FINANCIAL markets may be drawing breath after their recent falls, but one industry in particular has little reason to feel calm. The life-insurance industry has deeper problems than just temperamental markets. Years of doling out goodies from a seemingly bottomless sack are now catching up with these actuarial Santa Clauses, who in their worst nightmares did not imagine that the interest income from their investment portfolios could stay so low for so long.

Insurers tend to be prudent investors who like steady returns, which is why around 80% of their assets are in fixed-income securities. This served them well during the financial crisis, but today—with bond yields at historic lows, and even in negative territory—it hurts their investment income. This is particularly true for life insurers, which own over $21 trillion of the industry’s $28 trillion assets, and rely heavily on this investment income to pay policyholders.

European insurers are especially exposed. Over two-thirds of life-insurance policies in force in the EU today offer some sort of guarantee. More than half of these policies have promised a higher income to policyholders than insurers can currently earn on newly-issued bonds, according to the European Insurance and Occupational Pensions Authority, a regulator.

To make matters worse, many of these life insurers have a mismatch between the duration of the promises they have made to policyholders and the shorter time until their assets mature.

Although there are big differences between firms, Moody’s, a rating agency, reckons those most at risk tend to be in Germany, the Netherlands, Norway and Taiwan, where average duration gaps are especially large (14 years in Norway) or guaranteed rates are eye-wateringly high (4-5% in Taiwan).

On the top naughty step sits Germany. In the sunny years around the turn of the millennium most German life insurers gave customers a maximum guaranteed interest rate of 4% per year, both for savings and lifelong pensions. To meet such extravagant promises, insurers bought ten-year bonds at much higher rates than are available today. But when those assets matured, the liabilities remained (the average lifespan of existing German life-insurance policies is 20 years).

The average returns promised to German policyholders are far higher than the yields on government bonds that insurers can now buy. Corporate bonds offer returns that are barely higher, which leaves two options: invest in riskier assets such as equities (which will require the insurer to put more capital aside), or face the fact that annual payouts to policyholders will outstrip income, a recipe for losses.

Both outcomes sit uncomfortably with rating agencies, never mind investors. Fitch, another rating agency, warned in 2014 that some insurers might take too much risk in the hunt for yield. But the bigger worry today is that they stick to current policy and become unprofitable.

Moody’s fears that if rates stay low for another four years, loss-making insurers will eat into their capital buffers, and some could—eventually—become insolvent. The more an insurer looks like it might struggle to meet future financial obligations, the higher the cost it will face if it eventually seeks to raise capital from investors to shore up its balance-sheet.

Faced with this prospect, life businesses are doing what they can to push risk back to the customer. In some countries, such as France, the promises made to existing policyholders have the built-in flexibility to be scaled back. But mostly the burden falls on new policyholders, who are no longer sold products with guarantees.

Ironically this de-risking creates a different danger: that the industry becomes irrelevant. By removing the key selling point of an insurer over a mutual fund—the assurance that a policy will pay out no matter what—the industry risks negating its business proposition to investors looking for security. (It does so, moreover, at a time when pension funds are watering down their long-term financial commitments, says Daniel Hofmann of the Geneva Association, who worries about the consequences for society and the economy.) The big question is whether new customers will buy savings-based insurance products at all in this shaky market environment, says Benjamin Serra of Moody’s.

To survive, the life-insurance industry will need to address the question of what it is for. Most premium income for life insurers comes from the savings business, where guarantees play a central role. The classic model thrives on short-term interest rates of between 2-6%, government bonds yielding at least 4% and no worries about defaults. “That’s when we can sell policies cheap and generously,” sighs one nostalgic underwriter.

Change of policy
But with no prospect of such rate levels returning, life insurers must find a way to change. This could include merging with other (non-life) insurers, or developing new products that are not as dependent on yield but still give customers a long-term return. The transition will be a lot easier for those insurers without significant risks on their balance-sheets already. The unlucky ones with large loss-making policies already in place face a harder road.

The good news is that they have a bit of time of their hands. Insurers are not as vulnerable to the risk of a run as banks. The assets of insurers are usually liquid and their liabilities tend to be tied to specific events—such as someone getting ill, retiring or dying—whose probabilities can be calculated. Unlike banks, insurers should not become insolvent overnight. A financial reckoning, should it come, can be put off for years, even decades.

Regulation also helps, says Oliver Steel of Deutsche Bank. Banks were given until 2019 to raise new capital by the Basel 3 rules (and many did so earlier). But under the Solvency 2 regime set up by the EU to govern insurers, firms have generous transition periods of up to 16 years. The German government and regulator have also taken steps in recent years to strengthen the sector, such as forcing insurers to set aside specific reserves (Zinszusatzreserve) and limiting guarantees on new business.

Such comfort only goes so far, however. In spite of these reforms, Moody’s believes that the German industry will incur losses if interest rates stay at low levels. And that looks likelier than not.