Negative interest rates: issues for insurers

Negative interest rates have a direct impact on insurers both in terms of their investment strategies and the impact on the risks they are writing. We review alternative investment approaches and predict risk management and claims trends.

Negative interest rates have a direct impact on insurers both in terms of their investment strategies and the impact on the risks they are writing. We review alternative investment approaches and predict risk management and claims trends.

Some eight years after the financial crisis began, the climate of economic uncertainty continues. In 2014, the European Central Bank (ECB) began a policy of negative interest rates, in effect charging banks a levy for the privilege of holding their funds within the Eurozone’s 19 central banks. Since then other central banks have followed suit, including those in Sweden, Switzerland and, earlier this year, Japan.

This policy, which is reported to have cost banks around €2.64 billion since 2014, is intended to spark economic growth by giving banks the incentive to lend money out to businesses and into the wider economy, instead of holding on to it.

In August 2016 the Bank of England reduced the base rate, the benchmark for interest rates in the UK, for the first time in seven years to an all-time low of 0.25%. With interest rates on customer deposit accounts already low, this has triggered further rate reductions by banks. It remains to be seen whether banks will increase their lending activity, as the ECB hopes, or whether they will simply seek to pass on the deposit charges to customers, which would potentially undermine any positive effect of the rate reduction on the broader economy.

Alternative approaches

Reports indicate that private banks and investors are now looking for ways to avoid having to pay these deposit charges with Eurozone banks and/or to locate investments which yield more attractive rates. Options include the following:

  • Stashing the cash: one alternative is to stockpile cash in their existing vaults and/or arrange the transfer of funds to outsourced vault facilities. The storage and transport of funds may pose a significant additional risk to corporate insureds and their insurers, particularly under crime policies where employee infidelity and goods in transit cover are standard. Insureds should take steps to reduce the risk of losses as far as possible.
  • P2P lending: an attractive investment area for both private and institutional investors may be peer-to-peer (P2P) lending (i.e. loan-based crowdfunding) which has grown to be a sector valued at around £2.7 billion. P2P lending is, in particular, servicing a need for reasonable loan rates for small businesses, which the banks are currently not meeting.

P2P lending: regulation

The regulatory remit of the Financial Conduct Authority (FCA) was expanded to include P2P lending in 2014. In July 2016, the FCA reported that it had more than 80 applications for approval outstanding, with only nine firms presently approved as P2P lenders and widespread calls for tougher regulation of so-called ‘alternative finance’ providers.

Meanwhile, insurers offering cover to P2P lenders/platforms, and independent financial advisers (IFAs) advising consumers in the alternative investment sphere, may also take note.

The FCA has introduced a new regulated activity, specifically catering for advising clients on P2P agreements. It has also issued warnings concerning the high risk nature of these investments, in particular given that investors have no recourse to the Financial Services Compensation Scheme, the compensation provider of last resort for regulated investments.

Insurers of IFAs should be aware that their insureds may face claims where there has been inadequate documentation and explanation of the risk factors posed by P2P lending/investment. With the FCA set to revise the existing guidance on P2P investments in the months to come, we would expect IFAs and P2P businesses to closely monitor this area and identify any issues to their insurers on placing/renewal.

Lord Adair Turner, former chairman of the Financial Services Authority (the FCA’s predecessor), has warned that consumers are taking huge risks when lending via P2P. He commented earlier this year that:

“the losses on peer-to-peer lending which will emerge within the next five to 10 years will make the worst bankers look like absolute lending geniuses".

Pension fund trustees/fund managers

Insurers of pension fund trustees will note that the current interest rate environment, paired with the UK’s recent decision to leave the European Union, is also having a detrimental effect on pension funds. The Pension Protection Fund (the fund of last resort for pensioners whose employers become insolvent) recently reported that the aggregate UK pension deficit has ballooned by £114 billion since the end of May 2016, and is now at a new record high of £408 billion.

Pension fund trustees will no doubt be revisiting the appropriateness of their investment strategies. They will also need to consider what advice they should be providing to individuals within their schemes as to the appropriate level of pension contributions to ensure that their pension funds are sufficient to meet their needs when they retire. Careful records should be kept of the advice they are receiving and giving, in case they later face criticism from individuals within their schemes.

Likewise, fund managers will be taking similar steps to ensure they mitigate the risk of claims from investors should client assets decrease in value.

Conclusion

A base rate increase does not appear to be likely in the short term. Whilst that remains the case, alternative investments such as P2P lending will be attractive to investors, despite the risks.

Any insureds involved with P2P should be alive to the risk of FCA scrutiny and to their obligations to customers. The FCA will be quick to call to account those whose conduct falls short.

For other insureds, whether fund pension trustees or fund managers, the pressure to deliver a decent return on investment will remain. Care must be taken to ensure that investment strategy is clearly agreed and documented, to assist in the event of client dissatisfaction.

Read other items in Professions and Financial Lines Brief - October 2016