Jay Patel, insurance analyst at Timetric’s Insurance Intelligence Center (IIC), explains how the adverse economic impacts seemingly caused by Brexit – and felt by life insurers and pension schemes – may actually be longstanding underlying problems that had been hitherto left relatively ignored by business and government alike, due to their inherent complexity.
When the UK voted to leave the EU on the 23rd June, investors – most of whom were surprised by the result – poured billions of pounds into purchasing UK gilts as the political and economic uncertainty that was unleashed spooked financial markets.
The dramatic movements in the gilt market drove down yields, thus increasing the liabilities of pension schemes and life insurers. The magnitude of this fall has once again shone a light on the ticking ‘time bomb’ that defined benefit pension schemes have become and the difficulties faced by life insurers in a low interest rate environment.
The problem is not unique to the UK; most developed economies encounter the same issues due to unprecedented low interest rates along with ageing populations and now unrealisable guarantees made by final salary defined benefit pension schemes.
Pension funds in Europe, the US and Australia that experienced similar if not more pronounced inflows into their sovereign debt markets after the referendum, all warned of a negative impact on their returns and ability to meet their obligations in the aftermath of the Brexit vote.
Even a relatively sharp rebound in interest rates would cause problems of its own, leading to a bloodbath of bond prices, as the present value of coupon payments from these bonds would fall.
This would hurt insurers under the mark-to-market accounting standards they must use as part of the Solvency II, the EU’s insurance regulatory framework.
The deficits also threaten long-term economic growth. As companies allocate ever high proportions of their retained earnings to shoring up their deficits, there will be a consequential reduction in investment in the real economy.
Much of this investment, crucial for increasing productivity and building infrastructure will be lost, condemning the economy to lower growth and therefore lower interest rates.
Greater diversification of assets is part of the solution and this has already been undertaken by the industry. However, the cost of capital required to hold some of these risker assets may discourage insurers and pension funds from building the optimal portfolio.
Solvency II has been criticised for pushing insurers towards holding more government bonds as they incur no capital charges while equities and infrastructure require substantially higher buffers.
There has been plenty of comment (much of it justified) about the adverse economic effects of Brexit.
However, in certain instances the adverse economic impacts seemingly caused by Brexit, may actually be longstanding underlying problems that had been hitherto left relatively ignored by business and government alike, due to their inherent complexity.
For more information on Timetric's Insurance Intelligence Center, please visit http://www.insurance-ic.com