All Insurers are Currently Searching for Yield

Helmut Gründl about the challenges the life insurance industry faces with respect to premature termination of insurance policies in a negative interest rate environment

Helmut Gründl holds the Chair of Insurance and Regulation at Goethe University Frankfurt’s House of Finance and serves as Managing Director of the International Center for Insurance Regulation. Previous stations include Humboldt University Berlin and the University of Passau. His main research interests are insurance and risk management, policyholders’ behavior as well as financial planning decisions, taking into account biometric risks, e.g. long-term care risk.

Together with Martin Götz and Irina Gemmo, you are also working on a paper that deals with the topic of insurance surrender, i.e. the premature termination of life insurance policies. What is your objective?

In a first step, we aim to identify individual and household characteristics that influence liquidity demand in certain life phases because the termination of life insurance policies is usually associated with an urgent need for liquidity. We base our analysis on data of the Socio-Economic Panel which consists of long-term survey data from 11,000 German households. In contrast to other studies, which usually work with aggregated figures, we look at the individual household, which enables us to take the age of policy holders at the time of surrender into account (see Figure).

For example, we find that the probability of a divorce to be a driver for a surrender decision increases with the age of the couple, which can be explained by the fact that the costs of divorces rise with age. With respect to the birth of a child, the surrender probability is especially high with young couples and those that have recently had their first child. Of course, we also control for other parameters such as unemployment, income and the acquisition of real estate that are well known to influence surrender decisions. By assigning certain surrender triggers to age groups, we are also able to derive more general predictions about how demographic change will affect life insurance surrender rates.

Aggregate surrender rates by age of household head. The blue line displays all contract terminations, including those at contract maturity, the red line displays only contract terminations within the first 11 years of policy holding.

These results will certainly be of interest for insurance companies.

Absolutely. Therefore, in a second step, we will insert these findings into a multi-period shareholder value model of a life insurance company with different investment choices. We aim to find out which impact surrender decisions have on the company’s investment behavior. A large surrender rate might, for example, keep the insurer away from investing in long-term assets that would be important to secure considerable returns, especially in times of low interest rates.

Can large surrender rates affect the stability of an insurance company? One could imagine that the companies set their prices according to this risk.

On the profit-loss side there is indeed no real stability risk, given the observable surrender discounts. However, problems can arise on the liquidity side. In theory, what we know as “bank run” is also possible in the insurance sector. In particular against the background of the low and negative interest rate environment, it is not inconceivable that some life insurers get into financial distress and, thus, customers lose trust in a single company or even in the industry as a whole. Another scenario would be rising interest rates after a period of very low rates. This might induce a large number of customers who hold policies with very low guaranteed investment returns to surrender because they would get better conditions elsewhere. As a mass behavior this could evoke a liquidity problem for life insurers – and not only for them. If insurers had to sell assets in a “fire sale” situation, this could cause a downward spiral for asset prices and thus affect financial markets as a whole and even the economy beyond.

Can insurance companies design their contracts in a way that would help to lower surrender rates?

A general idea to overcome the problems that arise with either very low or rising interest rates would be to generally decrease the guaranteed return rates. This may sound paradoxical but it would make all parties better off. The insurers could easily fulfil their commitments so that solvency risk would go down; the insurers would need less equity capital to back the guarantees. Thus, equity capital is set free to back riskier and, in the long run, more profitable investments. As a consequence, policyholders would benefit from higher surplus participation. The drawback however is that you cannot swap existing contracts. The change can only come into effect with new contracts. This implies that, for a very long time, companies have to continue to suffer from the sins of the past…

…which are especially painful given the current situation of negative interest rates.

True. All insurers are currently searching for yield which they mainly try to find in long-term assets, for instance infrastructure investments. This brings us back to the question of an optimal investment strategy for insurers: how many long-term – but illiquid – assets can they hold to get the desired returns while, at the same time, disposing of sufficient liquidity to satisfy policy surrenders? With our project we aim to address this problem by giving more concrete information with respect to the long-term development of surrender-rates and the ensuing costs and benefits for the parties involved.

What is the regulator's approach to this problem?

Insurance regulation faces a tradeoff. In terms of consumer protection, we observe the tendency to allow customers to surrender their policies whenever they like and grant them considerable surrender values. While this is certainly important when you think of these unforeseeable situations in life when cash is urgently needed, people often neglect that, by protecting customers who surrender, you harm those who stick to their contracts for old age provision. They forgo the illiquidity premiums that could be collected if insurers were able to follow a long-term investment strategy.

Is a life insurance policy still an investment vehicle that people should consider?

For sure. There is no other possibility to hedge longevity risk – the risk of out-living your money – as well as mortality risk when you think of term life insurances. I suppose that, in the long run, life insurers will concentrate on these two core parts of their business.

Source: SAFE Newsletter Q3 2016