INFLATION AND BOND YIELDS (HIGH IMPACT, 1-3 YEARS)
1. Major central banks’ policy actions of near zero-interest rates, quantitative easing and other non-standard monetary policy measures have helped support the economic recovery, lower the probability of tail risks such as a deflationary spiral and reduce global risk aversion. However, the central banks‘ ultra-loose monetary policy has also created distortions in financial markets and asset prices. Most notably, the massive government bond purchases of central banks have led to negative real interest rates by lowering nominal interest rates, which can also be viewed as a tax on savers (financial repression).
2. The challenge for the central banks is to implement exit strategies from the various extraordinary policies currently pursued – even more so as this is all uncharted territory. If the economy were to recover more quickly than expected and market participants did not think monetary policy was being tightened fast enough in response, longer-term inflation expectations might very well increase disproportionately, causing both government bond yields and inflation to surge.
3. Financial repression has led to increases in financial institutions‘ exposure to sovereign debt, making them more vulnerable to adverse interest rate shocks. A prolonged period of low interest rates, which is particularly a risk in Europe, would be debilitating for the life insurance industry. A sharp rise in rates would be helpful to insurers with large blocks of interest rate guarantee products, but a burden for most other re/insurers.
3. Financial repression has led to increases in financial institutions‘ exposure to sovereign debt, making them more vulnerable to adverse interest rate shocks. A prolonged period of low interest rates, which is particularly a risk in Europe, would be debilitating for the life insurance industry. A sharp rise in rates would be helpful to insurers with large blocks of interest rate guarantee products, but a burden for most other re/insurers.
SOVEREIGN DEBT CRISIS (MEDIUM IMPACT, 1-3 YEARS)
1. The Eurozone authorities and the European Central Bank have taken policy action in recent months to reduce tail risks stemming from a break-up of the monetary union. However, the underlying debt crisis remains unresolved, and European policymakers must recommit themselves and push forward the implementation of national structural reforms, strengthen the architecture of the monetary union and stimulate growth.
2. In the US, the financial health of the private sector has improved. However, the lack of political consensus and the uncertainty surrounding the appropriate content and pace of fiscal consolidation is still a negative for the economy. The US Administration and Congress need to put in place a plan for funding the long-term social security and medical needs of the people. In addition, a tax reform would be helpful for the economy.
3. Japan also needs to move away from short-term partial fixes and adopt a comprehensive programme of structural and fiscal reforms.
4. Ongoing sovereign debt crises are likely to cause widespread liquidity and growth problems, which may ultimately result in shrinkage of the global insurance market. As insurers are important investors in government bonds, they may also be indirectly exposed through their securities holdings.
UNDERFUNDED INFRASTRUCTURE (MEDIUM IMPACT, 1-3 YEARS)
1. Infrastructure is vital for the proper functioning of an economy. However, in many regions of the world there is a chronic failure to adequately invest in, upgrade and secure infrastructure networks such as electricity provision, water supply or transport infrastructure. This is due in no small part to investors engaging in more short-term activities instead of long-term project financing.
2. Recent regulatory provisions have stepped up capital and liquidity requirements and prompted banks, insurers and non-traditional long-term investors to refrain from longer term infrastructure funding. Nevertheless, most developed countries need to upgrade and maintain their infrastructure while developing countries need infrastructure investment to support their growth.
3. Historically, governments have employed infrastructure investment to stimulate a flagging economy. Currently, however, the public sector is reducing its debt burden and funds become increasingly scarce. The possibility of a downturn in long-term infrastructure financing could dampen economic prospects for some time to come. There is consequently a need to encourage more institutional investors to enter the market not only by providing tax breaks or lowering capital requirements, but also through creating infrastructure-financing bond markets.
4. Long-term investment in infrastructure is compelling for the insurance sector. That said, the regulatory environment has to become more accommodating if the actual investment appetite is to satisfy the infrastrucure project pipeline.
(Source: SwissRe)
