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Living with an Uncertain Capital Climate

December 13, 2011 By Jan Willem Kuenen , Osselaer van , Kilian Berz , Christopher Kaye , Alison Sander , Wouter-Jan Schouten , and Miki Tsusaka

As a result of trends linked to global aging, companies must plan for a continuation of today’s low-real-interest-rate environment as well as a potential high-inflation scenario.

A period of prolonged low interest rates—while benefiting many industries by making borrowing cheaper—could have a serious impact on insurance companies, banks, and other types of organizations that invest either on their own behalf or on the behalf of others. Insurers and banks should therefore consider how to navigate through such a period successfully, adapting to the low-rate environment and even using it to gain an edge over rivals. At the same time, they should prepare for high inflation combined with low real interest rates—a scenario that could occur in some markets.

Insurers. Low nominal interest rates can cause huge difficulties for life insurers (and, similarly, for pension funds and asset managers). First, there can be serious problems with high-guarantee products sold in the past (when rates were higher) that have not yet matured. Insurers could struggle to match these guarantees in what they call their “in-force books.” Japan had this experience in the 1990s, resulting in the failure of eight insurers between 1997 and 2001. Ten million policies, representing about 10 percent of Japan’s life-insurance market, were affected, and the sector as a whole lost $11 billion in 2001 alone.

When real returns are low and inflation is higher, guarantees are easier to meet. But there is still an issue for clients who receive the nominal returns promised to them but not the commensurate buying power.

Moreover, it is a major challenge to sell new products when guaranteed rates of return are extremely low, with many consumers preferring more flexible investments such as savings products from banks that offer the ability to reinvest when market conditions warrant.

For their in-force books, insurers can take steps to mitigate the negative effects of a prolonged low-real-interest-rate environment, potential asset bubbles, and inflation uncertainty. They can invest more in asset classes such as infrastructure that are less vulnerable to speculative bubbles and can provide some inflation protection. And they can use financial instruments such as swaps and hedges to protect against downside macroeconomic risks.

To keep new business sales robust, insurers may have to rely more on their core activity: managing major risks for customers. Obviously, all products—such as those involving mortality risk (early death), longevity risk (outliving assets), and investment risk (low or negative returns)—need to be designed on the basis of various macroeconomic scenarios that could unfold.

Products with inflation-linked guarantees could become particularly attractive because they provide customers a guarantee on buying power, which is critical in times of high inflation. At the same time, these products protect insurers against periods of deflation.

Banks. When interest rates are low, banks generally have very low margins on plain-vanilla savings products, so the challenge becomes one of making higher returns on the asset side of their balance sheets—their loan books.

Today, as some banks are deleveraging, high interest rates can still be charged for loans in many markets. However, if the demand for mortgages and loans is less than the capital supply in the future, competition for a shrinking lending market may well heat up again. Additionally, large corporations may bypass banks and go directly to the capital markets to meet their funding needs less expensively.

In a competitive lending environment, sophisticated risk-management tools become a crucial element of success. Identifying high-risk customers will help differentiate the winners from the losers. In light of so much uncertainty about interest rates, banks should assess areas of vulnerability, particularly with regard to any mismatches in the duration of their assets and liabilities—and they should consider trying to shift their business model from one built on spreads to one in which fees play a more prominent role.

Living with an Uncertain Capital Climate
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