Macroeconomic fundamentals and latent factor of the EU yield curve

Since the portfolio of the insurers consists largely of bonds, out of which a significant weight consists of Government bonds, insurers are mainly exposed to interest rate risk and sovereign risk. We are motivated to contribute to the debate around the effect of the low yield environment and the effect on the insurers’ portfolio due to their high exposure to government bonds. In this respect, any rise in macroeconomic risk across Europe could lead to a joint hit to insurers. The paper provides a broader look of the impact of the macroeconomic variables on the underlying factors that describe the yield curve and their overall effects to the insurers’ portfolio. We show that the macroeconomic shocks have a different impact on bonds depending on their maturity. The life insurers are more affected by the low interest rate because the duration of long-term liabilities rises more than the one of the short-term assets. Therefore, the sensitivity of the long-term bonds to interest rate change is important for life insurers. We have estimated a structural VECM model to explore the interaction between the macroeconomic variables and the estimated factors of the yield curve. We conclude that 1) any change in the actual inflation can lead to small increases in the level factor, leaving almost unchanged the bond prices 2) the slope factor decreases faster after the monetary policy shocks affecting mostly the short-term bonds 3) a positive shock in monetary policy rate leads to a strong increase of the level factor.