Untitled

Why Some European Life Markets AreMore Sensitive To Interest RateMovements Than Others

Primary Credit Analysts:

Christian Badorff, Frankfurt (49) 69-33-999-199; [email protected]

Alexander Altinisik, Stockholm (46) 8-440-59-02; [email protected]

Johannes Bender, Frankfurt (49) 69-33-999-196; [email protected]

Anna Glennmar, Milan (39) 02-72111-252; [email protected]

Oliver Herbert, London (44) 20-7176-7054; [email protected]

Jean Paul Huby Klein, Frankfurt (49) 69-33-999-198; [email protected]

Sanjay Joshi, London (44) 20-7176-7087; [email protected]

Silke Longoni, Frankfurt (49) 69-33-999-195; [email protected]

Secondary Contacts:

Karin Clemens, Frankfurt (49) 69-33-999-193; [email protected]

Rob C Jones, London (44) 20-7176-7041; [email protected]

Ralf Bender, CFA, Frankfurt (49) 69-33-999-194; [email protected]

Mark Coleman, London (44) 20-7176-7006; [email protected]

Table Of Contents

Regulatory And Legislative Frameworks Set The Scene

The Importance Of Competition And Diversification

Customers Resist The Switch Away From Guaranteed Returns

Back-Book Management Is Crucial

Significant Changes In Investments And Improvements In Risk

Management Point The Way Forward

Low Yields Remain The Overriding Challenge

European Life Insurance: A Country-By-Country Snapshot

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MAY 14, 2014 1

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Table Of Contents (cont.)

Related Criteria And Research


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Why Some European Life Markets Are MoreSensitive To Interest Rate Movements ThanOthers

To ensure ratings consistency, Standard & Poor's Ratings Services regularly undertakes thematic portfolio reviews. In

our latest review, we've examined how sensitive insurers in Europe are to movements in risk-free rates (that is, the

theoretical rate of return of an investment with zero risk). We assessed the effects of a significant upward or downward

deviation from our current base-case scenario that we use as a macroeconomic background to our ratings on insurers.

Most recently, the European Insurance and Occupational Pensions Authority (EIOPA) launched a stress test with a

specific module that focuses on prolonged low interest rates. In our view, this highlights EIOPA's ongoing concern

about the impact of low yields on insurers' solvency.

Our review focused on life insurers operating in markets we consider to be most susceptible to changes in interest

rates, based on our insurance industry and country risk analyses (IICRAs). Within these sectors, we analyzed a set of

market-specific characteristics that in our view can positively or negatively influence insurers' interest rate sensitivity,

finding commonalities as well as differences between sectors.

We note that regulators and legislators have taken varying approaches in dealing with the current operating

environment. Markets also vary widely in terms of competition and the degree of diversification inherent in insurers'

business models. And while the economic picture is fairly similar in the markets, companies in different sectors may

not be exposed to the same challenges in managing their back books. Consequently, they have adopted different

strategies to counter the current conditions.

From our review, we conclude that a further fall in interest rates--an event that's not part of our base-case scenario--is

likely to have a more significant credit downside than a faster-than-anticipated rate increase.

Overview

• Our Insurance Industry and Country Risk Analysis provides a framework to identify life insurance sectors that

display high asset-liability mismatch risks and that are therefore particularly sensitive to movements in interest

rates.

• Insurers' sensitivity to interest rates is influenced to a large degree by the shape of the market, new business

trends and back book management, companies' progress in terms of investment and risk management, and the

regulatory environment.

• Our economists continue to forecast a slight increase in interest rates throughout Europe over 2014-2015,

which we account for in our base-case scenario for ratings on insurers. Such a development would, in our view,

be supportive of current ratings and outlooks.

The life insurance industry's sensitivity to interest rates centers on the prevalence of guaranteed rates in insurers' back

books that require an annual minimum return from investments or other sources and the resulting dependence on


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investment results. Most life insurers would likely benefit from an increase in interest rates in line with our base-case

scenario because it would take away some of the pressure on net investment returns. This, in turn, could help to

achieve stable or even increasing margins on guaranteed rates where they exist, as we've previously outlined (see "The

Low-Interest-Rate Fog Over Global Life Insurers May Be Lifting," published July 25, 2013, and "EMEA Insurance

Outlook For 2014: Signs Of Ratings Stability Emerge, But Downside Risks Remain," published Dec. 12, 2013, on

RatingsDirect).

Our economists continue to forecast slight increases in risk-free interest rates throughout Europe (see table 1). We

incorporate these projections in our base-case credit scenarios for individual insurers and they inform our ratings on

life companies. As such, we believe that some of the pressure on life insurers' business models could gradually

decrease over 2014-2015 under this scenario.

A more pronounced hike or a further fall of interest rates would likely have a less favorable impact on insurers'

financial strength, with a further fall in rates the clearly more negative scenario.

Table 1

Main European Economic Indicators (As Of April 2014)

Austria Denmark Finland Germany Netherlands Norway Sweden Switzerland

Real GDP (% change)

2013 0.4 0.1 (0.5) 0.5 (0.8) 0.5 1.0 1.9

2014f 1.7 1.3 1.0 1.8 0.8 2.0 2.6 2.2

2015f 1.8 1.5 1.5 2.0 1.3 1.8 3.1 2.5

CPI inflation (%)

2013 2.1 0.8 2.3 1.6 2.6 2.3 0.5 0.1

2014f 1.8 1.9 1.9 1.4 1.0 2.3 1.3 0.3

2015f 1.8 1.8 1.7 1.5 1.0 2.0 2.1 1.0

Unemployment rate (%)

2013 4.9 7.1 8.5 5.3 6.7 3.5 8.1 3.2

2014f 5.0 7.1 8.3 5.2 7.5 3.5 8.0 3.0

2015f 5.0 7.0 8.2 5.1 7.2 3.8 7.5 2.9

Ten-year bond yield (yearly average) Germany

2013 1.6

2014f 2.0

2015f 2.4

f--Forecast. Source: Standard & Poor's.

Nevertheless, a rapid recovery in most insurers' reported earnings appears unlikely to us because it would take time for

rising interest rates to show in returns, due to the industry's typically high asset durations and maturing higher-yielding

assets. However, such a recovery would benefit insurers' economic capital positions.

A faster-than-anticipated rise in rates, on the other hand, could prompt policyholders to surrender their policies,

choosing instead to reinvest in higher yielding products, offered either by insurers or by competing industries such as

asset managers or banks. The need for cash to meet payment requirements on these surrendered policies could force


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Why Some European Life Markets Are More Sensitive To Interest Rate Movements Than Others

insurers to sell bond investments just as bond prices are falling and the current unrealized gains on fixed-income

investments potentially convert into realized losses. At this stage, we believe this risk is limited in Europe because

many guarantees on the back book would continue to display an intrinsic value even with a 100 basis-point increase in

risk-free rates.

In Europe, we consider eight life insurance sectors to be most susceptible to a change in interest rates (see table 2).

These make up more than half of the total number of life insurance sectors worldwide for which we view asset-liability

mismatch (ALM) risk as high. All eight of these sectors have a significant amount of pension or savings products with

guaranteed rates and policyholder profit-participation mechanisms in the liability profile. Such dependence poses a

challenge to companies in times of low interest rates because of the guarantees and policyholder options in many of

the products they sell, although there is some difference in domestic interest rate levels by sector. What's more,

countries perceived by bond investors as so-called safe havens, such as Germany and the Nordic countries, are

experiencing lower investment yields than others (see charts 1 and 2).

Each market features country-specific competitive and regulatory characteristics that either help or hinder companies

operating in a low interest rate environment (see section headed "European Life Insurance: A Country-By-Country

Snapshot" for more details). This provides a context for management to take action in dealing with the current low

interest rate environment.

Table 2

Selected European Insurance Industry And Country Risk Assessments

Country/Sector Industry And Country Risk Assessment Product Risk Assessment

Austria life Low risk High

Denmark life Low risk High

Finland life Intermediate risk High

Germany life Intermediate risk High

Netherlands life Intermediate risk High

Norway life Low risk High

Sweden life Low risk High

Switzerland life Low risk High

Source: Standard & Poor's.


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Chart 1


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Regulatory And Legislative Frameworks Set The Scene

Regulation and legislation are important when assessing a sector's vulnerability to movements in interest rates. By

employing more advanced risk-based models to calculate solvency ratios, policymakers influence the type of business

insurers will be willing and able to write in the future. The policymakers' decisions also influence what measures

insurers take to effectively manage their investments, capital, and earnings. The results can be quite severe: in the

U.K., for example, the introduction of economic models for assessing risk-based capital has led to derisking, much

improved asset-liability management, and changes in the product mix.

The influence of low interest rates on insurers' solvency remains a key focus for EIOPA--the institution that oversees

and provides recommendations to national regulators. On April 30, 2014, EIOPA launched a Europe-wide stress-test

exercise, where one of the key modules will require insurers to scope the financial impact of persistent low interest

rates. The results of these investigations are due to be published in November 2014.

In the eight sectors that we reviewed, Swiss regulator FINMA has been the most active in terms of development

through the application of its Swiss Solvency Test (SST). The SST, which measures solvency using a risk-based

approach, has been in force since 2011, although it's still being run parallel to the old solvency system, Solvabilität I.


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Finanstilsynet in Denmark and Finansinspektionen in Sweden have been early adopters of more economic-based

supervisory tools as a precursor of Solvency II. In all three countries, this has resulted in companies managing their

duration mismatch (that is, the difference between the duration of their assets and liabilities) more tightly. Recently,

however, continuously low yields have moved some regulators to introduce forbearance measures, such as changes in

the yield curves being used, that somewhat dilute the strict economic character of solvency measures.

Regulators in other countries have not supplemented or replaced the traditional Solvency I calculation that does not

fully reveal the effect of low interest rates on companies' solvency. To ensure that companies prepare for a long-term

low interest rate environment, German regulator BaFin and its Austrian peer FMA have prescribed additional reserving

requirements for insurers that have back books with particularly high guaranteed rates. Also, regulators are already

applying many of the measures to come into place with Solvency II today--for example, by requiring insurers to submit

their own risk and solvency assessments (ORSAs).

In many countries across Europe, legislators and/or regulators determine guaranteed rates. Typically, the government

or the regulator sets maximum guaranteed rates for new business, as occurs in Austria, Germany, and Norway. In

Switzerland, the government sets fixed guaranteed rates not only for new life business but also the whole in-force book

for a significant proportion of the life business (obligatory group life). This measure can provide relief to insurers

because it helps to maintain stable margins between investment returns and guarantees. In Norway, the regulator has

gone a step further by allowing insurers to effectively reprice the guarantees in their individual life books.

The Importance Of Competition And Diversification

Competition varies greatly between European insurance markets, in part due to market concentration and saturation

and the existence of companies with a less pronounced focus on shareholder profitability, namely mutuals.

Market concentration appears to be highest in Austria, Switzerland, and the Nordic countries. Competition is

particularly intense in Germany and The Netherlands, but for different reasons. In Germany, there is a relatively lower

market concentration and mutuals are important market players. In The Netherlands, the market is highly saturated

and the important group pension system mostly relies on non-insurance products.

Diversification across business lines can help lessen the effect of low yields on insurers' financial strength. In markets

where composite groups--writing life, property-casualty, and possibly other types of insurance such as health--are

more prevalent, these groups usually are better able to offset the increased vulnerability of their life business to low

bond yields through a stronger focus on underwriting profitability in their other business lines. This is the case for

many Austrian, Dutch, German, and Swiss insurers, whereas Nordic life insurers generally do not benefit from

diversification across business lines due to their portfolio typically being concentrated in the life business.

International diversification, through which companies partly compensate for lower earnings prospects in certain

markets by expanding their business in markets that are potentially less competitive, offers an alternative approach.

Some large Austrian and Germany-domiciled groups have adopted this strategy.


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Customers Resist The Switch Away From Guaranteed Returns

In all countries in our study, life insurers are trying to move their new business away from savings products with

minimum guaranteed rates. Instead, companies are looking to savings products with no or lower or alternative kinds of

guarantees, and to risk products that exclude a savings component such as disability and term life policies.

However, customers are more risk averse, with the result that insurers have had varying success in accomplishing the

aforementioned product shift. In Germany, for example, insurers have failed so far to meaningfully reduce the amount

of guaranteed products in their new business. Consequently, companies continue to sell traditional products, albeit

with relatively low guaranteed rates of 1.75% currently (with a further reduction potentially coming up in 2015 or

2016). In The Netherlands, insurers recently have also been struggling to get customers to accept products that

exclude guarantees and have instead accepted lower life business volumes overall. The Nordic life insurers, on the

other hand, have managed to increase or at least maintain the proportion of non-guaranteed products.

Back-Book Management Is Crucial

The composition of back books varies considerably between the sectors, reflecting the different degrees of success in

moving away from traditional products and product specifics, namely shorter contract duration. We also see

considerable variation in the steps that companies take to make their in-force business less vulnerable to low interest

rates (see table 3).

Table 3

European Life Insurance: Guaranteed Rates And Back-Book Composition By Country

Country

Average guaranteed rate

in force (%)

Current guaranteed rate

for new business (%)

Share of traditional

back-book (%) Measure used

Austria 2.9-3.0 1.75 58 Gross premiums written

Denmark 2.60 < 2.0 74 Technical reserves

Finland 3.0-3.5 < 2.0 43 Gross premiums written

Germany 3.10 1.75 75 Gross premiums written

The Netherlands 3.60 2.0-3.0 40 Technical reserves

Norway 3.0-3.5 2.5 75 Technical reserves

Sweden 3.0-3.5 < 2.0 70 Technical reserves

Switzerland 2.0-2.3 1.25-1.75 82 Gross premiums written

Source: Standard & Poor's.

Insurers in all the countries in our study have reduced their policyholder crediting rates as a first step. This generally

helps to maintain policyholder capital at reasonable levels. However, competitive pressures in most of the countries

act as a disincentive for the required reductions in crediting rates, resulting in a considerable depletion of bonus

reserves generally.

Certain markets are traditionally more cost-efficient than others, with Nordic insurers generally displaying lower

expense ratios than their counterparts in Continental Europe because of early investments in IT infrastructure and


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economies of scale due to market concentration. Improved cost efficiency can help bolster underwriting results and

make companies less dependent on investment returns. Efforts to lower costs are therefore widespread throughout the

sectors we reviewed and we generally observe that companies have been reasonably successful in reducing

administration expenses. A meaningful reduction in acquisition expenses appears to be more difficult to achieve

because distribution (through brokers and tied agents, for example) in most markets is a bottleneck.

In some sectors we find that companies are striving to actively change the composition of their back book. Danish,

Finnish, Norwegian, and Swedish life insurers, for instance, are encouraging existing policyholders to exchange their

traditional guaranteed savings products for unit-linked products that do not provide a guarantee but offer more upside

potential. As a measure of last resort, companies are putting weakly performing life insurers into run-off, although

there are few examples as yet. We expect such measures to come under the close scrutiny of policymakers, regulators,

and consumer lobbyists.

Significant Changes In Investments And Improvements In Risk ManagementPoint The Way Forward

Companies in all sectors we reviewed have improved their asset-liability management considerably, usually as part of

their efforts to strengthen their enterprise risk management (ERM) processes. We believe this has in part been spurred

on by the arrival of Solvency II (see related article "Will European Insurers' ERM Developments Continue Without A

Solvency II Push?," published Oct. 21, 2013). As a result, companies are looking to close or significantly reduce the gap

between the duration of their assets and liabilities. Insurers operating in countries with non-benchmark currencies face

a smaller supply of long-term government bonds and try to offset this by implementing interest rate hedges. Either

approach can help reduce the potential vulnerability to low interest rates. Recently, we note that many companies

have moved to limit the duration of their fixed-income investments because of the forecast increase in risk-free rates.

Overall, asset risks vary greatly. Generally, we find that life insurers are increasing their investment risk to obtain risk

premiums that offset lower risk-free rates. Nordic life insurers, for example, invest more heavily in equities than their

counterparts in Continental Europe: In Finland and Sweden, companies operate with high equity exposures of

approximately 30% of total invested assets, whereas Swiss insurers report equity exposures of about 2% on average.

In sectors where equity risk is less prevalent, companies are increasing their investments in assets displaying higher

credit risk. Companies are increasingly investing in lower rated corporate bonds in order to obtain credit risk margins.

We also observe that some insurers invest in less liquid assets providing regular income streams. Examples include

Dutch insurers, which have considerably increased their exposure to residential mortgages recently; and German

insurers, which have focused increasingly on infrastructure investments.

Solvency II will likely play an important role in governing companies' future investment strategies, depending on the

detailed implementation guidance to be provided by the European Insurance and Occupational Pensions Authority

(EIOPA) (see related article "Underwriting The Recovery: Insurers' Role As Investors Expected To Be Preserved,"

published Jan. 14, 2014). In our view, well-capitalized insurers will likely be better able to continue to invest in riskier

and potentially higher yielding investments.


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Low Yields Remain The Overriding Challenge

The European life insurance markets are highly heterogeneous, we believe. A closer look at the European life sectors

that in our view display relatively high sensitivity to movements in interest rates brings to light huge differences in their

respective market environments and business models. To be fair, some of these factors, particularly the yield

environment, cannot be controlled by insurers' stakeholders, including management, policymakers, and policyholders.

And the long-term nature of traditional life insurance makes it difficult to accommodate short-term swings in the back

book. Nonetheless, we believe that stakeholders will have to take action to deal with the current challenge of low

yields, even if a slight recovery in interest rates continues to appear the most likely scenario.

European Life Insurance: A Country-By-Country Snapshot

Austria: Reserving requirements bolster resilience

We assess product risk in the Austrian life insurance market as high. Our assessment is mainly based on the sector's

exposure to long-term policyholder guarantees in insurers' traditional products, which create a duration mismatch risk

relative to shorter-duration assets, particularly in a low interest rate environment. Based on gross premium written

(GPW), about 58% of the life insurance business in Austria in 2012 emanates from traditional long-term life and

pension business, with an average guarantee rate that we estimate to be about 2.9% in the in-force book.

In the current low interest rate environment the margins between investment yields and average guarantees in the

in-force books are shrinking, creating some earnings difficulties for life insurers in Austria. However, we believe that

the effect is less pronounced than in other markets, particularly Germany. The average guarantee rate in the in-force

book in Austria is lower than Germany and the interest rate environment is slightly higher, with Austrian 10-year

government bonds yielding on average about 70 basis points higher than their German equivalents over the past three

years. Austrian life insurance companies have also successfully diversified into less interest-rate-sensitive products like

unit-linked (36% of GPW) and term insurance (about 4% of GPW) allowing for some earnings diversification.

Additionally, we note that companies are increasing asset duration and credit risk to partly offset a decrease in

risk-free rates.

Furthermore, to offset the negative effects of a potential long-term low interest-yield environment, Austrian regulators

have started to implement mandatory additional reserving requirements ("Zinszusatzrückstellung") following the

example set by Germany. While this will likely continue to put pressure on bottom-line earnings, we also believe it

could help to bolster the sector's resilience against continuously low yields. Austrian policymakers have also gradually

reduced guaranteed rates for new business. From 2013, new business has been sold with 1.75% maximum guaranteed

rate, compared with 3.25% in 2003.

We believe that a prolonged low interest rate environment might put the stand-alone credit profile of some Austrian

life insurance companies under pressure. However, most of the Austrian insurance groups are well diversified across

sectors, enabling them to partly offset negative trends in single business lines. Non-life business is the largest sector,

generating 49% of net premiums earned in 2012, followed by life (40%) and health (11%).


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Denmark: A material increase in unit-linked business

Provisions for guaranteed business represented 74% of total life insurance provisions in 2012 (latest available data).

Based on our estimates, the average guaranteed interest on the in-force business is about 2.6%. The current low

interest rates make it harder for life insurers to create investment returns above the guarantees. Capital adequacy is

also negatively affected because provisions are calculated based on market interest rates and insurers generally have

an asset-liability mismatch (ALM).

To derisk their portfolios and improve ALM, Danish life insurers are focusing more on unit-linked business, the

proportion of these premiums having materially increased to 52% of total premiums in 2012 from 22% in 2008.

Although the provisions for guaranteed business were still high at 74% in 2012, this is lower than the 93% of provisions

in 2008. We expect this trend to continue over 2014-2015, easing some of the pressure on capital and earnings. In our

view, Danish life insurers are in general managing the duration mismatch of their assets and liabilities more actively

than their Nordic peers, and using derivatives extensively for hedging purposes. Insurers have also reduced the

guaranteed interest on new business, lowered crediting rates, and increased investments in assets with higher credit

risk and liquidity risk. Some companies have even explored the potential divestment of guaranteed business, but

buyers' interest appears to below.

Regulators have also been focusing on the issues surrounding guaranteed business and the effect of low interest rates.

In 2011, Finanstilsynet introduced a voluntary floor to the discount rate used for the calculation of technical provisions

and later introduced a Solvency II-type discount curve in 2012. Although these measures partly mitigate issues related

to interest rate risk, they create regulatory uncertainty in the market. Finanstilsynet has also encouraged life insurers to

shift their attention to unit-linked business from traditional business, with some success.

Finland: The pressure eases as guaranteed rates fall

We assess the potential for product risks to trigger volatility in returns as high for the Finnish life insurance sector. This

is mainly due to our view of the sector's high ALM risk, heightened by the current low interest rates. Although many

Finnish life insurers have stopped writing traditional life insurance products with guarantees, or are focusing their new

business efforts on unit-linked products, guaranteed products still represented 43% of the sector's combined in-force

book at year-end 2012 (latest available data). While these liabilities have a long duration, Finnish life insurers have

made less use of interest rate risk hedging to match assets with liabilities than most of their Nordic peers. In addition,

Finnish insurers generally hold a high proportion of risky assets, notably equities, in their investment portfolios: Figures

from the Finnish Financial Supervisory Authority (FIN-FSA) indicate that 35% of total invested assets and 19% of total

assets for life insurance business with guarantees were invested in equities at year-end 2012--the highest equity share

among Nordic insurers.

Finnish life insurers have sought new business through unit-linked products and encouraged existing policyholders to

surrender or exchange their guaranteed savings products for unit-linked products that offer more upside potential.

Some insurers have guarantees of about 4.5% in their in-force book, but we estimate that the average guarantee for

most Finnish life insurers is 3.0%-3.5%. As we expect government bond yields to gradually increase, this risk would

consequently fall over time. However, since we expect yields to remain low at least through 2015, it remains a key

concern.


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FIN-FSA increasingly requires insurers to submit their own risk and solvency assessments, in line with the

requirements of the EU's Solvency II regime, which we believe should lead to improved risk governance frameworks

for Finnish life insurers.

Germany: Regulator requests additional reserves for guaranteed products

The German life insurance sector is very sensitive to movements in interest rates. Traditional guaranteed business

accounts for about 75% of total GPW and guaranteed rates are high, at about 3.1% in relation to total invested assets.

Guaranteed rates in the back book are decreasing gradually because of new business being sold with lower rates,

currently 1.75%. There is a significant mismatch of assets and liabilities because policies being sold today are more

often annuity contracts with guarantees extending to the retirement period, rather than endowments. What's more,

German bond yields have been among the lowest in the eurozone.

Companies have been trying to move away from traditional guaranteed business since the beginning of the decade,

with varying degrees of success. Savings products without guarantees or with alternative guarantees have been very

successful at times when financial market conditions were benign, but have suffered in the wake of the financial crisis.

The sector has extended its product offering in risk products, namely term life and disability insurance. Some

companies argue that writing new business with today's lower guaranteed rates helps to bring down the average

guaranteed rate in the back book more quickly while others think the business is not sufficiently profitable even with

today's guaranteed rates. Annual policyholder bonuses are an important feature of traditional savings products and

companies have cut these substantially in response to the prevailing low-yield environment, to about 3.4% for 2014

based on our estimates. We also see companies taking measures to uphold investment returns by extending asset

duration and increasing asset risk.

The German regulator, BaFin, and the government have a mixed track record in tackling the low interest rate

challenge, in our view. Over the past couple of years, maximum guaranteed rates have fallen considerably. Since 2011,

life insurers are required to set aside additional reserves for contracts with higher guaranteed rates. This has a

dampening effect on bottom-line profitability and has helped to discipline the sector as a whole to more quickly lower

the bonus payouts policyholders receive on top of their guaranteed rates. To date, policymakers have not enacted their

plan to abolish participation of leaving policyholders in fixed-income reserves due to public pressure (see "Germany's

Life Insurance Sector Carries An Intermediate Industry And Country Risk Assessment," published Nov. 8, 2013).

In summary, low interest rates constitute the dominant risk factor for the German life insurance sector. In terms of our

ratings, German insurers' financial strength continues to benefit from a relatively high degree of diversification through

other business lines, given that many life insurers are part of larger composite groups. Nonetheless, a further fall in

interest rates would likely increase the pressure on life insurers' stand-alone credit profiles and could also result in

groups increasingly questioning the long-term prospects of this line of business.

The Netherlands: Insurers' focus shifts to mortgage investments and hedging

The Dutch insurance sector is principally composed of composite insurers. However, many have a life bias overall and

interest-rate considerations remain material. Dutch insurers generally write guaranteed business and many insurers

have chosen to partially back these liabilities with equities, leading to a greater degree of ALM risk. Figures from the

regulator, the Dutch National Bank (DNB), indicate that about 8% of total assets for Dutch life insurers were invested


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in equities at the end of the third quarter of 2013.

Responding to the low rate environment is an ongoing challenge for Dutch management teams. The value of the

guarantees in the back book averaging 3.6%, combined with low interest rates, has led to losses under International

Financial Reporting Standards, especially on group life business. Shifting the sales mix to less interest rate-sensitive

products is difficult because of the historic demand for guarantees. This is compounded by the past misselling of

unit-linked business, which has discredited such products.

Companies have therefore sold much reduced volumes of life business and instead focused on managing the back

book. They have invested in residential mortgages to improve investment yields, increasing their allocation by about

€14 billion since year-end 2009 while looking to hedge against movements in interest rates. Looking ahead, we expect

initiatives to reduce administrative expenses to remain a feature.

DNB has responded by providing some forbearance measures to adjust the method for extrapolating the interest rate

curve, providing some uplift to solvency ratios. However, in late 2013 the regulator introduced a new risk-based capital

buffer, pre-empting Solvency II. Firms considered in danger of breaching the new capital standard will require

supervisory approval to pay out dividends.

A further fall in interest rates would not, in our view, materially affect our ratings over the rating horizon. Dutch

insurers typically write both life and non-life business, which helps to offset some interest-rate sensitivity. However, a

prolonged further decline in rates may lead us to revise downward our assessment of industry risk in the Dutch life

market. Such an assessment could affect our business risk profile conclusions, pressure insurers' fixed-charge

coverage, and lead to a weakening in their capital adequacy.

Norway: The pressure eases as guaranteed rates fall

Norwegian life insurers are particularly exposed to interest rate risk because of the preponderance of guaranteed

business and the shortage of assets available in the Norwegian market with long-term fixed interest rates. The three

major Norwegian life insurers--Kommunal Landspensjonskasse (KLP), DNB Livsforsikring, and Storebrand--all have

balance sheets that are heavily skewed toward guaranteed business. With average rates of about 3.0%-3.5%,

companies will not easily be able to find investment opportunities that meet this level of return in the current

environment. That said, new business currently written should be less onerous, partly because guaranteed rates on

traditional business are now lower at 2.5% (where this is written at all), and new hybrid products that have a zero

percent guarantee are available.

These factors should gradually ease the pressure on Norwegian life insurers. Furthermore, DNB Livsforsikring and

Storebrand are now focusing their new business strategy on capital-light unit-linked business, and any guaranteed new

business written is substantially more expensive for policyholders. There is also a trend toward actively encouraging

policyholders with guaranteed products to consider switching their policy to one with no guarantee and more

investment flexibility.

We consider Finanstilsynet, the regulator, to have been active in responding to this difficulty. Regulations implemented

as early as 2008 allowed insurers the option of repricing guarantees, even on in-force business, which essentially

allowed them to share this risk with policyholders. Other more recent interventions include allowing the industry the


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option to allow customers to give up their guarantees and switch to unit-linked business, and introducing a new hybrid

product with less capital-intensive features.

Besides being highly sensitive to low interest rates, Norwegian life insurers do not enjoy the same mitigating factors

seen in some other countries. The market is characterized by companies with little or no diversifying exposure to

non-life insurance or banking activities.

Sweden: Premium back guarantees enter the market

The Swedish life insurance sector is similarly sensitive to movements in interest rates, largely because of ALM risk.

The back book of traditional business with guarantees is large, at 87% of total invested assets in 2012 (latest available

data). The average guaranteed interest on the in-force book is relatively high in the range of 3.0%-3.5%, based on our

estimates. Current low interest rates make it harder for life insurers to create investment returns above the guarantees.

Furthermore, low interest rates negatively affect capital adequacy because provisions are calculated on market interest

rates and insurers generally have an asset-liability mismatch.

As interest rates have fallen, the number of insurers offering guaranteed business has decreased over the past decade.

Several life insurers have, however, re-entered the guaranteed business market by introducing new types of guaranteed

products, such as premium back guarantees. We expect this trend to continue because we believe there is a demand

for guaranteed business in Sweden. Meanwhile, most insurers are focusing on unit-linked business. The proportion of

unit-linked premiums has been steady, averaging about 38% over the past five years and we expect it to remain

around this level over 2014-2015.

Swedish life insurers are increasingly managing the duration mismatch and using derivatives for hedging purposes.

However, the lack of long-term assets makes it difficult to match the liabilities. Many insurers have chosen to

substantially back liabilities with equities, in particular mutual insurers. Based on our estimates, equities constitute

about 30% of total invested assets. Insurers have also lowered the guaranteed interest on new business to a level

generally well below 2%, lowered crediting rates, and increased investments in assets with higher credit risk and

liquidity risk.

The Swedish Financial Supervisory Authority (Finansinspektionen) has also been focusing on the issues surrounding

traditional life insurance business and the effect of low interest rates. In 2012, Finansinspektionen introduced a

temporary and voluntary floor to the discount rate used for the calculation of technical provisions and in 2013

introduced a Solvency II-type discount curve. In our view, these measures partly mitigate issues related to interest rate

risk, but also create regulatory uncertainty in the market.

Switzerland: A solid track record of minimizing ALM risk

ALM risks dominate Swiss life insurers' product offerings. The existing book of life insurance contracts mainly

comprises traditional products (82% of GPW), with minimum guaranteed rates to policyholders (currently 1.5%).

However, for the obligatory part of group life business--about 67% of Swiss life business--the regulator prescribes

guaranteed interest rate changes each year, both for new business and the existing book. As a result, the average

guaranteed in-force rate of about 2% is much lower than in other countries such as Germany. Furthermore, Swiss life

insurers have a strong track record of minimizing ALM risk. Nevertheless, some further product risks prevail, such as

longevity risk, given the importance of annuity products in the Swiss market.


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FinMA prescribes minimum permissible solvency positions and monitors insurers' solvency levels closely. For some

years now, the regulator has required insurers to submit their own risk and solvency assessments under the SST

regime. We view the use of this risk-based framework as favorable in our overall assessment.

Swiss life insurers are increasingly managing the mismatch of assets and liabilities and increasingly utilizing derivatives

for hedging purposes. However, liabilities in Switzerland have a long duration and insurers have difficulties in finding

assets locally to match these liabilities. Many insurers try and back these liabilities with fixed-income assets across the

eurozone and hedge the foreign exchange risk. As a response to the risk-based SST, many insurers have derisked their

investment portfolios.

In our view, Swiss life insurers are generally sensitive to interest rate movements. We believe low interest rates

generally have a negative effect on life insurers' capital and earnings, but with varying impact on different life insurers

depending on the company's product mix and ALM. Furthermore, Swiss insurers benefit from diversification through

other business lines, especially when life insurers are part of a larger composite group. Although increased interest

rates could relieve some of the pressure on life insurers, a spike in interest rates could result in increased surrenders

and affect market dynamics.

Related Criteria And Research

All articles listed below are available on the Global Credit Portal, unless otherwise stated.

• Credit Conditions: Europe Is On A More Stable Path, Amid Turbulence In Emerging Markets, March 21, 2014

• Denmark's Life Insurance Sector Carries A Low Industry And Country Risk Assessment, Feb. 28, 2014

• Finland Life Insurance Sector Carries An Intermediate Industry And Country Risk Assessment, Feb. 28, 2014

• Norway Life Insurance Sector Carries A Low Industry And Country Risk Assessment, Feb. 28, 2014

• Sweden's Life Insurance Sector Carries A Low Industry And Country Risk Assessment, Feb. 28, 2014

• Swiss Life Insurance Sector Carries A Low Industry And Country Risk Assessment, Feb. 28, 2014

• Underwriting The Recovery: Insurers' Role As Investors Expected To Be Preserved, Jan. 14, 2014

• EMEA Insurance Outlook For 2014: Signs Of Ratings Stability Emerge, But Downside Risks Remain, Dec. 12, 2013

• These Green Shoots Will Need A Lot Of Watering, Dec. 12, 2013

• Credit Conditions: Europe Sees A Slight Improvement, But Structural Weaknesses Persist, Dec. 9, 2013

• German Insurers Pursue Underwriting Profits As Low Interest Rates Bite, Nov. 26, 2013

• Netherlands Life Insurance Sector Carries An Intermediate Industry And Country Risk Assessment, Nov. 13, 2013

• Germany's Life Insurance Sector Carries An Intermediate Industry And Country Risk Assessment, Nov. 8, 2013

• Will European Insurers' ERM Developments Continue Without A Solvency II Push?, Oct. 21, 2013

• The Low-Interest-Rate Fog Over Global Life Insurers May Be Lifting, July 25, 2013

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Additional Contact:

Insurance Ratings Europe; [email protected]


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