Historically low interest rates will likely persist for some time, given ongoing stimulative central bank policy. This creates an enormous challenge for investors, and one that is particularly pronounced for insurance companies. The bulk of insurers’ assets are in fixed income, and depressed yields continue to chip away at book yield and its ability to help drive operating income. This reality, coupled with challenging underwriting results, signals that insurers more than ever need to find new sources of income and return to support growth, offer competitive products, and improve overall profitability.
To address the yield challenge that is almost certain to continue in 2021, successful investment strategies for insurers must deliver returns while addressing a range of regulatory, accounting, rating agency, and tax constraints. With the fierce competition in the industry and the goal of delivering better results for shareholders (or policyholders for mutual insurers), insurers are not only pursuing a broader array of return streams, but also placing much greater emphasis on the impact of investments on capital and balance sheet management.
As with so many other investors, insurers have sought out new sources of income or looked for ways to better optimize their surplus portfolios. Our observation is that while overall risk hasn’t increased significantly, insurers have been changing the composition of the risk they take on. Three types of risk have emerged as common themes:
Private market/illiquidity risk. Private markets continue to offer insurers the ability to capture an illiquidity premium. Many insurers have determined that they’re awash in liquidity through significant exposure to core fixed income, combined with their access to cheap funding sources, such as the Federal Home Loan Bank (FHLB) programs. Some insurers also have longer-dated liabilities that are more predictable and that make them natural providers of patient long-term capital. Notable areas of focus for insurers are corporate direct lending, real estate, private equity, and infrastructure. There are also more specialized strategies, such as litigation finance, esoteric asset-backed securities (ABS), and distressed debt. Private markets are not only receiving greater allocations, but insurers have also made significant strides in this area with identifying vehicles and structures that better fit their balance sheets.
Geographical risk. Emerging market (EM) debt denominated in US dollars is another area where we expect to see growth in insurance portfolios. EM economies in Asia appear to be recovering from the Covid-19 pandemic more quickly than the US and Europe, providing support for corporate issues as well as sovereign debt. Moreover, without the volatility and exchange-rate risks accompanying debt denominated in local currencies, hard-currency EM debt is likely to offer yields that are attractive both on a risk-adjusted basis and also, importantly, on a capital-adjusted basis. Insurers are able to add meaningful spread for similar rating profiles relative to US fixed income, and without taking on additional interest rate risk.
Complexity risk. Insurer holdings of more complex structured securities, such as collateralized loan obligations (CLOs), have grown significantly over the past few years. And while we don’t expect growth to continue at the same clip, we believe insurer appetite will remain robust. This is one area where we’ve seen innovation on the design of structures tailored to insurance balance sheets. Some of these structures (e.g., combo notes) are receiving greater attention from insurance regulators and could be subject to changes in statutory treatment. That said, the National Association of Insurance Commissioners (NAIC) recently published an analysis of the insurance industry’s exposure to CLOs, and concluded it does not present a risk to the industry as a whole.
It’s critical to assess how developments on the regulatory front could affect insurers’ investment strategies. The NAIC, for instance, has several working groups reviewing issue papers and is drafting new language regarding loan-backed and structured securities, as well as bespoke securities, which may include some private letter-rated debt. Under consideration are changes that may affect a security’s eligibility for filing exemption designation, the role and usage of nationally recognized statistical rating organizations (NRSROs), particularly for private letter ratings, and overall statutory capital charges for investments.
Given the broad scope, importance, and complexity of these regulatory issues, we expect that, if approved, many of these changes would take time to be adopted and implemented. US life and property & casualty insurers had over $170 billion of exposure across thousands of securities that carry private letter ratings at year-end 2019.
Looking ahead to 2021, market conditions signal that insurers should continue their diligent expansion into new and diversifying sources of income and return. Equally important is that they pursue these strategies in suitable structures and vehicles that best fit their general accounts. Finding the right strategies, structures, and investment partners will be essential to competing in a particularly challenging market and industry.
For more PineBridge views on what to expect across economies and asset classes in 2021, visit our 2021 Outlook page.
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As of 31 March 2020
Global
