9 min read 10 Jan 22
In today’s investment landscape, navigating periods of higher uncertainty and volatility in the public markets has become the norm for many investors as the pandemic rumbles on, and both old and new worries move in and out of focus. Regardless of the prevailing market and macro backdrop, for many investors their long-term investment objectives remain unchanged. We believe there continues to be a number of allocation opportunities spanning the public and private markets that are highly suitable for an insurer’s balance sheet.
The low yield environment is encouraging insurers to cast the net wider, beyond traditional fixed income asset classes and cash holdings, and optimise existing investment portfolios by making assets work harder to deliver against investment targets. Insurance investors are also considering the benefits of putting their capital to work in less liquid markets, like private debt, in the ongoing search for investment returns to meet long-term liabilities and add diversification of risk.
We explore four portfolio allocation themes and strategies that we consider to be particularly pertinent for insurance investors in 2022 and beyond:
Cash, alongside investment grade (IG) credit and government bonds, has always been a staple holding on insurance balance sheets. However, in the 12 years following the onset of the global financial crisis, cash rates have declined by around six percentage points in both Europe and the UK from their pre-crisis highs, with three-month EURIBOR falling to -0.6% p.a. and GBP LIBOR to 0.0% as at the end of 2021.
Cash has long been lauded as a ‘safe asset’, affording the holder flexibility and options as a portfolio asset, particularly when markets become more volatile. In reality, holding cash as uninvested capital on balance sheets today is a loss-making prospect in real terms. In inflationary environments the value of cash will be eroded by inflation over time, earning lower real returns than other assets. Clearly, if the insurance community had a relatively low overall cash exposure then this would not be problematic, however the European Insurance and Occupational Pensions Authority (EIOPA) estimates that around €190 billion of cash and cash-equivalents currently sit on the combined balance sheets of European insurers. A EURIBOR rate of -0.6% implies that around €1 billion of this cash will be lost through negative yields over a 12-month period – unless insurers put cash to work in assets earning positive real returns.
It is our belief that by being more tactical about long-term cash allocations, this cash drag can be mitigated or eliminated altogether, depending on required cash levels of an individual insurer. We have been working with our insurance clients to revisit their cash allocations and identify the ways in which they could deploy some of their allocation into credit asset classes that still exhibit ‘cash like’ characteristics – high grade, liquid, defensive, low duration assets – but, crucially, offer potential positive yields.
Insurance clients looking at their cash allocations have five investment options:
Although each of these cash reallocation opportunities have important considerations attached, in our opinion the biggest risk for return-seeking investors is remaining in cash and not exploring other investment options (even on a tactical basis) that could offer similar advantages to holding cash on the balance sheet. In turn, stepping out of cash would help insurers mitigate the associated cash drag and potentially enhance yields.
Read about each of these reallocation opportunities in more detail in our paper, Cash dethroned: reallocation opportunities for insurers under Solvency II.
Operating in an environment of low yields has been the norm for investors for a number of years. As we’ve mentioned, cash, which is not required for short-term operating needs – while having its virtues – is now nothing more than an expensive comfort blanket and holding onto it incurs an opportunity cost. Yields on short-dated European government bonds are negative across vast swathes of the Continent and IG credit indices have an average ‘BBB’ credit rating, which introduces downgrade risk. Against this backdrop, insurers have looked to broaden their staple diets of traditional IG credit, government bonds and cash holdings, and introduce some more exotic flavours of credit into their portfolios in the search for better returns and diversification of risk.
Optimising the risk and return profile of core fixed income portfolios has been a key topic of conversation, and will continue to be high up on insurers’ priority lists in 2022. By casting a wider net across different areas of the fixed income landscape, for example incorporating certain private debt assets which exhibit similar characteristics to traditional core fixed income asset classes (IG-rated, similar duration et al), insurers can potentially optimise their return on capital (RoC) metrics. If the illiquidity associated with these investments can be afforded then the upside potential can be highly compelling while still maintaining credit quality.
Over the past few years, we have been working with insurers on incorporating senior (commercial) real estate debt and residential mortgages into their core portfolios. Residential mortgage lending has historically been dominated by retail banks. However, multi-year regulatory change in the banking industry has introduced increased capital requirements for some of the lowest risk-weighted loan assets on their balance sheets, including mortgages, and is therefore creating opportunities for institutional investors to partner with banks and non-bank platforms to jointly originate mortgage loans or acquire existing whole loan pools.
From an insurer’s perspective, investing in residential mortgages can be an attractive proposition. These mortgage portfolios can typically be sourced at higher yields than investment grade corporate bonds, despite a similar credit risk profile. Residential mortgages also provide diversification away from corporate default risk, as their risk exposure is to underlying individual consumers rather than to companies. Most insurers have little or no direct exposure to residential mortgage pools, aside from Dutch mortgages. Furthermore, the solvency capital requirement (SCR) under the Solvency II Standard Formula for residential mortgage loan investments sits under the counterparty default risk module, and the associated SCR is calculated based on the mortgage pools’ loan-to-value (LTV) ratio. Under this framework, not only are IG-equivalent mortgages with lower LTVs treated favourably relative to comparable fixed income assets, exposure to these assets could also diversify an investor’s risk profile which as a result could drive an even lower capital charge and a highly attractive RoC. In a similar vein, senior-ranking commercial real estate loans are backed by collateral, which under Solvency II can reduce the associated spread risk SCR, by up to 50%, compared to a similar loan without collateral.
By incorporating asset classes like residential mortgages into core fixed income portfolios, insurers can seek to improve and optimise the capital, risk and return metrics of their investment portfolio.
Finding ways to enhance yield, optimise capital efficiency and diversify risk is not reserved only for the core investment portfolio. Making non-matching or surplus portfolios of assets work harder is often where asset classes offering more compelling risk-adjusted yields can be incorporated.
Appetite for asset classes that are more suitable for allocations comprising the non-core portfolio tends to be driven by both market valuations and market sentiment. The areas where we have seen most interest in from insurance clients are detailed below.
From our experience, there is typically limited appetite from insurance investors to assume unpredictable risks, such as interest rate and currency risk, or where yield generation is largely based on market speculation (and market timing). To help our insurance clients expand their non-core investments and reduce the associated governance requirements, we have been working to incorporate multi-asset credit into their portfolios which is designed to drive both diversification and yield, but without the need for additional risk approvals which can take up time and resources.
In addition, depending on an insurer’s risk appetite incorporating higher-yielding, sub-IG equivalent junior (or mezzanine) commercial real estate loans into their portfolios could help to enhance the return potential.
Faced with unique and diverse challenges, insurance investors have looked to increase their exposure to less liquid markets, such as private debt, over recent years.
Private debt is often well-suited to an insurer’s balance sheet, and we believe the asset class could and should form part of most insurers’ asset allocation regardless of the preferred route to market: accessing via single asset allocations or building flexible, multi asset private debt portfolios. In fact, modest market estimates according to findings from research company Cerulli Associates, suggest that 10% of insurance balance sheets will be allocated to the private markets over the medium term, in terms of assets that is somewhere in the region of €850 billion to €1 trillion.
Private debt offers a broad and diverse opportunity set to gain access to asset classes and asset types which have the potential to deliver enhanced return profiles, including numerous opportunities that could attract a lower SCR and thus increase both the capital efficiency and profitability of an insurance company.
When accessing the private markets, we believe there are several advantages offered by taking an unconstrained, bottom-up approach to asset selection and investing in areas of the market which offer good value. We believe building multi-asset private debt mandates that allow managers to flexibly source assets across the full range of opportunities in a scalable, deployable and optimised manner and manage portfolios with specific insurance-led risk constraints, can allow insurers to harness the full potential of the asset class, now and as it evolves.
Read our latest paper to discover more about the potential benefits of adopting a flexible, multi asset approach to investing in private debt.
In addition to the four portfolio allocation approaches for insurance investors that we have presented herein, we believe increased market uncertainty reinforces the importance of credit diversification and dynamically positioning portfolios for change – whatever shape or form ‘change’ may present itself over investment horizons – while ensuring alignment with long-term investment objectives. Therefore, consistent themes such as portfolio resilience and ESG and sustainability remain hugely important and will continue to have implications for insurance portfolios going forward.
There is a clear regulatory imperative in Europe when it comes to ESG, as officials seek to propel sustainable business, investment and capital markets forward – and provide structure for the investment community through new rules, standards and frameworks. The European Commission has mandated EIOPA for further action on sustainable finance, including drawing up a report by 2023 to review new evidence on potentially environmentally and socially harmful investments of insurers with a view to potential changes to the Solvency II Standard Formula. More broadly, the insurance industry has a major role to play in ensuring climate change mitigation progresses.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.