Why Japanese Insurers Are Turning to Risk Hedges
The article below is from our BRIEFINGS newsletter of 15 October 2020
A low-for-longer interest rate environment can be particularly difficult for insurance companies, which need higher-yielding investments to match their underwritten liabilities. So how are Japanese insurers adjusting to a prolonged period of negative interest rates? We sat down with Yusuke Ochi, who works with insurers and other institutional clients in Goldman Sachs’ Global Markets Division in Japan, to discuss.
To set the stage, can you give us some context about the life insurance industry in Japan?
Yusuke Ochi: The Japanese life insurance market is the third largest in the world after the US and China, with nearly 90% of Japanese households holding life insurance policies, in contrast to 70% in the US and 38% in the UK. The industry itself is a lynchpin of the economy, serving both as a repository for a substantial amount of the country’s savings and acting as a key institutional investor in the country’s domestic and international equity landscape.
In recent years, the operating environment for life insurance companies has become increasingly challenging. For one, the industry is overshadowed by Japan’s aging demographics and stubbornly low birth rate. Fewer people means fewer policy holders. In fact, the volume of in-force policies has dropped rapidly since peaking in 1996.
But a more immediate issue for the industry is the impact of the negative interest rate policy introduced in Japan in 2016. Not only has this hurt insurers’ profitability in the short term, it has also forced them to change their investment strategies in ways that—if left unchecked—could store up potential risks in the future due to upcoming regulatory changes.
What are these risks?
Yusuke Ochi: Negative interest rates have been a real body blow to Japanese life insurers’ traditional business model, which centers on charging customers premiums in exchange for insurance coverage, then reinvesting those premiums in other interest-generating assets. In the past, Japanese government bonds (JGBs) were the investment vehicle of choice due to their stable returns and their essentially zero risk weighting from a regulatory perspective, which means insurers don’t need to hold any capital against them. However, JGB yields had been falling for decades before the Bank of Japan finally pushed them into negative territory in a bid to boost bank lending to stimulate the economy after the financial crisis.
The impact of this is two-fold. Firstly, negative interest rates have hit profitability. While only the yields on shorter-tenor JGBs have actually fallen below zero, the Bank of Japan’s policy has effectively pushed down yields across the curve, squeezing the returns that life insurers can make. This has also led to a significant decrease in policy sales as ultra-low yields make life insurance products less attractive to consumers. Secondly, these firms now find themselves struggling with what is known as a duration gap—or the risk that stems from a gap between interest rates on assets and liabilities. When they sell policies, life insurance companies take on long-dated liabilities which, by their nature, expose them to long-dated interest rate market fluctuations. JGB purchases should act as hedge to this risk—but in the past, insurers left some liabilities unhedged as few predicted the BOJ’s policy change.
So what steps have insurers taken to mitigate these risks?
Yusuke Ochi: Insurers have largely turned to higher yielding foreign securities—bonds in particular—in recent years, with total holdings now reaching 95 trillion yen, marking an approximate 40% increase over the past five years. While offering potentially higher returns, such investments also expose Japanese companies to an added layer of market risk due to fluctuations in currency and interest rate movements. Compounding matters is the fact that regulatory changes set to take effect in 2025 will raise the capital requirements for Japanese insurers with longer liability durations that are unhedged.
That sounds like Japanese life insurers have been taking on more risk with their investments—what’s your take?
Yusuke Ochi: The priority for these financial institutions is to mitigate, or hedge, against fluctuations in interest rate and forex risks in order to reduce the capital requirements. As a result, we’ve seen more insurers turn to derivatives as a way to hedge interest rate risk in their asset-liability management book and currency movements on their foreign asset holdings. While some insurers are still relatively new to these instruments, the industry overall is getting more comfortable with using derivatives-based solutions—from vanilla interest rate swaps to more complex structured products—to optimize their asset-liability balance.