Eurozone interest rates are proving to be a challenge, says Cathal Rabbitte
The Eurozone crisis continues to morph in surprising ways. Goldman Sachs revealed on 14 April that over 2trn of outstanding Eurozone sovereign debt now has a negative yield. Previously restricted to theories in arcane economic textbooks, this may be one of the fastest growing asset classes in Eurozone finance. A mutant version of the common or garden sovereign bond, negative yield sovereign bonds are defined by what they don't do - deliver a positive yield. Investment in these instruments involves losing money in the name of security. While certain investors may talk about potential currency upside, it looks very much like deleveraging. One company may be able to do it but the whole system cannot gain the benefit. Negative yields appear to be the end of growth illusions in the Eurozone.
Klaus Regling of the European Stability Mechanism recently told a banking inquiry in Dublin that the design of the monetary union in 1988 was incomplete and that EU rescue funds were not included in the system as its designers did not believe a Eurozone member would lose market access.
Underestimating tail risk has been a hallmark of the global financial system since well before 2007. The Eurozone is no exception - it does not have the regulatory infrastructure to deal with failed banks or debt deflation. Within the Eurozone there is no sharing of economic risk between countries. Neither is there any convergence of economic interests. Economic and political pressures are downplayed until they explode at times of crisis. The current Greek crisis is the third in five years - proof of the inadequacy of the design of the Eurozone. Bogus Greek deals have bought time but nothing else.
Into difficulties
The emerging pattern of ineffective muddle-through, the recurrent eruption of crisis and the impact of quantitative easing in pushing down yields has driven the growth of negative yield Eurozone sovereigns. The phenomenon has also reached the neighbours. In April, Swiss National Bank sold CHF232.51m of 10-year bonds to investors with a yield of minus 0.055%. For local insurance and reinsurance companies, negative yields are head-wrecking. Effective capital allocation becomes very difficult. Customers expect to be paid interest for money invested.
For Eurozone insurers and reinsurers, negative yields also generate significant difficulties. Insurance pricing implicitly assumes there is a time value of money when calculating the present value of cashflows from long tail lines of business such as life insurance. Globally, bond yields have been falling since the early '80s when Paul Volcker at the Federal Reserve began to get a handle on inflation. For property and casualty business, the declining contribution of interest coupons to return on equity puts pressure on underwriting returns to make up the difference in order to keep the metric steady. Now that the yields of many sovereigns are negative, the pressure on reinsurers and property and casualty insurers to generate lower combined ratios is daunting. Increased competition via the flood of quantitative easing capital ratchets up the pressure.
A larger question is whether stable pre-crisis-level insurance returns on equities are sustainable in a world where there is such an imbalance between supply and demand for capital. Central banks may have a limited influence on the level of real interest rates. Perhaps low real rates indicate that many players prefer to invest in ultra-safe assets rather than borrow and invest. Ultra-low interest rates may actually be the point of equilibrium between a global oversupply of savings and a reduced pool of borrowers.
Solvency II is set to go live in 2016. At the time the framework was developed, the notion of valuing loss reserves using negative interest rates might have been considered as likely as Burnley winning the Champions League, had it even been contemplated. 'Discounting' loss reserves only makes sense with positive yields - the concept is so embedded in insurance culture that there is no word to describe how to generate a net present value that is actually higher than the sum of future cashflows.
It certainly wouldn't be called discounting.
As for Solvency II's concept of 'risk-free' sovereigns - how can the framework deal with the mutant version where 'risk-free' actually means losing money? Negative bond yields influence valuations of other financial assets, which under financial theory use nominally 'risk-free' sovereign bonds as a benchmark.
The UK has gilt yields that are still positive over 10 years, but it is not clear whether sterling can escape the negative yield trend, especially if the Bank of England cannot hit target inflation.
The first thing actuaries should do is generate an appropriate word to replace 'discounting'.
Cathal Rabbitte is an independent actuary working in thought leadership and risk analysis