Managing financial risks in (re)insurance in the postpandemic world - by Thomas Weber & Jörg Günther

managing financial risks in (re)insurance in the postpandemic world

by Thomas Weber & Jörg Günther

increased financial uncertainty

financial risk management considerations

After almost 25 years of relative macroeconomic stability and growth – a period called the Great Moderation (1980s to 2007)1, the shock of the Global Financial Crisis in 2007/2008 has now been succeeded by another global crisis, the coronavirus pandemic. This pandemic has caused a global economic shock not seen before in the past 75 years, triggering a rollercoaster ride in the financial markets. At the same time, debt levels are at record highs. Additionally, central banks are increasing their balance sheets, thus raising major concerns.

How does this translate into the risk management perspective of (re)insurance companies? Financial risk management for (re)insurance balance sheets typically uses a liability-based replication portfolio to define a risk-free position2. The balance sheets of (re)insurance companies consist of claims to be paid in the future and of assets backing those claims. Claims are partially sensitive to inflation (a sensitivity not always precisely known), and some of these have longer maturities than the longestmaturity liquid traded assets available, creating what is commonly known as mismatch risk. This poses new challenges in the current situation.

From a long-term-perspective, there could be significant risk in what we call risk-free (bonds). Fixed income with almost zero (USD) or negative (EUR) nominal interest rates has little upside and significant downside from both rising interest rates and/or rising inflation scenarios. What is being discussed in capital markets as an investment problem could destabilize the foundations of financial risk management, also taking into account that there is a leverage of fixed-income asset length in relation to risk-absorbing capital.

1 / Episodes of financial crisis like the bond market crisis of 1994, the Asian financial crisis of 1997, and the bursting of the dot-com bubble in the early 2000’s still occurred.

2 / Once the replication portfolio is translated into the world of real assets such as government bonds, risk (as credit/default risk) is unavoidable, even when considering the lowest-risk asset available.

This risk may materialize in the form of unexpected inflation or expected inflation in combination with financial repression (central bank yield-curve control and regulatory requirements for banks and insurance companies that provide incentives to hold government debt), deeply negative real interest rates for longer periods, or other forms not yet clear as of today. The change in established correlation relations could be another symptom of this regime change: The short-term/long-term correlation of equity return vs. fixed income return may reverse. It is unclear whether there is a clear-cut tipping point for this, but the likely end of the long-term trend of decreasing interest rates is the key driver (see box).

the bond-equity relationship

In recent decades, the relationship between bond markets and equity markets has been characterized by offsetting price movements in stress situations. This has been a consequence of increased risk aversion by investors in those moments and due to central bank intervention. Calculating the correlation based on historical time-series containing periods of stress yields a strong negative bond-equity correlation.

Looking forward, this relationship is in danger of breaking down3. There are three basic scenarios, none of which is pleasant: 1. A further reduction in their current low level leads to deeply negative interest rates only a few years from now – putting further stress on income levels from investment for insurance companies 2. Interest rates move sideways, with equities losing the tailwind of the past 35 years’ long-term trend of decreasing interest rates4 . 3. Interest rates increase in the long term, producing a headwind for equity returns in the future, flipping the bond-equity correlation from negative to positive.

All three outcomes, though of different quality, could be classified as a regime change. Looking forward, they may render current investment and diversification strategies less effective compared with historical data.

Does financial risk management logic hold up in a scenario in which the debt crisis becomes more acute, threatening the stability of the financial system? If stabilizing the economy and financial markets is considered the biggest problem by central banks and governments, there may be a higher tolerance for inflation risk induced by policy measures.

Risk management tools may get derailed if they rely exclusively on historical data, while the future follows a different logic.

3 / The Economist: Why people are worried about the bond-equity relationship, March 6th, 2021 4 / Lukasz Rachel and Thomas D Smith: Secular drivers of the global real interest rate (Bank of England, Staff Working Paper No. 571, December 2015)

The underlying assumptions regarding risk-return relationships, volatility, correlation, and inflation may change due to a regime change accelerated by the pandemic and the policy reactions thereafter, often characterized as unprecedented.

a broader risk management perspective

If low interest rates and inflation risk are significant relative to the riskiness of what is traditionally coined as risky assets, there is no absolutely risk-free position (in the long term).

How can insurance companies emphasize long-term robustness rather than short-term return maximization? One option would be to take more real (or “reflation”) assets such as equity and real estate as a risk mitigation tool (not a return-maximizing tool), backed by more risk capital as a short-term shock absorber. Risk modelling with a one-year time horizon captures volatility as the main risk, and by definition cannot account for the long-term trend risk to which long-term investors are exposed.

The short-term perspective could and should be complemented by long-term risk considerations. This broader view (as represented by the Own Risk and Solvency Assessment (ORSA) of the Solvency II directive) could ideally lead to more balance sheet resilience, a mitigation of trend risks and a countercyclical financial risk-taking strategy.

A logical reaction to a higher level of uncertainty in the post-pandemic world would be to rebalance the trade-off between capital efficiency and shock absorption capacity by providing more capital. There is no free lunch: The cost of this will be a lower return on equity, at least in the short run.

authors Thomas Weber

Thomas is Global Head of Financial Risk Management at Munich Re, responsible for financial risk related to insurance products and investment risk of the balance sheet. He has a background in mathematics and finance. Working in banking and insurance for more than 20 years.

Jörg is a Senior Risk Manager for Financial Risk Management at Munich Re, responsible for financial risk related to insurance products and investment risk of the balance sheet. Prior to that Jörg was part of the structuring team for Insurance linked Securities and worked in the banking industry in project finance, structured credit and securitization.