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Since the height of the global financial crisis in 2008, insurance companies have faced three key challenges: First, insurance companies urgently needed to address new critical risk management issues as banking sector and peripheral sovereign credit risks significantly increased in Europe. Second, the prospects of longer-term low yields forced insurers to identify alternative sources of meaningful yield. And third, insurance companies needed to prepare for pan-European insurance regulation Solvency II. While various left tail risks significantly diminished over the course of 2013, the fragile economic recovery in Europe will likely require central banks to maintain a low rate regime for longer than forward yield curves, as well as many investors, would suggest. Hence, locking in “safe” credit spreads over the medium- to long-term has become a strategic priority for many insurance companies in order to meet and exceed promises to policyholders. Already, insurers operate under a wide range of investment and operational constraints that render decision making on asset allocation increasingly complicated.
One might easily conclude that insurance companies face only competitive disadvantages when it comes to investment decisions. One exception to the rule, however, is insurers’ higher tolerance for illiquid fixed income assets given the long-dated and illiquid nature of their liabilities. Solvency II appears to have accepted these liquidity advantages as regulators prepare to quantify this advantage in capital requirements (i.e., the matching adjustment). The argument is also relevant to property and casualty insurers – even those with short-dated liabilities – which often seek to lock in a portion of their asset returns over the longer term.
In search of meaningful yield With post credit crunch liquidity highly dependent upon central bank activity and bank regulation (see Figure 1), insurers have an opportunity to invest strategically in illiquid or off-the-run investments to potentially capture stable sources of meaningful, incremental yield from a broad range of investment options.
To capture these opportunities, insurance companies should examine their asset allocation strategies in the context of this "New Normal” framework as described in our May 2009 Economic Outlook, “A New Normal”, and employ a forward looking and flexible investment approach. At PIMCO, we have identified four relevant asset classes which illustrate this shift towards a more global and credit diversified, multi-asset class investment approach. They share the following investment characteristics:
Emerging markets debt While the summer sell-off in emerging markets was primarily driven by technicals (i.e., speculation regarding U.S. Federal Reserve tapering) as opposed to fundamentals, it now may be a good entry point into emerging markets debt. The asset class offers attractive valuations and higher yielding opportunities, currently around 6% for an investment grade portfolio (as of 30 September 2013).
Post credit crunch, emerging markets debt has exhibited an upward trending ratings trajectory driven by high growth and low levels of debt (see Figure 2). We believe there is reasonable scope to expect strong returns in this asset class over the longer term. In fact, investing in emerging markets countries may provide investors with exposure to a secularly improving asset class with greater diversification than, for example, peripheral Europe which many would argue is a leveraged play on the eurozone.
Bank loans Prior to the credit crunch, insurers traditionally accessed bank loans via capital markets in the form of Collateralized Loan Obligations (securities that allow banks to reduce regulatory capital requirements by selling portions of their commercial loan portfolios to international markets in a structured format, reducing the risks associated with lending). While these instruments are enjoying some resurgence among U.S. insurance companies, Solvency II appears to severely restrict European insurers.
More acceptable, from a capital perspective, is the purchase of whole loans (e.g., not structured) whose capital treatment is in line with bonds. For insurance companies, the higher yield offered by bank loans provides a strong impetus to invest. Bank loans, typically five to seven years in maturity, usually are the most senior debt in corporates’ capital stock and often enjoy higher recovery rates than unsecured debt. While they provide reasonable spread duration, bank loans offer little interest rate duration due to the LIBOR-linked yields. However, there are some important technical differences to similar yielding instruments for insurers to consider:
Although European bank loan markets are significantly less mature than their U.S. counterpart, we may see increased interest from insurers that have the credit expertise and resources necessary to actively manage corporate loan portfolios.
Financials In the face of regulatory reforms, global financial institutions are deleveraging to comply with widespread regulatory pressure that should lead to fewer bank failures in the future due to stronger capital buffers. Given the current market size and the fact that some types of financials should qualify for matching adjustment under Solvency II, this asset class cannot be ignored by insurance companies.
Option-adjusted spreads for financials within Europe range from 10 basis points (bps) (senior secured credit in core Europe) to 500 bps over peripheral Europe, accommodating a broad range of risk appetites (as of 30 November 2013). Insurance companies that can participate at various levels of the capital structure have a particular advantage, given the rapid evolution of regulation, debt structures and spreads.
Infrastructure debt The long-dated nature of infrastructure debt and the prospect of long-dated, fixed returns free of mark-to-market constraints (as these debt portfolios do not frequently trade) are attractive to life insurers. Add in the potential of a benign capital treatment under Solvency II (i.e., matching adjustment) and one can appreciate why investing in infrastructure debt has become seductive for insurers. Under the European Commission and European Investment Bank’s Europe 2020 Project Bond Initiative, there are currently €2 trillion in public and private infrastructure investments planned across the EU between 2010 and 2020. While the range of projects is diverse, ranging from transport to utilities and renewable energy initiatives, and the market somewhat opaque, BBB-credit rated investments with spreads of 200 bps are achievable today (as of 2 December 2013).
However, current enthusiasm among investors often disregards some significant challenges in infrastructure debt.
Explore the natural advantage In summary, as insurance companies increasingly need to seek out more specialised, higher yielding investments that balance top-down macro views with bottom-up security selection and overlay insurance specific capital and accounting constraints, they need to actively exploit their natural advantages in investing: a long-term horizon with limited liquidity needs.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed. Illiquid securities are securities that cannot be disposed of within the ordinary course of business at approximately the value at which securities have been previously valued. Investments in illiquid securities may reduce the returns of a portfolio because it may be not be able to sell the securities at an advantageous time or price. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Infrastructure entities are involved in the construction, operation, ownership or maintenance of physical structures, networks and other infrastructure assets that provide public services; infrastructure entities, projects and assets may be sensitive to adverse economic, regulatory, political or other developments and may be subject to a variety of events that adversely affect their business or operations. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. The value of most bond strategies and fixed income securities are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and more volatile than securities with shorter durations; bond prices generally fall as interest rates rise.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2015, PIMCO.
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