The ABI’s director of policy, long-term savings and protection, Yvonne Braun, has described the Bank of England’s interest rate cut decision and quantitative easing measures as “disappointing news” for customers looking to buy an annuity.
Her comments came after the Bank of England cut UK interest rates from 0.5% to 0.25% in a decision announced on 4 August 2016
The Bank of England package comprises: a 25 basis point cut in Bank Rate to 0.25%; a new term funding Scheme to reinforce the pass-through of the cut in Bank Rate; the purchase of up to £10bn of UK corporate bonds; and an expansion of the asset purchase scheme for UK government bonds of £60 billion, taking the total stock of these asset purchases to £435bn. The last three elements will be financed by the issuance of central bank reserves.
Braun said: “While we recognise there are wider economic judgements underlying this decision, continued low interest rates and sustained quantitative easing are the main factors keeping annuity rates low.”
She added: “This further drop of the interest rate to unprecedented low levels and the additional injection of quantitative easing are likely to put downward pressure on annuity rates.”
Commenting on the Bank of England’s decision, Stephen Lowe, group communications director at specialist financial services group Just Retirement took a less pessimistic view on its impact for annuities.
Lowe said the base rate cut does not undermine the case for annuities, but reinforces it.
He said: “The Bank of England has taken this drastic step because it has looked into the future and does not like what it sees. There have been comments about what that might mean to annuity rates but those have to be seen in context.
“At the moment, most alternatives look a lot worse in terms of extra risk and cost with no guarantee of any reward. Annuities don’t just pay an income, they deliver certainty in an uncertain world.”
Timetric Insurance Inteligence Center analysis
Analysing the Bank of England's decision, Jay Patel, insurance analyst at Timetric’s Insurance Intelligence Center (IIC), explained the lower central bank base rate and the purchases of gilts via quantitative easing will increase demand for government bonds and thus drive down yields.
Patel said: "As life insurers use these yields to discount liabilities, any reduction in yields will increase the present value of the liabilities and eat into life insurers’ capital ratios."
He noted that the other channel through which low interest rates can adversely affect insurers is their investment income. When insurers’ fixed income assets mature, they have to reinvest at much lower rates and possibly close to the peak of the market in terms of price.
Patel said: "With the Bank of England now buying government and corporate bonds, this will directly impact on insurers’ investment strategy. They may have to consider allocating more capital to equities, property and infrastructure. However, they could face constraints through the capital charges incurred for holding these assets under Solvency II."
Insurers feel the impact of a change in interest rates through the balance sheet sooner than through changes in their investment income.
Patel noted: "Insurers with large maturity mismatches between assets and liabilities tend to be more vulnerable to falling interest rates. This is because liability portfolios have longer maturities, while the fixed income investments of insurers tend to have shorter maturities.
"This implies that the financial guarantees sold in the past stay on the portfolio for a longer period of time and so adjust to the prevailing interest rate regime more slowly than assets do. Therefore, while the relatively expensive promises made by insurers stay on their books for a long time the relatively good returns turn do not and turn into lower returns within a shorter timeframe."
Accordng to Timetric's Patel, small and medium-sized insurers that are undiversified will be most vulnerable to interest rate risk. He said a study by the ECB last year found that such insurers are most affected by changes in the interest rate.
For more information on Timetric's Insurance Intelligence Center and its in-depth insurance regulatory information and analysis, visit www.insurance-ic.com