they need a considerable amount of capital specifically to cover interest-rate and spread risks.
In the current interest-rate environment, national and international accounting regulations are also imposing repeated increases in reserves, but the rules differ from the valuations required by Solvency II.
Though insurers could utilise unrealised gains on their assets to compensate for additional costs, in practice their use may be restricted by the regulations on policyholders’ participation in gains on investments. Furthermore, a sudden rise in interest rates can result in a drop in unrealised gains such that the required amount for strengthening the technical reserve might no longer be covered by sufficient assets.
Traditionally, these asset-liability management challenges have been managed on the assets side using structured financial instruments. However, the current situation is more difficult in that, unlike in the past, the market-consistent valuation of liabilities has to be taken into account – both for Solvency II and for the national rules for creating additional reserves in the balance sheet. In addition, it is apparent that there are fewer possibilities for covering these requirements using financial instruments. There are a number of reasons for this – investment banks, for example, are increasingly loathe to offer life insurers tailor-made financial solutions because they give rise to high capital costs under Basel III.