Payment lapses increase European insurers’ capital risk
A growing number of insurers have sought reinsurance to manage lapse risk and protect their portfolios and bottom line.
Andrew Putwainposted on Friday, September 29, 2023
The life insurance sector – and its investments – are at risk due to the recent economic volatility that could see their customers abandon them and cause a hole in their finances.
These findings come from a new Gallagher Re report, which has been launched as the first in a series of “Gray Rhino research papers”. A ‘grey rhino’, a play on the more frequently referenced ‘black swan’, is a preventable danger that people choose to ignore.
In the report, Gallagher Re warns of potential hidden dangers to investment capital from these events.
“Capital losses from rising policyholder lapses could be catastrophic for the industry and create acute financial problems for carriers,” said the report due to “politicians and business leaders grappling with inflation, low growth and the threat of recession”.
The papers are designed to raise awareness of insurance industry challenges before a major event occurs. This is the company’s first publication addressing mass-lapse risk in European life insurance.
“The continuing cost-of-living crisis for consumers is also increasing the likelihood they will cancel policies and/or take their money elsewhere."
Lapse reinsurance transactions have increasingly been executed in Europe, with a growing number of first precedents of these transactions receiving local regulators’ blessings.
“As interest rates rise, life insurers are increasingly aware of the capital losses that could result from rising policyholder lapses,” said Gallagher Re. “The continuing cost-of-living crisis for consumers is also increasing the likelihood they will cancel policies and/or take their money elsewhere."
It added that the macroeconomic drivers of a mass-lapse event are complex and difficult to model, but the consequences are “clear” and “could be catastrophic for the industry”.
Gallagher Re said this event would include large fixed-income portfolios being sold at a capital loss to fund surrender value, which could in turn lead to a material mismatch in the duration of assets and liabilities.
“Driven by an extended period of low interest rates and bond yields, European insurers have moved their portfolios toward less liquid assets in recent years,” it said.
What would a lapse risk event do?
Lapse risk has been formally recognised by European regulators for some time, requiring insurers to hold sufficient capital under lapse up, lapse down, and mass lapse scenarios, said Gallagher Re.
“The mass lapse is defined under Solvency II as a one-off first-year shock where 40% of life policies immediately lapse (70% for some specific categories),” it added.
“Coverage can be configured to transfer lapse risk to reinsurers, where the reinsurance policy responds if lapse rates are higher or lower than expected."
In a scenario where lapse rates accelerate, the situation could “rapidly deteriorate”, said the paper. “As we saw during the 2008 crisis, the collapse of a major insurer could even be a systemic risk. Mindful of this, a growing number of insurers are seeking reinsurance solutions to manage this lapse risk, as well as liquidity risk, and protect their bottom line,” Gallagher Re said.
The report went on to add that, “coverage can be configured to transfer lapse risk to reinsurers, where the reinsurance policy responds if lapse rates are higher or lower than expected. The cover also provides a substantial Solvency II benefit, largely through lapse solvency capital requirement (SCR) reduction and from some risk margin relief."
Wider industry context
The paper noted that ratings agencies, such as Moody’s and Fitch Ratings, have already taken of the issue – beginning to examine the risk in detail in recent reports.
“Lapse risk is distributed unevenly across Europe, with insurers in some markets more exposed than others, and different mitigating factors involved,” Gallagher Re’s paper said.
France and Italy were identified as the two markets where insurers were the most exposed to the risk. This was due partly to the laws in these countries that enabled consumers to withdraw from or lapse their policies with little to no financial consequences.
The effects of such policies have already had wider implications for the market. For instance, the volatile market had, earlier this year, seen a large amount of capital pour into Poste Italiane, the national post office that also offers financial services functions.
The post office’s leaders said the situation was due to large scale public nerves about the state of the economy, which would help its balance because it meant the office did not have to dip into its government investment assets to make payments.
At the end of last year, numerous reports highlighted the difficulties of those two markets in 2023 with the current conditions. Analysis showed that the Italian insurance market was ‘deteriorating’, with worsening credit fundamentals for the French market.
"The average portfolio was invested 33% in government bonds and 31.5% in corporate bonds in 2019.”
This risk was seen as prominent in other countries – including other major markets, such as the UK, because of restrictions on withdrawals.
The report focused on potential resulting investment issues, partly as European insurers have moved their portfolios towards less liquid assets in recent years.
“According to statistics from the European Insurance and Occupational Pensions Authority (EIOPA), the average portfolio was invested 33% in government bonds and 31.5% in corporate bonds in 2019,” it said.
The average portfolio also had 10.4% in unlisted equity, 4.9% in mortgages and loans, and 2.5% in property.
At the start of 2022, investments in government and corporate bonds had dropped to 29.1% and 28.7% respectively, “while unlisted equity allocations rose to 14.9%, mortgages to 6.1% and property to 3.5%,” it continued.
Regardless of exact portfolio makeup, the impact lapse risk could have is widespread. In 2021, SCOR released a report discussing lapse risk for US life insurers due to the pandemic – which showed that there was almost no preparation for these events. This means that life insurers would be advised to take heed of this.