European insurance companies, under pressure from shrinking margins in their core underwriting business, are increasingly looking for ways to improve their investment returns.
In the face of persistently low interest rates in their traditional fixed income assets, for many it means diversifying into more complex securities they might not have considered just a few years ago.
Chris Price, insurance solutions strategist at AXA Investment Managers (AXA IM), says that most insurers’ still identify low interest rates as their biggest challenge.
“AXA IM’s recent interactions with European insurers on asset management strategies indicate that while regulation and governance are a concern, low interest rates still top the list of challenges,” he reckons.
“Before the financial crisis, investment returns were providing something like 40% of the entire profit of non-life insurers’ business. Now, with those returns practically disappearing, there’s huge pressure on underwriting, which itself is suffering from low premium rates.”
Price worked in the insurance industry for over 20 years before going into asset management. At AXA IM he works in an advisory role helping clients build an investment strategy that meets their individual objectives. That includes examining constraints such as Solvency II, accounting, cash flow requirements and internal risk budgets.
He says that in the past, insurers, especially smaller and medium sized ones, were reluctant to invest in what they considered more complex asset classes: “An insurance company chief investment officer once told me that when he was hired he was given two golden rules by the CEO: one, don’t lose money; two, don’t forget the first rule.”
But times are changing and the largest insurers especially are taking a more sophisticated approach, looking into more complex asset classes. The trend is filtering through the market and today even small to medium sized insurers, often working with asset management partners who can provide complex analysis, modelling and reporting solutions, are starting to consider such strategies.
This change has come about largely because returns have been so low for so long, Price explains: “Insurers who in the past were unwilling to invest the time in researching alternative assets or derivatives for hedging, for example, are resourcing their CIO teams to better understand some of the more complex investments. They know they have to respond to the economic pressures placed on them and the need to make a decent return on their investments,” he says.
Credit where it’s due
Price says that insurers are surprisingly diverse when it comes to asset allocation preferences already – but most are being driven to evaluate an even wider range of asset classes with illiquid credit asset classes an area of focus.
For life insurance companies, long duration assets like commercial real estate loans and infrastructure are growing more attractive, for example, as they can better match the term of their insurance liabilities.
For non-life companies, private lending across a wide spectrum, including large and medium cap companies, is gaining momentum. Insurers are also beginning to consider investing in high yielding SME loan assets where they have access to the origination and credit analysis expertise. “In terms of diversification, credit risk from private lending gives insurers access to fixed income returns from a broader range of companies than are represented in the traditional corporate bond market,” Price points out.
CIOs, where their companies use the standard model for Solvency II, are still resistant to investing in collateralised loan obligations (CLOs) as they attract high capital charges. However, internal model users are finding CLOs attractive where more reasonable capital charges may be available. Additionally there is a much better understanding of the loan market today than existed prior to the financial crisis. The ability to distinguish between sound credit risk and poor credit risk, as exhibited by the sub-prime mortgage market, is much more highly developed. Price stresses.
“The creditworthiness of CLOs has been strong historically even through the global financial crisis, and default rates remain at very manageable levels,” he says. The loans are secured and accordingly recovery rates are high when problems arise.”
One of the main attractions of the credit risk marketplace is also one of its challenges: not all investors can easily take advantage of the relatively good returns on offer because of the expertise needed to originate the deals.
Deal origination is challenging and deep relationships with banks and private equity partners are important. “Good credit analysis capability is also key. Bringing these capabilities in-house for an individual insurer can be expensive which makes partnering with an experienced asset manager often more attractive,” Price says.
Insurance investors also need to be aware that these assets really are illiquid and that they tend to be floating rate, which adds a little uncertainty to the liability matching process - although in a rising interest rate environment floating rate returns might not be such a bad thing, Price adds.
A further point to bear in mind with credit risk is that it is advisable to diversify investments within the asset class and to have a good range of loans within the portfolio. To obtain that diversification requires a reasonable size allocation, although fund solutions are also available.
Looking at other asset classes further up the risk spectrum, equities have generated attention from insurance CIOs. “Equity markets have enjoyed a good run since 2009 and it’s possible that the US election result will push equity markets on for a little longer,” Price says.
A potential problem associated with equities is the punitive capital charge imposed by Solvency II, compared with other assets. “As a result some insurers are seeking ways to access equity risk without incurring the high equity capital charge, by structuring transactions to protect the downside,” Price notes. “Another equity risk option is investing in convertible bonds, where a component of the risk being taken is ‘equity like’ but without the capital charge.”
Continuing evolution – and uncertainty
The UK’s Brexit decision added a new layer of uncertainty for insurance CIOs reviewing their investment strategy, as did the election of Donald Trump in the US. It means that investors now have to consider political risk and its potential effects on financial markets more than ever.
While insurers do have concerns about the complexity of alternative asset classes, their desire to add to both return and diversification is driving them to look further afield. “From both a solvency capital point of view and an economic risk perspective there are many benefits to taking a broader view of what is available in the investment space,” Price said. “So they are more open than ever to conversations about new asset classes.”
Prior to the Brexit vote there was considerable attention focused on UK commercial real estate. Interest in this market has been more modest since, with the fear that overseas investors in UK property might withdraw. Continental European and US real estate markets are still receiving the attention of UK insurers however.
“More generally, following the Brexit referendum, is the willingness for insurers to invest outside the currency of their liabilities and hedge back where they see opportunities for greater return or diversification in other markets,” Price says.
“Insurers haven’t talked about inflation for a while because it has been stable and low. But now it has re-emerged as a topic. The question is will the spike wash through in 12 months or will it become more embedded? The jury is out,” Price says.
In Europe, depending on how the Brexit negotiations progress, the UK’s decision to leave the EU could have an effect on solvency regulation. “Will regulations in the UK remain aligned with EU? Again, there’s uncertainty over how the UK will react and the possibility that regulation in the UK could become either more or less onerous as UK regulators gain more freedom following the UK’s withdrawal from the EU,” Price says. “The planned review of Solvency 2