EIOPA: coordination needed over low interest rate environment

The European Insurance and Occupational Pensions Authority (EIOPA) has highlighted the importance of cooperation between national supervisory authorities (NSAs) in response to the sustained low interest rate environment threatening the insurance industry.

EIOPA recommends a coordinated supervisory response, wherein NSAs regularly report back on any progress or planned supervisory action. According to EIOPA, NSAs should first assess the potential scope and scale of the risks arising from the low interest rate environment. They should then engage with insurers to explore private sector-led solutions.

The opinion reads: “unsustainable business models should face challenge from supervisors at an early stage and it is expected that insurance undertaking should be encouraged to resolve their own problems. National competent authorities should actively engage with insurance undertakings in exploring private sector measures to address the risks raised by a prolonged period of low interest rates.”

In turn, EIOPA will coordinate an exercise to quantify the scale and scope of the risk arising from such an environment. Captive International spoke to EIOPA about their opinion.

How will a coordinated effort make the regulation process more effective?
EIOPA aims to build up a consistent and convergent approach towards the scope and scale of the risks arising from the low interest environment. This approach will help national competent authorities to identify early those insurance companies that have a significant exposure to the risks posed by low interests and to better respond to the risks posed by low interest rates. Working together within EIOPA in this way will clearly allow a more consistent and convergent approach to be developed as national authorities develop together possible supervisory actions.

What do you see as some of the benefits of letting the private sector essentially self-regulate, and how effective do you think it will be?
This initiative is not a question of self-regulation, but rather challenges participants to address the risks that they face by encouraging action on their part. This of course is a clear example of how Pillar 2 is intended to operate.  

As far as companies differ in terms of their size, complexity and risk profile there can be no unique solution for all of them. If the company identifies and understands well its own risks, it is much easier for this company to find the proper solution. This approach represents a quality change in the business culture: companies should not wait until their competent authority prescribes precisely what action they should take, instead they should proactively address the issue under the oversight of national supervisors’.

We have set out a staged approach focused on early engagement with firms by national authorities, development of a consistent understanding of the impact of a prolonged period of low interest rates and promotion of private sector solutions. We intend to take stock of this approach in 2014, which will include consideration of what further action could be required.

What is the likelihood of the current low interest rate environment causing economic hardship of the kind seen in Japan in the 1990s and early 2000s?
The European insurance sector is in a different situation today compared to the Japanese insurance sector in the 1990s, but the Japanese experience is a reference point for what can happen. EIOPA is taking a forward-looking, risk based approach that promotes early action on the part of industry to deal with emerging risks, thereby seeking to pre-empt any problems.

It is also important to put the issue in context.In 2011 EIOPA carried out a stress test including a “low yield scenario” to assess the effects on the EU insurance sector of a prolonged period of low interest rates/yields. The exercise concluded that “5 to 10 percent of the included companies would face severe problems, in the sense that their minimum capital requirement (MCR) ratio would fall below 100 percent.

In addition, an increased number of companies would observe that their capital position would deteriorate with MCR rates only slightly above the 100 percent mark, whereby they could become vulnerable to other potential external shocks.” This was also highlighted in the recently published EIOPA Risk Dashboard as a significant risk identified by national supervisory authorities. Furthermore, in its Financial Stability Report of December 2012, EIOPA also highlighted that the low interest rate environment has a negative impact not only on insurers but also on occupational pension funds. EIOPA plans to explore this issue more fully during the course of 2013.

What are the implications for captives?
The impact on captives really depends on the nature of the business that they are writing and their exposures to interest rate and reinvestment risk. Like other firms, they may face challenges to their business models from national authorities consistent with their nature, scale and complexity. Equally, if future supervisory measures are recommended, then captives operating in the EU could be expected to be subject to such measures.