Insurance Liability Discount Rates Change... Insurers' Net Profit and Capital May Fluctuate

Life Insurance Companies Expected to Have Greater Impact

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Financial authorities are adjusting the discount rate applied when evaluating insurance liabilities. As the discount rate decreases, insurance liabilities are expected to increase, impacting profits and capital.

According to the industry on the 3rd, the Financial Supervisory Service (FSS) disclosed at the end of last month the "2024 Insurance Liability Discount Factor Application Standards and the Gradual Application Plan for Discount Rates until 2027," which contains these details.

The plan mainly addresses ▲final observation maturity ▲long-term forward rate ▲liquidity premium. The final observation maturity in Korean won terms will change from 20 years to 30 years starting in 2025. The final observation maturity refers to the longest issuance maturity among market interest rates that meet the DLT evaluation criteria.

The adjustment limit for the long-term forward rate will also be raised from 0.15 percentage points to 0.25 percentage points starting next year. The long-term forward rate for next year is set at 4.55%, a decrease of 25 basis points (bp; 1bp = 0.01%) compared to this year. The long-term forward rate is the forward rate applied to the period after the final observation maturity. The FSS expects the long-term forward rate to be adjusted by 25bp annually for the next 3 to 4 years.

The implementation of the improvement plan for credit risk spread in calculating the liquidity premium has been postponed to 2027. From 2027, external factors such as credit crunches will be excluded from the individual bond liquidity premium when calculating the credit risk spread.

Currently, the insurance liability discount rate curve uses the market-observed government bond rates up to 20 years, converging to the long-term forward rate up to 60 years, and is calculated by adding a liquidity premium to the risk-free rate. With the phased application of the improvement plan, the discount rate for the 20 to 30-year segment is expected to decline first. Subsequently, as the adjustment range for the long-term forward rate expands, the discount rate for the 30 to 60-year segment is also expected to fall. Additionally, as the liquidity premium shrinks, the discount rate is anticipated to decrease across all periods.

A decrease in the insurance liability discount rate ultimately means an increase in insurance liabilities. In terms of capital, the net financial income of insurance contract assets, a sub-item of other comprehensive income, will decrease, leading to a reduction in capital.

Changes in capital due to market interest rate fluctuations offset each other between asset and liability changes, but a decrease in the liability discount rate reflects only an increase in liabilities without changes in assets. Therefore, the impact on capital is expected to be significant.

Seunggeon Kang, a researcher at KB Securities, explained, "Considering that the implementation is phased and that available capital increases and total risk amount decreases as existing contracts mature, the impact of the new solvency regime (K-ICS) can be mitigated. During this period, insurance companies will continue efforts to defend K-ICS by increasing available capital through selling new contracts."

Europe, which first introduced a market value-based solvency regime, has also seen a decline in long-term forward rates. In Korea, the rate has been lowered by 15bp increments from around 5.2% in 2022. The reduction of the long-term forward rate itself is considered an expected step.

However, the supervisory authority has increased the pace of discount rate reduction to 25bp. Therefore, the absolute level and management capability of K-ICS are expected to become more important. Researcher Kang predicted, "Life insurers, which have a relatively large proportion of premium reserves, will be more significantly affected."