On December 22, 2014 Standard & Poor's published an article titled "Nordic Insurance Sectors Are Healthy, But Exposed To Interest Rate Risk". According to Anna Glennmar, credit analyst at Standard & Poor's, the rating agency see features common to insurance sectors in the region. The analysis of the Nordic insurance sectors is based on S&P’s insurance industry and country risk assessment (IICRA). Our IICRAs allow for a deeper evaluation of the industry and country risks insurers face and are a part of our rating analysis. They also enable us to benchmark the 103 insurance sectors we review worldwide, Glennmar says. Seven of nine Nordic insurance sectors carry low-risk IICRAs, while just two carry intermediate or moderate risk, according to our assessment. Nevertheless, the sectors still face various risks, particularly from low interest rates. We believe the life insurance sectors are somewhat riskier than the property/casualty (P/C) sectors, mainly because of asset-liability mismatches amid continually low interest rates, which pose significant product risk. However, Nordic insurance markets are generally concentrated, with high operational barriers to entry, dissuading non-Nordic competition. "We expect long-term interest rates to stay low, at least until year-end 2016, leading P/C insurers to keep focusing on underwriting profitability and life insurers to continue derisking the balance sheet and shifting toward less capital-intensive products”, Glennmar added.
What is your view on the country risk in the different Nordic countries?
Apart from Iceland, we see country risk as low or very low and therefore a key strength. Denmark, Finland, Norway, and Sweden are all wealthy, supporting our IICRAs in those countries. Yet, we see differences in the underlying economies, financial systems, and industries that could test insurance companies over the next two years.
What are your expectations on the economic development in the Nordic countries and what does that mean for the insurance industry?
We expect the demand for insurance protection to generally keep pace with overall economic growth in the region. This supports our forecast for the insurance sectors in Denmark, Finland, Norway, and Sweden, which have high GDP per capita. We estimate real GDP growth in these countries to average between 1% and 3% in 2015-2017 as consumer confidence strengthens, fostering demand and investment. That said, high household debt remains a threat to economic growth. According to our estimates, household debt ranges from about 300% of gross disposable income in Denmark, to 215% in Norway, and about 175% in Sweden, and is significantly lower in Finland. Still-low interest rates are relieving some of the pressure on households. But a rise in interest rates could slow down consumption growth, including the demand for insurance protection.
We continue to see substantially higher risk for insurers in Iceland. Iceland's economy is small, concentrated and highly leveraged. Following the collapse of the three major Icelandic banks in late 2008, the government's success in reining in its fiscal and external deficits saw GDP per capita start to recover, after contracting by more than 10% during 2009-2010. The 36% depreciation in Iceland's real effective exchange rate between 2007 and 2012 has also helped rebalance the economy. We expect continued strong economic growth in Iceland averaging about 3% over 2015-2017.
What impact do the financial systems in the Nordics have on the insurance industries?
In general, financial systems are supportive, but depressed yields remain a challenge. The insurance sectors in Denmark, Norway, and Sweden benefit from stable financial systems, in our view. Combined with these countries' strong creditworthiness, this provides a solid platform for investment opportunities and growth. We believe Finnish insurance companies operate in a slightly weaker environment, mainly because the three largest banks account for more than 75% of the financial system and almost all of its external funding.
Overall, the low issuance levels of long-term bonds in Nordic markets (although less so in Denmark) means fewer domestic investment opportunities for insurers. It also limits options for asset-liability management, which is especially important for life insurance companies because of their need to meet guaranteed yields on long-term policies. What's more, continuously low yields, which decreased significantly in 2014, have dampened insurers' earnings prospects and investment returns and reduced their solvency levels. Low yields are particularly challenging for life insurers because of the relatively high guarantees on inforce life insurance contracts.
In Iceland, we consider that the financial system puts the insurance sectors at a disadvantage. Capital controls limit insurers' investment choices, as well as their access to external funding, mainly because they discourage investment. However, we recognize the risks associated with removing capital controls, such as significant capital outflows, the extent and speed of which are hard to predict. Combined with sluggish economic growth, this could hurt the debt-laden economy and expose insurance companies to significant balance-sheet volatility.
What is your view on the Property/Casualty sectors?
Overall, we see lower risk in Nordic P/C insurance sectors than in many other such sectors in Europe. Several larger players are focusing on profitability rather than growth, and we expect them to continue doing so during 2015 and 2016. We also see material entry barriers for new insurers, the main ones being the need for a strong brand and much lower expense ratios than in other markets. These positives are partly offset by moderate exposure to natural catastrophes and some long-tailed products. Our IICRAs for the P/C sectors in Denmark, Finland, Norway, and Sweden are low risk. The only P/C sector we consider stronger is that in Switzerland, where we see an even steadier economy and a stronger institutional framework. The Icelandic P/C IICRA is moderate risk, in our view.
What are your expectations on the generally strong profitability in the Nordic P/C sectors?
Profitability remains strong in Denmark, Norway, and Sweden, with the five-year average return on equity (ROE) at between 10% and 20%, benefitting from strong underwriting margins. Companies are focusing on profitability, mainly through price increases, enhanced risk selection, and cost efficiency. We believe that, with low yields pushing investment income downward, insurers have increased their focus on improving underwriting results. This is evident in the five-year average net combined ratios in these countries, which are below 95%. The lower profitability of Finland's P/C sector is partly due to the comparably weaker reported underwriting performance of several smaller mutual insurance companies, which are inherently less focused on profitability. The average net combined ratio was 96% in 2013 and the five-year average net combined ratio is 100%.
In our view, profitability remains a negative factor in Iceland, but there are signs of recovery. Iceland's P/C sector continues to report losses, with the five-year average net combined ratio at 103%. However, the average ROE was 11% in 2009-2013, and we see a positive profitability trend that we expect will continue as companies remain focused on earnings. Consequently, the net combined ratio, which exceeded 100% for many years, improved to about 95% in 2012 and was 97% in 2013, and we expect it to remain below 100% during 2014 and 2015. Consequently, if Iceland's P/C insurance sector stays profitable over the next few years, we could change our assessment of profitability to neutral from negative.
How exposed are the insurance companies to natural catastrophes?
Overall, we consider exposure to natural disasters moderate in Denmark, Norway, and Sweden. Despite claims from weather-related events, the P/C sectors in these countries have remained profitable over the past five years. Countrywide risk pooling and comprehensive reinsurance programs lessen the impact of natural catastrophes on insurers' earnings. Although Iceland can experience earthquakes, volcanic eruptions, and mud slides, among other things, these are all covered by the Icelandic Catastrophe Fund. In addition, all residential and commercial properties in Iceland are insured against natural disasters through obligatory fire insurance. The risk of natural catastrophes in Finland is low, in our view. There's a lower impact from weather-related events than in other Nordic countries, which we view positively in our assessment of product-related risks in Finland. Apart from natural catastrophes, insurers also face moderate exposure to long-tailed business. This exposure varies across the Nordic countries and relates mainly to annuity-based worker compensation and motor-related claims.
What is your view on the Life sectors?
Generally, we consider that the life insurance sectors in Denmark, Finland, Norway, and Sweden carry somewhat higher risk than the corresponding P/C sectors. The main reason is the mismatch between the amount and terms of insurers' assets and their long-term life insurance liabilities, including relatively high guarantees on inforce life insurance contracts. In our view, the low interest rates prevailing in the Nordics, and across Europe, heighten this risk by hampering investment income and consuming capital. That said, the positive contribution of very low country risk has resulted in low-risk life IICRAs, except in Finland.
Our IICRA for Finnish life insurers is intermediate risk mainly because country risk is higher, Finnish life insurers do not hedge interest rate risk to the same extent and have a greater appetite for high-risk investments.
What challenges is the low interest rate environment creating for Nordic life insurers?
Low interest rates have been making it harder for companies to meet guarantees on life insurance policies without taking on riskier investments. We expect long-term interest rates to remain low, at least until the end of 2016, and therefore guaranteed yields will remain a key concern, in our opinion. Continually low rates also heighten risk from life insurers' large asset-liability mismatches. In our view, this poses significant product risk, owing to the policy guarantees, and constrains our IICRAs for the sectors.
Most of the region's life insurers have taken measures over the past decade to reduce risk in their product portfolios. These measures include a general shift of new business toward unit-linked products without guarantees, or to products with different types of guarantees. Although we see some progress, we believe it will take time before the pressure on earnings and capital adequacy dissipates. Life insurance and pension policies vary, but the guaranteed interest rate on inforce policies averages 3.0%-3.5% in all Nordic countries except Denmark, where we estimate it at about 2.6%.
We believe the strategic move away from traditional guaranteed business to other product types will be positive for our assessment of product-related risks in the Nordic region in the longer term. However, guaranteed business still dominates many companies' inforce books; therefore, asset-liability management risk is still high, in our view. The degree of asset-liability mismatch also differs by country. In our view, there is better availability of long-term bonds in Denmark than in other Nordic countries, and Danish life insurers actively hedge interest rate risk. Finland's debt market is considerably smaller than the other Nordic markets, and the life insurers there hedge interest rate risk to a lower degree. In addition, Finnish life insurers have the highest proportion of equities in their investment portfolios, making their investment returns prone to volatility. According to our estimates, equities made up 30%-35% of the assets backing life insurance business with guarantees. Equivalent Swedish portfolios showed an equity share of just below 30% of total invested assets. Insurers' equity holdings are substantially lower in Denmark and Norway, but still higher than in many other European life sectors.
How does the profitability in the life sectors compare to the P/C sectors in the Nordics?
In our view, profitability is lower than in the Nordic P/C sectors. Profitability (as measured by ROE) is a neutral factor for our life IICRAs in all four countries. The average ROE is lower than 8% in all four countries and considerably lower than the strong ROE of 10%-20% in the P/C sectors in Denmark, Norway, and Sweden. Companies' bottom-line earnings fluctuate, largely because of asset-liability mismatches and a relatively high proportion of equity investments. In addition, companies in Denmark and Sweden use a market-value approach to report assets and liabilities, which makes their balance sheets more volatile than in other jurisdictions. In the long term, we expect the highly developed Nordic life insurance sectors to continue to expand roughly in line with GDP growth, but not without setbacks. Changes to regulations and the tax regime, for example, have led to a decline in business in the past. We also anticipate some volatility in business volume growth from the transfer of traditional business with guarantees to other products.