JGBs: are rising yields a risk to insurers?

Over the last couple weeks, we have seen an ongoing increase in government bond yields across the major global economies, with a particular focus on Japan as yields on longer dated Japanese government bonds (JGBs) have moved sharply higher. The shift attracted renewed headlines late last week after Nippon Life (the world’s third largest life insurer by reserves) published its full-year results and the financial press picked up on a “tripling” of unrealised losses on its domestic bond holdings.

Considering the Japanese life insurance market is among the largest globally, a stress event here could certainly have consequences beyond the country’s borders. However, the headlines around these unrealised losses do not capture the full picture.

To add some much-needed context, Japanese insurers have been big buyers of longer dated JGBs in recent years as they have been preparing for a new solvency regime, which came into effect from April 1. The move higher in JGB yields has clearly led to material unrealised losses on these long-dated positions. Reporting its full-year results last week (covering the 12 months to March 31), Nippon Life reported a decrease in unrealised gains from all securities to ¥7.4tr from ¥12.0tr previously. Significant unrealised gains or losses are not unusual; over the years, Japanese insurers have accumulated quite large unrealised gains in equities positions, for example, which have similar accounting treatment to JGBs. The biggest driver for the decrease in unrealised gains overall was the increase in unrealised losses from domestic bonds, which grew to -¥3.6tr from -¥1.0tr. During the reporting period 30-year JGBs had moved around 90bp higher, and they have since risen by a further 60bp, so unrealised losses from bonds are also likely to have risen further.

Insurer balance sheets differ from banks

However, the increase in unrealised bond losses is only part of the story.

First, it is worth highlighting that for Japanese life insurers, the duration of policyholder liabilities tends to be longer than that of assets. This means the net impact of higher rates on insurers’ equity can be positive. One way to capture the regulatory solvency position is through the economic value-based solvency (ESR) ratio. As an example, despite material changes to the value of its investments over the last year, Nippon Life’s ESR has decreased by only two percentage points to 222% (the regulatory minimum is 100%).

Second, it is worth reiterating that unrealised losses on bonds for life insurers do not have quite the same effect on the liability side as they do for banks (for those thinking of Silicon Valley Bank). This is first because unrealised gains and losses on securities are included in insurers’ regulatory capital ratios – unlike in the case of Silicon Valley Bank, where part of its unrealised losses did not have to be deducted from regulatory metrics. In addition, the liability side of bank balance sheets tends to have more propensity for outflows (think of on-demand deposits). It is true that higher interest rates increase lapse risk for insurance policies (i.e. the early redemption of policies), given there are more attractive alternative investments available to investors out there. However, Japanese life insurers have generally seen low levels of lapse risk in the past, even when rates trended higher in 2022 and 2023, according to data from The Life Insurance Association of Japan.

Third, it is worth noting that Japanese life insurers do not employ leverage when buying JGBs in their general accounts. It is important to draw this distinction for anyone thinking about the liability-driven investment (LDI) experience in the UK. At that time, corporate pension schemes had employed leverage to enhance their returns on Gilt positions through LDI arrangements. The sell-off in Gilts induced by Liz Truss’ “mini-Budget” resulted in margin calls on these transactions, putting further selling pressure on Gilts until the Bank of England eventually had to step in

Japanese insurers reacting to developments

All this is not to say the sector doesn’t face risks from higher yields. Rising interest rates could indeed lead to weaker equity valuations and erode material unrealised gains from years of appreciation in equities. Lapse rates could also increase materially from their current benign levels, defying past experience. Still, the key players in the sector remain well capitalised and are reacting to the market developments. After years of JGB accumulation to meet the incoming solvency rules, at the end of April (i.e. prior to the latest weakness) half of the 10 largest Japanese life insurers had already flagged that they intended to reduce their domestic bond holdings, according to Daiwa Securities. One motivation for this is purely economic, as the market remains concerned about further increases in interest rates in the context of rising inflation. Another rationale is to avoid the need to realise the impairments down the line, say if lapse rates were to increase. In some cases, insurers will also be replacing off-the-run, lower coupon JGBs with the new, higher coupon issuances.

Generally, given the strong equity positions of the major life insurance groups and their ability to absorb the realised losses, we would view this rotation as prudent and done from a position of strength rather than stress, contrary to what some of the headlines have suggested.

In terms of any read across to European life insurers, we would note that by and large, with some exceptions, life insurers’ solvency positions in Europe benefit from higher rates. Indeed, it was the ultra-low or negative rate environment that has been particularly challenging for some long dated, guaranteed policies in certain regions. Instead, European life insurers are generally more exposed to credit risk and the widening of government bond spreads (over swap rates) or rating downgrades. The use of leverage in Gilt purchases, which can accelerate the liquidity stress, has seemingly re-appeared in some recent UK life insurance transactions, but remains limited in scope. In any case, earlier this year the Bank of England put in place facilities such as the Contingent NBFI Repo Facility which are aimed at avoiding the severe Gilt market dysfunction seen in late 2022.

The sharp increase in JGB yields has certainly been important for the market more broadly, not least because the magnitude of such moves can lead to unexpected risks materialising. That said, we do not see a material risk from this development to the solvency positions of life insurance firms in Japan, at least to the extent that higher yields will not have an adverse impact on the local equities and credit markets. Further afield, we take comfort in the fact that European life insurers are generally positively geared to a higher rate environment, while the action taken by the Bank of England to mitigate stress in the Gilt market is also reassuring.