Low interest rates and their effect on investment income is a major challenge facing insurers this year, according to a new report from New York-based PricewaterhouseCoopers L.L.P.

According to the report, “The Insurance Industry in 2012,” lower investment income will require insurers to redouble efforts to trim costs or incur greater risks when underwriting in order to improve financial performance.

In fact, about 75% of insurance industry respondents to PwC's 15th annual Global CEO Survey anticipate at least some further change in the way they manage risk over the next 12 months. Moreover, nearly 40% of insurance CEOs indicated that they are planning to modify their company's capital structure.

“The low interest rate environment is forcing companies to address fundamental strategic issues,” said the report. “If companies assume the current low interest rate environment will be temporary, then a business-as-usual approach may serve them most effectively. If they expect low interest rates to persist indefinitely, then they should consider fundamentally redesigning their product portfolio to reflect new economic realities.”

The report, released March 5, also says economic conditions have stifled merger and acquisition activity.

“Despite high expectations for increased insurance M&A activity in 2011, deals remained relatively flat compared to 2010,” the report states. “Insurance companies continued to search for opportunities to effectively deploy their excess capital in 2011, but, as a result of continued valuation gaps in the market, many of them were unable to find willing sellers from whom to make acquisitions.”

But the economic challenges faced by the insurance industry may well be superseded by the challenges in the regulatory arena, according to the report.

Initiatives such as the European Union’s Solvency II and the National Assn. of Insurance Commissioners’ Solvency Modernization Initiative are tightening supervisory focus around enterprise risk management at insurance companies, the report said.

“ERM and the assessment of solvency are becoming more important to both rating agencies and regulators,” said the report. “Formal assessment of ERM and capital modeling is becoming the norm, and many insurers are starting to invest in developing more formal capabilities. Communicating this to rating agencies is just as important and should be a focus both for insurers developing their ERM and modeling as well as for those with existing capabilities.”