As interest rates steadily rise, life insurers have become acutely aware of the potential capital losses that may ensue from escalating policyholder lapse, Gallagher Re, a leading global reinsurance broker, unveiled in its first installment of research papers titled “Gray Rhino.”
These papers aim to shed light on looming challenges within the insurance industry before they escalate into major crises. The inaugural publication tackles the critical issue of mass-lapse risk in European life insurance, an increasingly pressing concern for insurers in the region.
The “Gray Rhino” metaphor, originally coined by Michele Wucker, emphasises the importance of recognising and addressing preventable dangers rather than focusing solely on rare, unforeseeable catastrophes, often referred to as “black swans.”
With the gradual increase in interest rates, life insurance companies are becoming increasingly conscious of the potential financial losses that could result from a rise in policyholders deciding to lapse their policies. Simultaneously, the persistent cost-of-living challenges faced by consumers have raised the probability of policy cancellations and a redirection of funds to different investment options.
The triggers for a mass-lapse event are multifaceted and challenging to model accurately. Nevertheless, the repercussions are alarmingly evident and could spell disaster for the insurance sector. This includes the sale of significant fixed-income portfolios at a capital loss to cover surrender values, resulting in a substantial mismatch in asset and liability durations.
European insurers have been compelled to diversify into less liquid assets in recent years due to prolonged periods of low interest rates and bond yields.
Credit rating agencies have been closely scrutinising this risk, with detailed reports highlighting the potential pitfalls. Lapse risk is not uniformly distributed across Europe, with insurers in certain markets being more vulnerable than others, each with its unique set of mitigating factors.
European regulators have long recognised lapse risk, mandating insurers to maintain sufficient capital under various lapse scenarios, including mass lapses.
Under Solvency II, a mass lapse is defined as a one-off first-year shock, where up to 40% of life policies immediately lapse (or up to 70% for specific categories).
In the event of an accelerated increase in lapse rates, the situation could swiftly deteriorate, potentially leading to a systemic risk, similar to what was witnessed during the 2008 financial crisis.
Consequently, a growing number of insurers are actively seeking reinsurance solutions to effectively manage lapse risk, alongside liquidity risk, to safeguard their financial stability.
Reinsurance coverage can be tailored to transfer lapse risk to reinsurers, thereby ensuring the reinsurance policy responds proportionally to lapse rates deviating from expectations.
This approach also confers substantial benefits under Solvency II, mainly by reducing the lapse-related solvency capital requirement (SCR) and providing some relief in terms of risk margin.
Notably, the list of European countries where lapse reinsurance transactions have been executed continues to expand. Regulators in various jurisdictions have increasingly blessed these transactions, recognising their invaluable role in enhancing risk management within the insurance industry.
