High volatility and falling asset valuations in financial markets can have a significant impact on insurance companies’ balance sheets. These companies’ investment portfolios are dominated by fixed income securities. A sharp increase in risk premiums on these securities has a direct impact on their valuation, which falls sharply, all the more so the longer the durations of the bonds they hold in the portfolio. It should be noted that risk premiums may be affected by various influences, the two main factors being the state of liquidity of the financial markets and, closely related to this, the perception of a possible credit or insolvency risk affecting the counterparties involved in bond investments.
In jurisdictions with a risk-based solvency regulation system, such as the European Union, there are mechanisms to correct the effects of occasional bouts of market volatility on insurance companies, given their character as long-term investors. These mechanisms seek to prevent them from having to make forced sales in times of financial market turbulence, with their consequent pro-cyclical effects. The business model of insurance companies leads to the maturities of their investment portfolios being largely aligned with the estimated payment path derived from the commitments assumed in their insurance contracts, so that these assets can be conserved until they themselves reach maturity.
The measures taken by the major central banks worldwide are largely helping to solve the problems of liquidity shortages in bond markets, allowing these markets to continue to function properly. Issuing companies and states can thus continue to place their issued products in order to gain access to the liquidity needed to deal with the situation they face and, most importantly, to be able to refinance their debts at a reasonable cost.
The quantitative easing strategies adopted so far by central banks have been generous, thereby avoiding excessive tensions in bond spreads (in terms of risk premiums), particularly with regard to sovereign debt, but for corporate debt too. In this regard, even the United States Federal Reserve has included debt issued by companies in its program of asset purchases, for the first time in its history.
The Bank of Japan was the pioneer in such purchases, followed by the European Central Bank, which has again approved two new programs including both the purchasing of sovereign and corporate bonds, and the relaxing of rules on the volumes of assets that can be acquired from the various Member States. These programs are already being implemented and have led to the biggest bond purchases in the history of the ECB. In addition, some central banks like the Fed or the Bank of England have agreed to lower monetary-policy interest rates, helping to counter the negative impact on valuations of both sovereign and corporate bonds arising from increases in their respective risk premiums. These interest rate reductions are an important measure to revive the economy, but they damage traditional savings and annuity Life insurance business, until such time as the economic agents assume the new levels as something permanent and decide to invest in savings instruments at lower rates, or choose to acquire risk products in which the policyholder assumes the risk of the investment.
In addition, if the problem persists and bond counterparties begin to suffer a deterioration in their credit quality, the situation may translate to the insurance companies’ balance sheets. In this respect, the composition of investment portfolios is of particular relevance. Those markets where the majority of investment is in sovereign bonds, backed by the asset-acquisition programs of their respective central banks, have a more limited risk. The Spanish insurance industry is a paradigm in this regard, given its traditionalist, markedly conservative nature, in which eurozone sovereign bonds are the dominant investment.
The situation that we are facing, as a result of the COVID-19 pandemic, puts the Spanish industry in a stronger position than other markets in which the majority of investment is in corporate bonds, given that in such situations the latter are often subject to faster changes in their credit ratings which can leave them below investment grade, and even lead to their falling into insolvency. In this sense, it should be highlighted that, in the United States market, insurance companies’ aggregate rate of investment in corporate bonds at the close of 2018 was 51.5 percent, compared to 31.4 percent on average in the eurozone.
In Spain this percentage was 21.8 percent of the aggregate portfolio, so insurers’ exposure was lower. The same is true of equity investments, which have suffered widespread declines in valuations due to the pandemic crisis. Again, the United States and eurozone markets (with over 13 percent of the total portfolio in both cases) have a higher percentage than that of the Spanish insurance companies, whose aggregate equity investments accounted for about 6 percent of the total portfolio.