Low rates troubles for insurances and pension funds

A CGFS report highlights the pressure of a ‘low for long’ interest rate environment on life insurance companies and defined-benefit pension funds. This pressure reflects a fundamental mismatch: the duration of liabilities is greater than that of assets. Hence low rates (discount factors) have reduced funding ratios below 100% after the great financial crisis. Simulations suggest that funding ratios could decline further, possibly accompanied by negative net cash flows. A ‘low-for-long’ scenario would broadly make things worse. While the nature of this risk is well known, its manifestation is gradual and partly mitigated by the asset reflation of the 2010s. The worst scenario for insurance companies and pension funds is one where rates ultimately fail to rise or are pushed even lower (negative) due to new deflationary financial market shocks.


Credit market herding and price distortions

Corporate credit markets have historically been especially prone to herding. The main drivers of herding have been past returns, rating changes and liquidity. Sell herding has been particularly strong and flows have been disproportionate after very large price moves. Herding can be persistent and lead to significant price distortions. Non-fundamental price overshooting is a valid basis for profitable contrarian trading strategies.


Insurance companies and systemic risk

The contribution of life insurers to systemic risk has increased, according to the IMF Global Financial Stability Report. They now hold about 12% of global assets and common exposure to aggregate risk has risen. Insurers are vital for key market segments such as corporate bonds and securities lending. Meanwhile, low global interest rates have aggravated duration gaps, increased interest rate sensitivity and may encourage greater risk taking.


Understanding duration feedback loops

When long-term government bond yields are low enough, further declines can ‘feed on themselves’. European insurance companies and pension funds are plausible catalysts. The duration gap between their liabilities and assets typically widens non-linearly when yields are low and compressed further, triggering sizeable duration extension flows.


The global systemic consequences of Solvency II

The new European insurance regulation will be introduced in 2016 with important consequences for the global financial system. A paper by Avinash Persaud argues that Solvency II introduces an undue bias against assets with high market and liquidity risk, such as equity. Meanwhile it encourages excessive holdings of low-yielding sovereign and high-grade bonds. (more…)

The “reach for yield” bias of institutional investors

‘Reach for yield’ describes regulated investors’ preference for high-risk assets within the confines of a rule-based risk metric (such as credit ratings or VaR). Bo Becker and Victoria Ivashina provide evidence that U.S. insurance companies act on this principle and show that ”conditional on ratings, insurance portfolios are systematically biased toward higher yield bonds”. ‘Reach for yield’ would be a form of regulatory arbitrage, a source of inefficiency, and a reward for “unaccounted risk” of securities and issuers.