Negative spreads are likely to worsen among Taiwan's life insurance companies, forcing them to either invest more aggressively or curtail business activity, according to a new comment by Fitch.

Most insurers in Taiwan continue to suffer from legacy business, when they wrote policies with guaranteed returns based on high interest rates during the 1990s. As a group they are weakly capitalised, in part because historically they have failed to earn decent investment returns.

This has led them to invest abroad. The likes of Cathay Life and China Life invest 35% of assets overseas, and Shinkong Life and Hontai Life invest over 30% offshore. Although market turmoil hasn't led to substantial falls in AUM (thanks to their international exposures being mainly to the most liquid sectors of US fixed income), it has created currency volatility that has made hedging costs soar.

The need to earn big returns has also prompted insurers to invest heavily in domestic equities, which fared badly in 2008; while a few, such as Shinkong, lost money on structured products. Even if AUM levels remain intact, their capital strength has been weakened. Fitch calculates aggregate shareholders' equity had decreased to NT$230 billion ($7 billion) at the end of April 2009, from NT$433 billion ($13 billion) at the end of 2007, and now represents only 2.6% of total assets.

The new low-interest-rate environment, however, will make it more difficult to earn returns from bonds, at home or abroad. Weak capital positions put Taiwan's insurance companies at greater risk from equity and FX volatility. Although some firms have realised capital gains from selling government bonds, this results in lower running yields on their existing portfolios. The upshot: negative spreads will return or will widen, undermining the sector's profitability.

Fitch says most of these companies need to earn a return on investment of 4% per annum in order to maintain profitability and capital levels, but given low interest rates, this seems difficult to achieve (the 10-year government bond in Taiwan yields only 1.6%, and one-year deposit rates are below 1%).

Prolonged low interest rates are bad news for insurers, and their shareholders; Fitch calculates that a 25 basis point fall in assumed investment returns can reduce Taiwanese insurers' embedded value from 15% to 43% (and a rise in investment returns would have a positive effect of similar magnitude).

Those companies aggressively pursuing new business have had to allocate more of their capital to low-yield cash and bank deposits, in order to service their liabilities, which only makes their negative spread worse. Fitch says that if Taipei's regulators allow this to continue, it could threaten the industry.

Finally, the past few months have seen several foreigners sell their Taiwanese insurance businesses, including ING (to Fubon Financial Holding), Prudential (to China Life), and Aegon (announced to go to Zhongwei). Fitch says such acquisitions will only further stress weak capital bases and enhance systemic risk (with fewer providers left), and could require parent companies to subsidise their insurance arms' capital requirements.