Impacts of interest rate environment on Japanese insurance sector

- From "negative spread" to "negative rate" -

November 2016 Takashi HAMANO

Deputy Commissioner for International AffairsFinancial Services Agency of Japan (JFSA)

* Any views expressed in this presentation are those of the author, and should not be considered as official views of the JFSA.

NOT FOR CIRCULATION

ContentsI. Negative spread and its impact on Japanese

insurers1. Causes and consequences of negative spread

problem2. Mitigating the negative spread problem –

industry efforts and regulatory measures3. Overcoming the negative spread problem

II. Negative rate environment and its impact onJapanese insurers

1. What happens?2. What we would expect ?

1

I. Negative spread and its impact on Japaneseinsurers

1. Causes and consequences of negativespread problem

2

1. (1) Background

After the “bubble economy” in 1980s, long persisting lowinterest environment since 1990s has caused a “negativespread” problem.

“Negative spread” is an interest loss generated from thedifference in the guaranteed (assumed) interest rate topolicy holders and the actual investment yields.

Several life insurance companies failed during 1997-2001.

3

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

0

1

2

3

4

5

6

7

8

9

(JPY)(%)

(year)

1. (2) Assumed interest rates of life policies, 10-Year JGB yield and Nikkei Stock Index

10 year JGB Yield(Left-hand scale)

Assumed interest rate of life policies(Left-hand scale)

Nikkei 225 Stock Price Index (Right-hand scale)

The negative spread issue has persisted since the 1990’s,due to the low interest rate environment

4

1.(3) Failure of Japanese life insurance companies7 life insurers failed between 1997 and 2001. However, it should be noted that there were some specific risk factors behind the failures (e.g. deficient risk management, high-risk investment strategies etc.) in addition to an adverse market environment.

18,277

21,900

13,000

1,545

22,330

37,250

6,900

▲ 3,029

▲ 6,500

▲ 3,177

▲ 365

▲ 5,950 ▲ 6,895

▲ 731

▲ 100

0

100

200

300

400

Nissan(Apr 97)

Toho(Jun 99)

Daihyaku(May 00)

Taisho(Aug 00)

Chiyoda(Oct 00)

Kyoei(Oct 00)

Tokyo(Mar 01)

(100 million Yen) The figures for total assets and excess liabilities are those at the time of failure

Total Asset

Liabilities in excess of assets

5

I. Negative spread and its impact on Japaneseinsurers

2. Mitigating the negative spread problem– industry efforts and regulatory measures

6

2. (1) Industry efforts

Even in a difficult business environment, life insurancecompanies in general are making profits even after offsettingof the negative spread. It is partly because mortality gainsfrom death insurances tend to be significant. Cost savingsalso contributed to offsetting of the negative spread.

N.B. Profit sources from basic insurance business (Core profits) of lifeinsurance companies are classified into three categories.(a) Interest gains : Difference between the assumed interest and the actual

interest(b)Mortality gains : Difference between the assumed mortality rate and the

actual mortality rate(c) Cost savings : Difference between the assumed expenses in business

operations and the actual expenses in business operations.

7

0.6 0.6 0.5 0.3 0.1 0.0 0.1 0.1 0.2 0.1 -0.0

2.8 2.9 3.0

2.92.9 2.9 2.7

3.0 2.8 3.0 3.1

▲ 0.9▲ 0.7

▲ 0.4 ▲ 0.5

▲ 1.0▲ 0.8 ▲ 0.7

▲ 0.5▲ 0.2

0.20.3

2.62.7

3.0

2.7

2.0 2.1 2.1

2.62.8

3.3 3.4

▲ 1.5

▲ 1.0

▲ 0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14

Cost Profit Mortality Profit Interest Profit Total 3 (≒Core Profit）

Profits generated from lower-than-assumed mortality rates and costsavings had offset losses from negative spreads until recently

8

2. (2) Three profit sources of life insurance companies

2. (3) Introduction of regulatory measures

Japanese insurance regulatory regime was reinforced bythe full revision of the Insurance Business Act(promulgated in 1995 and enforced in 1996).

Some regulatory measures that helped to mitigate theproblem were introduced.

(a) “Standard Policy Reserve System” including the statutorydefined standard assumed interest rate was introduced in 1995.

(b) The statutory method for setting the standard assumedinterest rate was amended in 2014 to make it more consistentwith market rates.

(c) A new accounting treatment for life insurers was introduced in2000 to avoid fluctuation of insurers' net worth due to changes ininterest rates.

9

10

2. (4) Method for setting the standard assumed interest rate

The method for setting the standard assumed interest rate used forthe calculation of the standard policy reserve requirements is basedon JGB yields and hence it has also been in decline continuously.The standard assumed interest rate was reduced in 2013 from 1.5%to 1.0% for the first time since 2001.

Assumed interest rate1990 5.5% (more than 10Y), 5.75% (10Y or less)1993 4.75%1994 3.75%1996 2.75%1999 2.0%2001 1.5%2013 1.0%

N.B. From 1990 until 1994, the most common assumed interest rates forendowment insurance contracts. From 1996, the statutory defined standardassumed interest rates.

2. (5) Amended method for setting the standard assumed interest rate

Pre-Amendment

Post-Amendment (Since June 2014)

OthersSingle-premium saving types（whole life, endowment,

annuities etc. ）

Benchmark yield 10 year JGB Same as before 10 year JGB

Reference term of yield

Lower of 3 years average or 10 years average Same as before Lower of 3 months average or

1 year average

Reference yield Yield to subscribers Same as before Current yield

Frequency of adjustment Once per year Same as before 4 times per year

Trigger for adjustment 0.50% or more deviation Same as before 0.25% or more deviation

Safety factor coefficient 90% confidence level 95% confidence level

11

The method for setting the standard assumed interest rate was amended in2014 to be more consistent with market rates.The rates for some single-premium products were lowered in April 2015.

2.(6) Transition of “Standardized Assumed Interest Rate”

“Standardized Assumed Interest Rate” has continuously declined due to decrease in long-term interest rate

12

※ “Standardized Assumed Interest Rate”: In order to ensure soundness of insurers and to protect policyholders, insurers are required to accumulate their policy reserves based on the "Standardized Assumed Interest Rate", which is set by a formula defined by the FSA regulation based on market interest rate. Decrease of “Standardized Assumed Interest Rate” means that life insurance companies must accumulate more policy reserves. Life insurance companies, therefore, may have to raise insurance premium.

（％）

2016 2017

(FY)

20152013

1

0.5

0.0

201486 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 2001 2012

6

5

4

3

2

5.5％

4.75

3.75

2.75

2.0％

1.5％

1.0

【July, 2016】Single premium whole

life：0.25％

6.0％

【July, 2015】Single premium whole

life：0.75％

I. Negative spread and its impact on Japaneseinsurers3. Overcoming the negative spreadproblem

13

3. (1) Background

• The negative spread problem mainly matters to insurance contracts entered into in the high interest rate environment until early 1990s. Those legacy insurance contracts have been decreasing in the last two decades. In addition, newly entered insurance contracts with lower assumed interest rate have increased in the same period.

• With a favourable investment environment (e.g., higher stock prices and increased return from foreign securities investment) in the last few years, major life insurance companies have recorded strong core business profits.

• Against these backdrops, the negative spread problem is being settled for many life insurance companies.

14

15▲ 5,000

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

FY90 FY95 FY00 FY05 FY10

（100 billion yen）

3. (2) Financial results of life insurers in Japan

(*) 42 life insurers

Core Profit

Current Net Profit

Recent financial results of life insurance companies have been generallystrong

0

20

40

60

80

100

120

140

0

5,000

10,000

15,000

20,000

(JPY/USD)(pt)

(year)

Nikkei 225Stock Price Index(Left-hand scale)

JPY/USD exchange rate(Right-hand scale)Start of the Abe

Administration(Dec 2012)

Start of BOJ’s QQE

(Apr 2013)

The market environment has improved since the launch of so-called“Abenomics”

3. (3)Nikkei Stock Index and JPY/USD exchange rate in recent years

16

II. Negative rate environment and its impact onJapanese insurers

1. What happens?

2. What we would expect ?

17

II. Negative rate environment and its impact onJapanese insurers

1. What happens?

18

1. (1) Background

• Bank of Japan’s negative rate regime (on central bank deposits) was announced on January 29 and applied from February 16.

Negative rate (- 0.1%) only applies to a small portion of banks’ deposits with the central bank (central bank deposits).

• Since end-February, JGB yields up to 10 year have turned into negative.

• Although the amount of central bank deposits in total remained almost the same, there are significant changes in money flow in the Japanese financial markets.

19

1. (2) Low/Negative interest policies of BOJ

April 2013 : QQE (“Quantitative and Qualitative Monetary Easing”)

January 2016 : QQE with a Negative Interest Rate

September 2016 : QQE with Yield Curve Control

20

1. (3) How negative rate regime works

Name of Tiers Applied Rate

① Basic Balance +0.1% Average outstanding balance from January 2015 to December 2015 (Benchmark reserve maintenance periods)

② Macro Add-on Balance

0% Outstanding amount of required reserves, outstanding amount related to the Loan Support Program etc. + Addition based on Basic Balance

Policy-Rate Balance －0.1% Outstanding balance in excess of the amounts outstanding of ① and ②combined

Three-tier system of BOJ’s current account balance(Since Feb 2016)

21

1. (4) BOJ’s QQE with Yield Curve Control (Introduced in Sep 2016)

22

Negative rate(currently △0.1%)

applicable toa portion ofcentral bank

deposits

Yield Curve Control

JGB purchaseto keep 10 year

JGB yield at around 0%

Inflation-Overshooting Commitment

Observed CPI inflation rate exceeds the price stability target of 2% and stays abovein a stable manner

Monetary base continues toexpand until the above-mentioned condition is fulfilled

Long-termShort-term

23

1. (5) 10/40 year JGB yields(%)

(Source) Ministry of Finance, Japan

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.64-

Jan

11-J

an18

-Jan

25-J

an1-

Feb

8-Fe

b15

-Feb

22-F

eb29

-Feb

7-M

ar14

-Mar

21-M

ar28

-Mar

4-Ap

r11

-Apr

18-A

pr25

-Apr

2-M

ay9-

May

16-M

ay23

-May

30-M

ay6-

Jun

13-J

un20

-Jun

27-J

un4-

Jul

11-J

ul18

-Jul

25-J

ul1-

Aug

8-Au

g15

-Aug

22-A

ug29

-Aug

5-Se

p12

-Sep

19-S

ep26

-Sep

3-O

ct10

-Oct

17-O

ct24

-Oct

31-O

ct

10 year40 yearApplication of negative rate

(Feb 16, 2016)

BOJ's Monetary Policy Meeting(Sep 21, 2016)

0.229(1/28)

0.104 (1/29) 0.052 (2/16)

-0.03 (9/21)

BOJ's Monetary Policy Meeting(Jan 29, 2016)

-0.049(10/31)

24

1. (6) JGB yields by maturity

5y 7y 10y 15y 20y 30y 40yEnd-Dec2015 0.032 0.064 0.267 0.603 0.997 1.282 1.406

Jan 292016 -0.071 -0.055 0.104 0.436 0.833 1.103 1.235

End-Feb2016 -0.228 -0.217 -0.055 0.216 0.573 0.902 1.034

End-Mar2016 -0.19 -0.183 -0.049 0.176 0.441 0.547 0.632

End-Jun2016 -0.317 -0.331 -0.237 -0.094 0.067 0.128 0.157

End-Jul2016 -0.261 -0.292 -0.178 -0.002 0.184 0.263 0.328

End-Aug2016 -0.18 -0.186 -0.058 0.114 0.334 0.41 0.479

End-Sep2016 -0.249 -0.241 -0.084 0.118 0.361 0.457 0.522

End-Oct2016 -0.193 -0.177 -0.049 0.127 0.384 0.505 0.574

(%)

(Source) Ministry of Finance, Japan

1. (7) Changes in money flows

25

Short-term money market (e.g. uncollateralized “call”

loans)

Pension fundsInvestment

funds

Trust bank

Major banks

InsurersMarket funding

Investment of surplus funds Investment of

surplus funds

Deposits

TrustAccount

BankingAccount

II. Negative rate environment and its impact onJapanese insurers

2. What we would expect ?

26

2. (1) Current status

• Impacts will be more gradual and creeping than sudden and abrupt.

• Impacts may differ by firms depending on their business model and balance sheet structure.

• However, some harbingers have been observed Changes in investment behaviors Suspension of or limitation on provision of certain life

products

27

2. (2) Assets of life insurers (As of end Mar 2015)

28

Cash / Deposits (1.5%)

Loans (10.0%)

Securities (81.5%)

Others (6.9%)

(Source) Life Insurance Association of Japan

JGB (49.7%)

Municipal bond (4.6%)

Corporate bond (8.3%)

Stock (7.6%)

Foreign securities (24.5%)

Other (5.3%)

2. (3) Insurers’ foreign investment

Life insurers Non-life insurers2015 Jan 159 11

Feb -283 1Mar -512 0Apr 654 8

May 839 -1Jun 55 -16Jul 70 -8

Aug 64 3Sep 215 14Oct 505 -6Nov 321 -4Dec 318 -8

2016 Jan 159 -9Feb 1,075 -3Mar 1,503 3Apr 986 -44

May 813 10Jun 1,054 -14July 1,957 21Aug 1,149 2Sep 1,029 0

(Net Basis. Billion JPY)

(Source) Ministry of Finance, Japan 29

30

2. (4) Changes in investment behaviors

36.3 37.5

54.4 57.0 57.7 58.0 59.5 58.9 58.1 56.1 54.0

10.9

19.4 19.1

17.8 17.2 16.7 16.2 16.2 15.5 15.114.6

14.2

77.6

12.2 11.8

7.0 6.4 6.1 5.5 4.9 4.4 4.23.9

4.0

3.0

30.1 29.7

19.7 18.6 18.8 19.7 19.0 20.7 22.0 24.5 26.6

2.5

0

20

40

60

80

100

06/3 07/3 08/3 09/3 10/3 11/3 12/3 13/3 14/3 15/3 16/3 14/12

（％）

Domestic Gov. Bonds (JP/US) Domestic Bonds (JP)Bonds including Foreign Bonds (US)

Domestic Stocks (JP)Stocks including Foreign Stocks (US)

Foreign Stocks (JP)Foreign Gov. Bonds (US)

Others

USAJapan

31

Examples of insurers suspended in part or in full provision ofsingle premium whole life insurance and/or single premiumpersonal annuity insurance (as of April 2016)⇒ Fukoku Life, Asahi Life, Taiyo Life, Daido Life , Daiichi Frontier Life etc.

Examples of insurers that lowered the assumed interest rate (i.e.,increased premiums) of single premium whole life insurance (asof April 2016)⇒ Nippon Life, Daiichi Life, Meiji-Yasuda Life, Sumitomo Life

2. (5) Impacts on provision of life products

Some insurers have either suspended in part or in full or otherwiseincreased premiums of certain long-term products.Some insurers are more inclined to sell purely protection-type productssuch as health insurance.

2. (6) Considerations for insurance supervision

As the continued low/negative interest rate environment

could negatively affect financial results of insurers in the

long-term, JFSA conducts in-depth monitoring through

ORSA reporting and ERM hearings regarding.

One of the main focus is upgrading of asset management

capacity.

32

2. (7) Upgrade of asset management capacity

Diversification of investment portfolios (such as investment in foreign securities) with appropriate risk management is a key.

JFSA monitors the development of asset management sophistication by life insurance companies.

Excerpt from JFSA’s ““Progress and Assessment of the Strategic Directions andPriorities 2015-2016”” (Sep 2016)

Looking at asset management of life insurance companies, global diversification of investments (such as investment towards foreign corporate bond market, growth market, hedge transaction using derivatives) has continued, as domestic interest rate decreased and management of JGBs became more and more difficult. One cannot foresee the future interest rate environment, but it is expected for life insurance companies to contribute to nation’s assets formation and promote initiatives for upgrading asset management capacity.

33

2. (8) Challenges and way forward

• Exploration of alternative investment asset allocation for higher returns

Robust risk management and proper cash management will be needed

• Control of duration mismatch could become more challenging

Asset management with long-term perspective is crucial for life insurers

34

Thank you for your kind attention !