(Updates with quotes, detail from report and background)
BERLIN, June 27 (Reuters) - Low interest rates pose the biggest threat to Germany's financial system, encouraging greater risk exposure by investors and threatening the health of the nation's insurance sector, a government report said on Tuesday.
The annual study by a committee for financial stability in Germany predicted that rates would remain low for some time to come and warned that cheap financing can create incentives for banks to finance projects that maybe riskier than they would otherwise like in an attempt to seek higher returns.
The committee, comprising members of the finance ministry, Bundesbank and financial regulators, said the proportion of long-term capital investments financed at low interest rates is growing, increasing cost risks if rates rise sharply.
"There is also the danger that market participants systematically underestimate and are in a state of false security with too positive expectations about future political and macroeconomic developments," they said in the report.
"In the event of unfavourable developments, it could lead to abrupt corrections."
Policymakers have cut interest rates to help Europe to weather the financial crisis that hit Greece, Spain and Portugal particularly hard.
As the crisis deepened five years ago, European Central Bank president Mario Draghi declared that the ECB was "ready to do whatever it takes to preserve the euro". A succession of cuts in interest rates to zero followed, and they remain there despite signs that the German economy is gathering pace.
Expectations among economists, analysts and corporate executives are for interest rates to remain at historic lows for the foreseeable future. Felix Hufeld, head of the German financial regulator BaFin and a member of the committee, emphasised that it was important to prepare in advance for crises.
"It would be grossly irresponsible to only begin to build a fire engine when the house is already burning," he said. "It should be standing ready in the garage."
In the run-up to the financial crisis, many German life insurers sold savings policies with guaranteed interest rates as high as 4 percent and are now finding it increasingly tough in the current low-rate environment to achieve the returns needed to pay policyholders.
"There is a risk that the income generated will no longer be sufficient to meet the long-term commitments," the report said of the insurers. (Reporting by Klaus Lauer; Writing by Madeline Chambers and Tom Sims; Editing by Paul Carrel and David Goodman)