Insurance Research Institute: "Life Insurers' Solvency Risks Rise Despite Rate Hikes... Basic Capital Ratio to Fall 18.4 Percentage Points if Rates Rise 100 bp"

'Interest Rate Risk and Capital Quality in a Rising Rate Environment' Report
Life Insurers to Set Interest Rate Risk Limits Based on Basic Capital Ratios
Regulators Should Assess Interest Rate Sensitivity of Insurers with Weak Basic Capital

A study has found that life insurers’ risks related to basic capital have actually increased despite rising interest rates over the past year. It also estimated that a 100-basis-point increase in the base rate (1 bp = 0.01 percentage point) would cause the basic capital ratio to plunge by about 20 percentage points. The study advised life insurers to set interest rate risk limits based on their basic capital ratios and financial regulators to assess how sensitive the implementation paths of improvement plans for insurers with weak basic capital are to interest rate fluctuations.

On November 8, the Korea Insurance Research Institute released a report titled “Interest Rate Risk and Capital Quality in a Rising Rate Environment: Life Insurers,” which contains these findings.

In general, rising interest rates can improve insurers’ profitability indicators by increasing returns on asset investments and boosting the likelihood of higher net interest income. However, during the rate increases over the past year, life insurers’ basic capital rose only slightly, and their basic capital ratios fell.

According to Cho Young-hyun, a research fellow at the Korea Insurance Research Institute, yields on Korean Treasury bonds surged from the second half of last year, with long-term yields leading the increase in the first half of this year. The yield on 10-year Korean Treasury bonds rose 1.28 percentage points, from 2.81% at the end of June last year to 4.09% at the end of June this year. Over the same period, the 20-year yield rose 0.91 percentage point, and the 30-year yield increased 1.09 percentage points. Since monetary policy shifted toward tightening following two base rate hikes after the end of June this year, life insurers need to review their risks in preparation for further rate increases.

According to Cho, the life insurers’ ratios under the new Korean Insurance Capital Standard (K-ICS) fell 6.8 percentage points over the past three years, from 184% to 177.2%, while their basic capital ratios dropped 35.4 percentage points, from 116.7% to 81.3%. During the past year, when interest rates rose, both available capital and required capital increased, so the K-ICS ratio was generally maintained. However, basic capital rose only slightly, causing the basic capital ratio to fall.

The K-ICS ratio fell 1.1 percentage points, from 178.3% at the end of June last year to 177.2% at the end of June this year, while the basic capital ratio dropped 7 percentage points, from 88.3% to 81.3%.

Cho estimated life insurers’ basic capital ratios by applying their disclosed sensitivities to additional interest rate increases after the end of June this year. The basic capital ratio, which stood at 88.3% at the end of June this year, was estimated to fall by 16.1 percentage points to 72.2% if interest rates rose by 50 bp (1 bp = 0.01 percentage point). A 100-bp increase was expected to bring it down by 18.4 percentage points to 62.9%.

Cho advised life insurers to rigorously manage asset soundness by setting interest rate risk limits based on their basic capital ratios. He urged companies where potential losses from rising interest rates are large relative to their basic capital to defend their soundness indicators by adjusting the interest rate sensitivities of assets and liabilities, managing excess exposure, and setting priorities for capital expansion.

He also advised companies facing significant interest rate risk to adjust their sensitivity to interest rates through their asset composition and interest rate derivatives. As expanding the last liquid point (LLP) increases the interest rate sensitivity of liabilities and narrows the duration gap (the difference between the maturities of assets and liabilities), he urged insurers to make adjustments in stages in line with the LLP expansion schedule. The last liquid point refers to the longest maturity for which an insurer uses actual market interest rates when calculating its liabilities.

He urged the life insurance industry to strengthen basic capital through measures including (1) retaining earnings by restructuring the surrender benefit structure of new policies; (2) increasing basic capital through capital increases and capital securities eligible as basic capital; and (3) including in internal stress tests not only shocks specified by supervisory standards but also scenarios involving long-term rates leading the increase and a simultaneous rise in interest rates and widening of credit spreads.

Financial regulators should use existing interest rate shock scenarios to assess how sensitive the implementation paths of improvement plans for insurers with weak basic capital are to interest rate fluctuations. They should also apply the same scenarios to duration gap management to ensure it does not conflict with basic capital ratio regulations.

“Each company’s disclosures on risk sensitivity cover only items related to the K-ICS ratio. They should also include changes in basic capital under the same shocks and explain the calculation methods in detail,” Cho said.

This content was produced with the assistance of AI translation services.