Writing from an equity research perspective, John Hocking outlines an approach to re-risking that could benefit insurers both with Solvency II and in the eyes of rating agencies
The European insurance sector is one of the biggest participants in European capital markets and derives a significant share of earnings from investment income. With yields low and credit spreads tight, the industry faces unprecedented pressure. If insurers keep their operating and investment strategies constant, around 40% of sector earnings could be under threat. Taking ‘no’ risk could actually be the bigger risk for insurance companies. So how can improving asset allocation help insurance companies meet investment goals while keeping market risk below historical levels?
Insurers differ from many other market participants in their motivations as investors. Investment income forms a substantial portion of shareholders’ returns for both life and non-life insurance companies, representing over 70% of life insurers’ operating profits and over 60% for non-life insurers. They are liability-driven investors, seeking to generate returns to meet cash-flow commitments to policyholders. So insurers, unlike many other investors, are not typically targeting benchmark-plus returns on assets. Lastly, in addition to looking for risk-adjusted returns, insurers also have to balance many different factors when deciding on an investment strategy – including accounting metrics, Solvency I and II, rating agencies and economic considerations.
Conventional wisdom – and indeed investor pressure – has led European insurers to seek to minimise investment risk in recent years. This philosophy has its roots both in the aftermath of the early 2000s equity market declines and the significant subsequent losses for the sector, and in its material exposure to securitised credit, corporate credit and peripheral sovereigns during the more recent financial crisis.
The current low-yield environment, therefore, acts as a significant drag on earnings, and is forcing insurers to re-examine their asset allocation decisions. While low bond yields have been an issue for European insurers for some time, the recent tightening of credit spreads is forcing the sector closer to a pivot point regarding investment income.
With falling yields continuing to exert pressure on insurers’ earnings and return on equity, our estimates suggest that if yields and spreads remain at current levels, all else being equal, the sector could lose around 40% of its earnings over the course of the next five years. Using these assumptions, the sector could lose 120bps of investment return, or around 28bps per annum.
Given this scenario, there are three main strategies open to insurers. First, they can hope that long-term bond yields increase structurally over time. However, returns on core sovereigns remain substantially below the levels required by life companies to make adequate returns and consequently would have to rise substantially to protect earnings.
The second strategy is to offset the impact of lower investments by cutting costs, shifting the business mix, re-pricing products and other restructuring initiatives. Lowering costs has limitations and, if too aggressive, it can end up being counter-productive. Also, all of the large companies, and many of the smaller ones, have cost-cutting programmes in place already. So this strategy offers limited scope as well.
The third possibility, which we argue would be most effective, would be to re-risk portfolios. While we do not advocate that insurers should return to high-risk investment strategies, by continuing to limit investment risk so severely, they might passively be taking on significant risk to future earnings (and therefore implicitly with capitalisation). A moderate re-risking that raised returns for a modest additional level of risk could bring potential benefits not just from an economic perspective, but also from a rating agency and Solvency II perspective.
The sector’s current asset allocation appears to be influenced more by regulatory capital considerations than by pure economics. Our analysis shows that ‘smart’ re-risking, or risk optimisation, could raise investment yields of the sector to around 3% from the current 2.2%, which would in turn reduce the proportion of earnings at risk from 40% to 13%. This is based on a proprietary market model developed by Morgan Stanley that incorporates factors such as historical and prospective asset class returns, probability of shortfall and capital considerations.
One way to calculate the optimised asset allocation in the key asset classes, such as equities, real estate and government bonds, is to use an asset liability management model. The basic assumption is that the required return for investment income is 3.25% in life and 1.75% in non-life. To produce these returns, our model suggests that insurers could consider increasing investment allocations to certain asset classes that are currently out of favour – for example, subordinated financial bonds – although that might offer attractive risk-adjusted returns.
Accordingly, the allocation to non-financials fixed income would increase, particularly in high yield. Direct real estate would also have a bigger allocation, while equities would be more or less stable. Within financials, there would be a large rotation from senior to subordinated debt. Senior financials and covered bonds would fall, yet securitised debt would rise marginally. Furthermore, the target allocation implies a minimised exposure to sovereigns, cash and CRE loans.
The extent to which insurers could take a more proactive decision to moderately re-risk asset portfolios depends on their capital position. Those groups that are strongly capitalised could potentially have a material advantage versus peers because they enjoy the luxury of being able to focus on the economics of the situation.
Life and non-life insurers face some different challenges. The majority of life insurers would be constrained by regulatory capital – in particular, expectations of where the future Solvency II framework will end up. The model suggests that those insurers driven purely by assessment of market risk should reduce holdings of government debt (both core and periphery) and seek extra return through direct property, subordinated financials and high-yield debt. Those that are principally driven by the Solvency II framework should consider switching from core into periphery sovereigns, reduce exposure to investment grade and high-yield bonds (ex financials) and increase holdings in property (mainly through CRE loans), subordinated financial debt and equities.
Non-life insurers place most weight on rating agency capital when asset allocating. The S&P capital model, for example, is not particularly supportive of increasing investment risk. However, judging from the calculations of the model, there are some asset classes that could help the non-life names to make a more attractive risk-adjusted returns. Investment grade bonds (ex financials), financial subordinated debt, securitised credit and CRE loans fare well. Conversely, core sovereigns and covered bonds screen less well. For those non-life insurers that have shorter liability durations there is little reason to take additional investment risk, as liquidity requirements generally take priority.
European insurers own an estimated €5.4trn of European assets, excluding unit-linked and third-party holdings. About 80% (€4.2trn) of these assets are held by life insurers and 20% (€1.2trn) by non-life insurers. A one-percentage point shift in asset allocation of non-unit-linked holdings for the sector implies a movement of €54bn of assets, so even small shifts could have a large impact on different asset classes.
Insurers’ share of the large asset classes government and corporate bonds is 20% and 38%, respectively, whereas they only own a very small part of the equities market (around 6%). In particular, the sovereign, corporate fixed income and equities sectors appear large enough for the insurance industry to switch into them without taking an overly large share of total issuance.
The analysis suggests large potential benefits from re-allocation, not just economically, but also from Solvency II and rating agency perspectives for life and non-life insurers. A better allocation with only a marginal increase in market risk could raise investment yields and offset the pressure from low yields and tight credit spreads that characterise the current market environment and threaten sector earnings.
Jon Hocking is head of the European insurance equity research team at Morgan Stanley