Opening notes by Assistant Superintendent Neville Henderson, prepared for Northwind’s 27th Annual Life Insurance Invitational Forum via webcast, Toronto, Ontario, December 2, 2020

I've been asked to speak about the impact of "low for long" interest rates on the insurance industry and our supervisory response.

Japan has experienced low and sometimes negative interest rates since the mid-1980's. Many leaders in our industry thought it could not happen in other developed nations, but it has and is likely to persist for many years.

I recently attended an FSB meeting where the statistics that cause the decline in Japan were plotted against the same statistics in a number of developed nations. The major difference between the resulting curves was that the Japanese decline was a cliff while the curve in the developing nations was a slope from the mid-1980's to today.

But, the ultimate levels are converging. The main reason for the difference is attributed to immigration. This long-term decline is considered structural as low birth rates and rapidly aging populations in the developed nations are causing a move from investing to provide for retirement to disinvesting to support retirement.

COVID-19 has acted as an accelerant in decreasing interest rates. There may be some recovery after the pandemic but the long-term outlook is for persistently low interest rates. It is possible the massive government debt created during the pandemic may lead to increased inflation. But, all we can be assured of is continued uncertainty and volatility.

It seems counterintuitive that during a health crisis most insurers are more affected by the economic impacts than contractual claims. This was the case during the last health crisis and results because insured lives are;

  • generally in a younger age group,
  • are a relatively healthier cohort of lives due to underwriting,
  • are in a higher socio-economic group, and
  • generally have better access to health benefits than many of the unfortunate people affected by the virus.

All of the institutions that OSFI supervises are affected by low interest rates but the degree varies by line of business, product type, asset structure, etc.

The insurance market is very competitive and a company's response to the environment presents a challenge. For example, increasing prices ahead of competitors may appear to restore profitability but could result in a significant loss of new business and ultimately lower profit.

Some insurers have sought yield by moving up the risk curve. The change has not been significant and moving up the risk curve is acceptable as long as a company has effective risk management procedures, policies, limits and oversight in place to manage the risk. Interest rates also influence the behaviour of policyholders, new purchasers and investors and these effects must be considered.

While investors are not mentioned in OSFI's mandate they are an important source of capital when it needs to be replenished. Low long-term interest rates may decrease the return on investment and investors may be incensed to search for alternative, higher yielding options than the insurance industry.

The interest rate assumption is critical in pricing any life insurance product and its importance varies directly with the duration of the liability as well as any interest rate guarantees embedded in the products. We are witnessing a number of strategies for managing the risk such as:

  • ceasing sales of products with embedded guarantees;
  • lowering the interest rate assumption in new products;
  • lowering profitability targets to reflect the decreased investment margin;
  • divesting legacy business;
  • developing products that transfer some of the investment risk to policyholders; and
  • offering shorter term products.

The in-force business poses a different issue and companies have been providing for lower interest rates through reserve strengthening and asset liability management techniques. To date, these actions have been effective and companies are projected to continue to be profitable.

One element that remains top of mind for OSFI is climate risk. Physical risk caused by climate change is largely borne by the P&C companies. The transition risk, the transfer from carbon-linked to lower carbon-linked assets, is largely borne by institutions with long-term liabilities. Transition risk is the most difficult to quantify and is heavily dependent on how rapidly the transfer takes place. A slow cadence will give companies a chance to manage the transition; a rapid cadence could cause liquidity concerns for some companies.

A further consideration is the potential effect on the value and rates of return on government bonds. This is especially true in countries whose economy is heavily dependent on oil and gas and industries that depend on carbon fuels, such as Canada. A high percentage of the assets backing long-term liabilities in Canada are invested in government bonds.

The most effective approach to understanding the impact of these complex relationships is through comprehensive modelling involving multiple scenarios and stress testing and using those results to inform decisions and in assessing risk appetites. After that, it becomes a matter of managing those risks.

The risks that existed before COVID-19 such as IFRS 17 transition, low-for-long interest rates, concerns about a recession, climate change, digitalization and changing demographics are still present. These risks will be compounded by the new risks arising after the pandemic such as increased government debt, potential creditor defaults, a changed environment for employment and probably others.

The non-linear and competitive implications resulting from the uncertainty of COVID-19 recovery will further reshape and rebalance the risks and priorities for institutions. This is something that I know many insurers are taking to heart and it is something that OSFI continues to consider under our "mantra" of analyzing the impact of severe but plausible risks and making appropriate decisions.