Significant changes in recent years have led to what we could call a New Normal in the way European insurance companies manage their investment portfolios. Lessons from the financial crisis have been particularly consequential in reorganizing the investment management functions in the insurance world. Meanwhile, the decline in book reserves (the funds at hand for paying insurance claims) and the preparations for the upcoming Solvency II regulation have expedited the trend toward more transparent asset allocation processes, increased asset-liability management and risk control considerations and historically low levels of equity holdings.
Insurance investors and broader bond market participants are evaluating the implications – for risk management, asset allocation, accounting and regulation – of these dramatic industry shifts.
More Global Investments, Including Emerging Markets
The trend toward increased global exposures is particularly visible in the insurance investment world. Over the last 18 months, the PIMCO insurance team has observed that global credit or emerging market (EM) investments have constituted most of the net new flows at our European insurance clients. Given their generally low initial levels of global exposures, they have room to grow. And in the current low yield environment for core European bonds, going global opens opportunities for long-term value investors seeking diversification and higher potential returns. The upward credit rating migration and the maturing of the local bond markets in countries like Brazil may offer attractive opportunities, particularly when compared to some of the more traditional markets at the periphery of Europe that have suffered from a downward rating migration. Events such as these support the trend for more global and particularly more EM exposure.
More Credit Spread Exposure, Less Equity Exposure
The Solvency II regulatory regime, which will be implemented on January 1, 2013, encourages investments in income-generating instruments like bonds as opposed to more volatile asset classes like equities. Given the steepness of the capital charge curves (the lower the credit rating and the longer the maturity, the higher the capital charge), we believe that insurance companies will tend to focus on increasing credit spread exposures at the front end of yield curves, while duration and convexity management will generally be expressed via higher quality cash bonds (core government, agency or covered bonds, for example) or derivative overlays (swaps, options). In any case, low government yields in Europe combined with the relative decline in government bond credit quality compared with the corporate sector will very likely continue to favor more credit exposures at the global level.
More Income-oriented Investments
The PIMCO insurance team has witnessed a significant increase in Insurance companies’ investments in real estate and infrastructure over the last 18 months and, although not particularly well treated under Solvency II, the income and inflation-hedging attributes of real estate and infrastructure are likely to continue to appeal to insurance companies as substitutes for bonds. According to PIMCO’s macroeconomic analysis, the secular outlook is inflationary, and at current levels of nominal bond yields, real estate, infrastructure and project financing with embedded inflation hedges may be warranted.
Less Differentiation Between Interest Rate and Credit Risk in Europe
Interest rate risk and credit risk used to be clearly distinct. Insurance companies, for example, used to think of their core government and covered bond portfolios as free of credit risk, while credit risk was concentrated in corporate or emerging market bond portfolios. Needless to say, the Euroland sovereign debt crisis as well as concerns about the sustainability of high debt levels in the Western world, including the U.S., have demonstrated that credit risk is everywhere and that government bond yields contain a sovereign credit risk premium that can vary dramatically over time. Hence the need today to closely analyze and monitor credit risk in every part of a bond portfolio: There is no credit-risk-free asset, and robust credit research capabilities have become critical.
It seems remarkable that the Solvency II directive does not foresee any capital charge for European sovereign debt holdings by insurance companies. Currently, there is no differentiation between Greek and German debt quality nor respect for credit ratings that are nonetheless used to calculate other capital charges. The new regulations’ zero credit risk hypothesis for European government bonds is being tested by the markets, making the regulations, which are supposed to promote a more risk-based approach, appear self-contradictory.
More Sector-focused Investment Mandates
Last year’s unexpected appearance of credit risk within supposedly “risk-free” asset classes illustrates a larger theme: the increased desire to limit potential surprises in portfolios relative to the expectations at the time of funding. In 2007 and 2008, many investors were surprised by the potential volatility impact of so-called off-benchmark positions in their portfolios. Some money market funds went down in value due to their ABS (asset-backed security) exposures, and some government bond pooled vehicles and separately managed accounts exhibited high correlation to credit spread volatility.
As a consequence, many insurance CIOs have tended to look for more risk control and transparency, implementing stricter guidelines and tightening investment managers’ discretion to implement off-benchmark strategies. They want their government bond portfolios to avoid significant credit risks and their money market portfolios to limit ABS exposures. Thus, they will likely continue to allocate more of their investments into clearly defined and possibly sector-focused strategies, and less into aggregate, diversified and less transparent strategies.
Increasing Importance of Tactical Asset Allocation
Following the global financial crisis, many investors are allocating less risk budget to off-benchmark strategies within the investment buckets (for example, restricting investments in ABS securities in government bond mandates, and vice versa), but they are more actively managing the tactical asset allocation process among the buckets in their overall portfolio. Being more tactical is key in the current secular environment, in which unexpected events happen more often and swift adjustments in asset allocation are more likely to be warranted. Many large insurance companies outsource asset management, asking managers to focus on mandates in individual sectors, while the sector allocation itself is either handled in-house or outsourced as a tactical asset allocation mandate. Strategic asset allocation typically remains in-house.
Greater Integration of Risk Management
The systemic changes in the economic and regulatory environment have encouraged insurance companies to target tighter risk management across their investment portfolios, with greater transparency and a more efficient allocation between in-house and outsourced investment management functions. To further enhance risk management, many global insurance companies have also accelerated the integration of their cross-border processes, typically with more centralization, coordination and standardization from the head office and less authority given to local operating entities. And to better mirror the trends at our clients, PIMCO too is increasingly organizing the coverage of institutional insurance companies at the global level.
Prepare for Solvency II
Preparation for Solvency II has been and remains a key challenge for insurance companies and their investment managers. While more than 70% of European insurance companies (representing 90% of insurance premiums) have participated in the last Solvency II quantitative impact studies, according to a European Insurance and Occupational Impact Authority report, we would expect the consequences on asset allocation strategies to magnify as we get closer to implementation on January 1, 2013. Our view is that Solvency II, rather than being a revolution, will amplify the trends already in place: improved risk control, crystallization of larger bond exposures and lower equity allocations for life insurance companies and potential for more consolidation in the insurance industry.
Asset managers will need to adapt to Solvency II, particularly with regard to reporting and disclosure policy requirements. Greater coordination within the asset management industry could promote standard practices that best serve clients and simplify managers’ and auditors’ processes.
Accounting Considerations
As book reserves have declined (last year’s investments at low coupons vis-à-vis minimum guaranteed rates on annuity and universal life policies have accelerated the trend) and as Solvency II is forcing insurance companies to increase risk control and transparency, investment management accounting considerations are gaining in importance. This is particularly the case for life insurance companies, which are naturally more liability-driven and income-oriented, and less focused on total return. The reduced flexibility inherent in lower (or sometimes nonexistent) excess capital leads insurance companies to impose more granular restrictions on asset managers, at least in their core portfolios. Accounting considerations are essential for the core part of insurance companies’ balance sheets and, as they outsource larger parts of their core portfolios, asset managers should expect to see non-alpha-related key performance indicators, like the realization of profit and loss targets, to play an increasing role. Alpha is not the only objective in core insurance asset management!
More Outsourcing of Management
The trend toward more outsourcing is global, widespread in the insurance industry and has accelerated in recent years. Insurance companies have tended to separate the investment management (i.e. asset-liability management, strategic asset allocation, risk control, manager selection) and asset management functions (i.e. the actual management of the assets). While they keep the investment management function in-house they are increasingly outsourcing large parts of their asset management. Historically, property/casualty insurance companies outsourced a greater proportion of assets than others in the industry, but as of 2010, life and health insurers (with typically larger amounts at stake) have the most outsourced assets under management, according to Insurance Outsourcing Exchange.
Until the end of the 1990s, most insurance companies managed their general account portfolios entirely in-house, with dedicated investment teams and a very local geographical focus. This was a time when unrealized reserves were generally high and portfolios were more simple and local. But now, in a world of lower rates of return, lower reserves and more complex global investment strategies, insurers are motivated to outsource larger parts of their general account portfolios. Recent crises have shown that managing more global and complex portfolios requires resources and scale that small and even larger insurance companies would find too costly and challenging to develop in-house. Many are turning to asset managers as reliable and critical resources, and investment consultants are playing an increasing role in many insurers’ manager selection processes.
Insurance Investment Implications
The broad trends reshaping the insurance industry will likely result in better risk controls, more liability-driven investments, greater global exposures (particularly with regard to credit spreads, emerging market bonds and equities), a tendency to allocate more risk budget to tactical asset allocation, and less discretion within managed portfolios. As insurance companies outsource larger parts of their core assets, asset managers should consider key performance indicators that are not alpha-related, including accounting considerations.
PIMCO, as a large insurance asset manager, is prepared for the shifts and trends in this new environment and has designed forward-looking solutions to support insurance clients and target their specific objectives.