Interest rate risk management by life insurance companies and pension funds

This article focuses on the specific features of the exposure to interest rate risk and the hedging strategies of life insurance companies and pension funds, stemming from the long-term nature of their commitments. In particular, the combination of guaranteed returns and numerous contingency clauses may complicate the liability management of life insurers and defined-benefit pension funds, especially given the uneven regulatory environment that is currently undergoing major changes. Admittedly, this problem also exists for other financial institutions, in particular banks, but the latter offer fewer and less diversified long-term guarantees. For life insurance companies and defined-benefit pension funds, interest rate risk is therefore more complex to assess and more difficult to manage. However, these institutional investors have become major players in the financial arena: in France, life insurers’ assets total some EUR 900 billion and life insurance products account for almost one-third of the financial investment of households. In the euro area, at the end of the third quarter of 2004, the liabilities of life insurance companies and pension funds stood at EUR 3,660 billion.1 In the United States, life insurance technical reserves amounted to USD 970 billion at end-2003 2 and public and private defined-benefit pension funds managed assets worth USD 4,300 billion3, in spite of the sharp growth in defined-contribution pension funds and individual pension savings accounts whose risks are borne by the policyholders. Consequently, the authorities are assessing the implications, in terms of financial stability, of the strategies of these investors, whose solvency depends on the sound management of interest rate risk. The BIS annual report 2004 recalls that some life insurance companies failed in 2003 in Germany and the United Kingdom “as a result of losses due to overly generous polices that had induced companies to look for higher returns in riskier investments”. Similarly, the value of certain pension fund assets appears lower than that of their liabilities which could indicate an inappropriate asset/liability management strategy. The assessment of interest rate risk is rendered more complicated by the fact that life insurance companies are active in a number of areas, and available data are not always suitable for these purposes.