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:
- Lower liquidity but appreciably higher yields than core European government bonds
- Good technical and fundamental reasons to invest with the possibility of catching “rising stars”
- Capital treatment under Solvency II is expected to be reasonable (for example, structured credit and securitisations are excluded due to onerous expected capital charges)
- Investment strategies that have been executed by insurers in a variety of markets, but are not yet universally accepted.
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.
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:
- The LIBOR floor provides insurers with some protection in very low interest rate scenarios such as those envisaged under Solvency II stress tests.
- The issuers’ option to refinance means that the opportunity for profit is capped due to spread narrowing if the loan is trading at or close to par.
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.
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.
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.
- The number and nature of infrastructure projects will not increase sufficiently in the short- to medium-term to accommodate the rising demand from insurance companies. Long-term trends are difficult to predict as a meaningful increase in the supply of investible infrastructure projects will require thoughtful government-led changes to national economies.
- Infrastructure lending requires flexibility post-deal inception (e.g., early repayment and/or reacting to the need to change terms as the project evolves). Insurers with longer-term, stable liabilities seek to strip away borrower optionality to meet matching adjustment requirements and/or wish to treat the debt as hold-to-maturity from an accounting perspective.
- Banks are unlikely to surrender their existing commercial position. While they face clear funding and capital challenges, banks enjoy considerable competitive advantages – such as a broader product suite, a tradition of accommodating some borrower flexibility and the ability to cross subsidize – over newer entrants, including insurance companies.
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.