And as we have discussed, German 10-years are in negative territory.
But what we’ve also got are these insurance companies writing long-term contracts that go on for 20-25 years and in big parts of the European Union there are no bonds that go that far. And if there are no bonds for that length of time, there are no interest rates to use to discount the liabilities.
This has forced the regulators to come up with some sort of discount rate. As a result, they’ve concocted a yield curve from a series of interest rates from one-year, two-year, five-year etc bonds. But the problem with that is the rates are set by committee and are not based on any bonds the insurance company actually holds.
The technical term for the discount is the ultimate forward rate (UFR), which insurance companies should use for their longer-dated liabilities. It has been set at 4.2%.
This is lunacy and creates a lot of issues. So what the insurance companies are doing is discounting at a higher rate, depressing their liabilities and overstating their solvency and financial strength.
The 16-year window is farcical, especially when we have a UFR of 4.2% when the bonds are actually generating around 0.4%.
Will we see consolidation in Europe, as we have in the UK, as a result?
Absolutely. The sooner you recognise you have an issue, the sooner you realise it is hopeless. You don’t want to waste capital or make your policyholders suffer.
Although there has been a huge amount of consolidation in the UK, there have been a number of cases where the company is just clinging on, hoping they will come up with a new strategy. So more consolidation in the UK is likely. Unfortunately, Solvency II is going to cause people to delay the inevitable and actually make the situation worse.
You have these complete disconnects with the interest rate used for discounting and this hugely long transitional period. If Solvency II is going to be brutal they are not going to make it.
What it should be doing is getting companies to recognise they are not going to pass the tests and meet the requirements, and say, ‘Let’s give ourselves a decent burial, consolidate ourselves out of the marketplace and take appropriate action now’.
What do you think the future holds?
I doubt much will have happened by this time next year but, in around five years’ time, I think things will look very different. There is still be a lot of work to be done, a lot of opportunity for consolidators and asset managers to pick up business.
What does Brexit mean for all of this?
As an industry that has gone through such massive change in the past 20 years, I don’t think it means a great deal. There are a number of UK life companies that had already set up subsidiaries, whether on the Isle of Man and/or Dublin to do offshore business.
I think Brexit fears are overdone on passporting and everything else. It is not really in French or German interests to cut off their nose to spite their face. There will be a period of uncertainty but it will probably settle down with little practical difference. However, it is going to be a question mark in people’s minds for the near term.
