Insurance outlook: Managing change as standard practice

The operating environment continues to evolve rapidly—especially for insurers. Insurers are impacted by economic cycles and fundamentals, but unlike many other sectors, they must also navigate financial market risks and evolving regulatory frameworks. In this environment, agility and disciplined risk management remain central.

Looking back over the past five years, from the pandemic to the present day, it has been a bumpy road for insurers. After a decade of ultra-low interest rates, post-pandemic-driven supply-side disruption, followed by the Russia-Ukraine conflict, led to a sharp rise in inflation, significant monetary tightening, and elevated rate levels and volatility.

However, many of the typical adverse consequences of restrictive financial conditions did not fully materialize, with the US notably demonstrating surprising resilience. The influence of much tighter monetary policy has been offset by stronger-than-anticipated consumption and investment as well as a significant fiscal expansion.

This period presented both challenges and opportunities for insurers. While interest rate volatility remains complex to manage, multi-year-high yields and resilient risk assets have allowed insurers to rebuild book yields – yields locked in at purchase– and help strengthen balance sheets.

Easing back

Inflation and monetary conditions have been progressively easing, although at different paces, across different economies. Weaker macroeconomic conditions in Europe and a faster convergence toward its target inflation rate prompted the European Central Bank to begin normalizing policy rates by mid-2024, with policy rates around 2% by mid-2025. The Organization for Economic Co-operation and Development (OECD) projects Euro Area GDP growth of 1.2% in 2025 and 1.0% in 2026.¹

In the US, conditions differ, with the federal funds rate around 3.75%. Market expectations suggest a potential decline toward ~3.0% in 2026, reflecting both the expected softening of the labor market and GDP growth as well as above-target inflation. Notably, market expectations are still subject to uncertainty over the economic impact of President Donald Trump’s trade tariffs and overall policy, while the OECD is forecasting US GDP growth to fall from 2.8% in 2024 to 1.8% in 2025 and 1.5% in 2026.²

A global easing cycle can challenge insurers (duration and reinvestment risks), though current curve dynamics differ from prior cycles. 

Curve steepening and compressed credit and equity risk premia

Despite softer growth and inflation outlooks, yield curves have steepened across major markets, reflecting political uncertainty and the resurgence of concerns around fiscal expansion, fiscal deficits, and debt sustainability. The US and France illustrate these dynamics, including recent sovereign rating actions.

Curve steepening across major markets

Key: Blue line: euro swaps; green line: US Treasuries; purple line: UK gilts; red line: Japanese government bonds. Source: Barclays Live

Ongoing political instability, combined with expected increases in net issuance next year might reinforce a shift in sovereign risk premia. Other technical factors could also exacerbate curve steepening, such as the Dutch pension system reform, which could reduce long-duration positions among pension funds, potentially contributing to higher long-term rates and volatility.

Steeper curves can benefit long-dated liability profiles, but portfolio and collateral dynamics complicate implementation.

Moving into long-duration bonds too quickly can leave insurers with significant unrealized losses and reduce their ability to manage and rotate portfolios. Insurers with long receiver-swap positions may face higher liquidity needs and reduced eligible collateral.

For life insurers with very long-dated liabilities and a negative duration gap, higher long-term rates may support balance sheets. This could be more pronounced with Solvency II reforms expected in 2027³ (higher sensitivity beyond the Last Liquid Point⁴). On the other hand, widening swap spreads are not completely captured by the volatility adjustment (VA) – a counter-cyclical measure that reduces the impact of changes in credit spreads on insurance liabilities valuations under the standard formula – and, as a result, the actual portfolio can diverge from the regulator’s benchmark.

While sovereigns face pressure, risk premia on risk assets are compressed despite the political uncertainty, concerns around trade war and tariffs, a softening growth outlook, and rising geopolitical risks. High all-in yields across the credit spectrum have supported a strong demand for credit over the last few years. So far, credit fundamentals have proven to be resilient, monetary conditions are easing, and corporate bond issuance is running at elevated levels. Given current valuations and identified risks, vulnerability to shocks persists.

The same applies to equity markets, at least in the US. Optimism surrounding the potential benefits of artificial intelligence (AI) has driven massive capital inflows into a small group of companies that have accounted for the majority of recent market returns. Forward earnings will need to validate elevated expectations around AI to avoid valuation-driven setbacks.

Insurers have some room to maneuver to manage change and uncertainty

Recent history shows insurers need to be ready and equipped to manage ongoing changes and uncertainty. That may sound self-evident, but against this uncertain backdrop, a core principle remains: diversify risk exposures. This principle applies equally to liability duration-matching portfolios; in many European countries, over half the government bonds held by insurers are issued by their own government.⁵ 

Insurers can now find more opportunities to diversify via bonds from European institutions or supranational organizations. They can also aim to mitigate swap-spread risk by combining high-grade bonds with interest-rate derivatives.⁶ Derivatives can potentially provide significant value and flexibility but require a sound collateral management framework. Solvency II reforms are expected to incentivize greater diversification and closer alignment with the VA benchmark⁷. Under the standard formula, bonds, loans, and securitizations are eligible inputs for the VA—derivatives are not. These should also inform the use of interest rate swaps.

The home bias found within risky assets and corporate bonds investments in particular is generally lower than for high-quality fixed income assets. However, the potential for enhanced diversification remains significant. Diversifying into foreign credit markets and across economic areas cancan reduce concentration risk and may broaden relative-value opportunities.

Diversifying away from the domestic market will likely require hedging against unwanted risks. Once again, interest rates and currency derivatives prove useful. They give insurers more flexibility, allowing them to adjust the spread risk exposure to market conditions, as the credit portfolio can be more agnostic about the liability profile.

There are multiple degrees of diversification in fixed income, with the ultimate step being to implement a global multi-sector approach and to exploit the entire risk spectrum across developed, emerging, public, and private markets. For instance, at similar ratings, certain asset-backed securities may offer a meaningful risk-adjusted spread pickup versus corporate bonds. Of course, insurers should consider the return on capital requirements. In this regard, the lower capital charges proposed in the Solvency II reform for securitized products will likely reduce the breakeven.

With multiple risk factors on the horizon, insurers must be agile and consider enhanced risk diversification in their portfolios. As usual, the complexity lies in combining a more active and sophisticated investment management approach with regulatory and accounting constraints.

Insurers who run portfolios valued using the Variable Fee Approach model under the new International Financial Reporting Standards (IFRS) 17 standards should find this new accounting framework provides more flexibility to manage the risk return profile of portfolios more actively.⁸ But more broadly, we believe there is some room to maneuver across portfolios, regardless of the applicable regulatory framework, meaning insurers have scope to adapt and to thrive.