As the global reduction in interest rates shows no sign of abatement, who is affected the most? Given compounding returns, it would logically be those who hold their investments for the longest, and this is often life insurance companies and other similar retirement-related services.

Life insurance involves a number of different financial instruments with slightly different business models. In the classic term insurance format, a payout is given upon death. Insurance has turned out to be a highly flexible financial product, however, and many sub-sectors of the industry have evolved into other roles. Health insurance in the US, for instance, as labor unions have been sidelined, has moved from a risk management tool into a mechanism for collective bargaining with health providers.

So it is with life insurance as well – in this case encroaching into the role of asset management. In contrast to term insurance, whole life insurance accounts have an investment component and a cash value. As an asset, the policy can be used as collateral for personal loans. In this low-return environment, whole life has become particularly popular in Taiwan, Japan, and Korea, with assets exceeding US$ 5 trillion. Much of this sum is invested overseas, enough to even attract attention in the destination markets (such as the US).

These three countries were pioneers of a distinctive of East Asian development model in which the state has historically preferred to centralize investment decisions, although not necessarily within the government itself. Neither pension systems nor individual investment advisors have been developed as thoroughly in Asia as in the West. Regardless of the sector in which the problem is concentrated, however, it reflects a couple of fundamental issues. First is the well-known problem that these countries are leading the world in aging demographics.

The second issue is the limited investment opportunities within these local markets. The IMF’s October Financial Stability Report highlights the ratios between life insurer assets and the domestic corporate bond market in these countries: 23, 14, and 10 times in Japan, Taiwan, and Korea respectively, much higher than in the Euro Area and the US. In the latter two countries, the supply of government bonds is relatively small as well, and in Japan the central bank has sapped up most of the supply. Individuals tend to prefer intermediaries for bond investments, particularly overseas.

Given these considerations, even interest rates may be a second-order problem. They could end up being solved at some point even while the underlying issues remain.

Letting the Market Decide

Despite the differences between term and whole insurance from a consumer perspective, the business models for the insurer are largely the same. The probabilities of individuals dying sooner or later tend to cancel out, leaving interest rate and asset market fluctuations as the main risks in both cases, as long as the policy promises fixed returns.

The new IFRS 17 accounting rules for the insurance industry have crystallized the pressures noted above, requiring them to be disclosed early rather than allowing problems to fester until policies come due. The impact of the new regulations, whose implementation has now been pushed back to January 2022, is expected to be especially severe in Korea, where insurers have previously sold many fixed-return policies at unsustainable rates. (IFRS reporting is optional in Japan.)

Accounting for the insurance industry is relatively complex, and was previously not well standardized. One major difficulty involves the Contract Service Margin (CSM), which means at what time over the life cycle of the insurance policy the insurer can book profits, and how much. Money which is being held in reserve to eventually be paid out to the policyholder should instead be considered debt, and tabulated on the balance sheet rather than the cash flow statement.

The most controversial change of IFRS 17, however, is a move towards market valuation for both assets and liabilities. Previously, liabilities were priced using book value, which means the value at the time of issuance. Lower interest rates mean a lower discount factor. When the previously sold polices are adjusted on the balance sheet to reflect the recent lower rates, the present value of future liabilities increases, as they cannot be paid off simply through compounding interest.

Dual Pressure on Returns and Asset Quality

As much trouble as this new standard will cause for policy issuers, however, it allows reporting to better reflect asset quality. If insurers are feeling pressure now based on this change, they would have felt even more later. They may have held out hope that rates would return to their previous equilibrium before policies would come due, but that argument looks weaker with each passing year. In any case, longer-term rates are largely determined by market projections, rather than manipulation by central bank policy.

One result of this cost pressure will likely be less issuance of large, long-term guarantees by insurers. If that is the case, the new state of the industry will reflect properly aligned incentives. At the same time, insurers are also adjusting the liability portion of the balance sheet through convertible bonds, which are counted as equity for purposes of capital adequacy despite functioning as debt in normal situations.

Another, more refined objection is based on stability, rather than costs. When low rates cannot be passed on to policyholders, insurers may “reach for returns,” and lower their investing standards. Investments with returns that would previously be reasonable may turn out to be unstable, even if they currently have acceptable ratings. In the context of Europe, which has also experienced negative rates for some time, the New York Times notes an “explosion in investor demand” for BBB securities, which are barely investment-grade. This could trigger a potential shortage of available assets in case of an overall market movement. The IMF’s report also highlighted an increasing number of unrated bonds on Asian insurers’ balance sheets.

The notion of “reaching for yield” is difficult to define formally, considering that investors prefer better risk-adjusted returns in any situation. Nevertheless, it appears that low rates may magnify existing distortions in risk measurement in ways that may not be fully understood. Liquidity is one example of an important concept that can be difficult to capture quantitatively.

One area of growing concern is holdings of US Collateralized Loan Obligations (CLOs), corporate debt instruments which are reminiscent of the Collateralized Debt Obligations (CDOs) at the center of the 2008 financial crisis. Meanwhile, some foreign currency holdings are not hedged, or hedged at a much shorter duration than the underlying security, leading to possible macroeconomic risks in case of currency movements.

Solve the Demographics Problem First

Risk, rather than interest rates, seems to be the core problem. Analysis by Louis-Vincent Gave of Evergreen Gavekal investment advisors argues that since those over 70 are strong dis-savers, the world will return to an inflationary regime soon after 2020, led by countries like Korea. For Japan, whose aging has progressed the most, consumer price deflation is already not quite as significant as it was earlier in this decade. One can imagine that even having resolved deflationary pressure, an economy driven by end-of-life capital consumption may not be as dynamic as one driven by a large young population. In other words, low-flation may turn into stagflation, which still might not translate into strong asset price growth.

One complication of analyses like these is the assumption of static working-age population definitions.  As longer working tenures become the norm, it may instead be more useful to think about the healthy working population – a measure which would give countries like Korea and Japan an advantage over poorer nations like China, despite their quantitatively similar position in a few years. In many ways (though not all), working longer can be a blessing.

For this to happen, some aspects of work will need to be adjusted. Older workers, although experienced and generally proficient in holistic skills like communication and problem solving, may have trouble adapting to new technologies and business environments. Concerted efforts are required on both in-job and independent training. The either good or bad news is that according to OECD data from the Programme for the International Assessment of Adult Competencies (PIAAC), both Korea and Japan have relatively low participation rates in job-related training. Thus, both countries have room to improve.

Technology can impact this process in a variety of ways, in addition to its effects on health as mentioned. E-learning is making it easier to learn flexibly, at lower cost – a change which may be complemented by more flexible working arrangements in general. Furthermore, aging is helping spur automation in affected countries, replacing workers in some tasks in order to improve their productivity elsewhere. One tricky aspect to this transformation will however be ensuring that the new opportunities for older workers do not impact the work prospects of the younger generation, who will still be responsible for the long-term growth of the economy.