15 min read 28 Jun 22
Insurance investment portfolios comprised largely of fixed-rate government and corporate bonds have come up against several headwinds over the past few years.
Operating in an environment of ultra-low yields had been the norm for some time, with yields on short-dated government bonds and traditional investment grade (IG) credit largely anchored by central banks’ ‘lower-for-longer’ interest rates guidance. Now that inflation is hitting in a real way, policymakers are taking decisive action to bring inflation under control by rising short-term interest rates and winding back pandemic-era stimulus. This has led to widening credit spreads and market dispersion, as investors assess how corporate issuers are positioned to withstand inflationary pressures and a higher cost of capital, particularly in a scenario in which demand could soften.
For insurers, the current market environment reinforces the importance of active management of investment portfolios and allocations in helping to manage risks and identify high quality opportunities through the credit cycle. Having the flexibility to dial up and down exposures can be hugely helpful during times of higher uncertainty and avoids becoming a forced seller of assets, allowing investors to focus on optimising portfolios amid shifting markets and macro conditions.
Insurers are recognising the benefits of investing in private and illiquid markets which typically offer higher returns and good return on capital (RoC). Private credit can also help to mitigate against downside risk, as private lenders often have the capacity to structure the assets with features designed to protect investors during tougher economic periods. The ability to incorporate tightly-set covenants into the documentation, is also a distinct advantage of private credit relative to traditional fixed income, and could help to retain value in an investment in the unexpected event of default.
There is a fundamental shift underway. Globally, insurers are expected to double their private market allocations in the space of two years, with allocations increasing to 14% of overall portfolios by next year1. In absolute terms, we estimate that this could equate to potential investment over the medium term of c.€850 billion to €1 trillion from European insurers alone.
It is not only the pace at which insurers are looking to allocate capital to private assets that is encouraging. Some insurers are looking at their private asset allocations in a different light, and see them taking more of a ‘core’ role than ever before.
For several years, Dutch insurers have incorporated certain private credit assets into their core investment portfolios, as they have sought to improve the risk/return profile of their investments, beyond what they can get from their traditional core holdings. Dutch insurers have a significant allocation to ‘mortgages and loans’2, which can represent 25% or more of their investment portfolios in some cases. Over the years, these investors have shifted towards these higher-yielding assets, with the low capital charges on offer proving attractive while default rates on mortgages (residential and commercial) have remained historically low.
More insurers are expected to follow suit and utilise private credit in this way. The latest market estimates suggest 93% of global insurers are aiming to reallocate part of their core fixed income portfolio, typically between 10% to 20%, to alternative strategies exhibiting ‘core-like’ characteristics, of which half is predicted to go into illiquid credit; with multi-asset and multi-credit solutions set to make up a good proportion of the reallocation as well.
When looking at core portfolio allocations, we believe it is important to select asset classes that are a naturally good fit for insurance balance sheets and with respect to key insurance metrics. For instance, private credit that is investment grade (or equivalent) is well-suited to an insurer’s balance sheet – assets typically come with embedded security and sufficient risk diversification potential – and can be seamlessly integrated into core portfolios, while offering yield enhancement and potentially suitable long duration.
Many private asset classes exhibiting ‘core-like’ characteristics could also offer capital efficiency under the Solvency II standard formula – potentially helping to improve SCR and RoC metrics for insurers. Residential mortgages receive favourable capital treatment as these assets fall into the counterparty default risk module and not the market risk module, giving investors additional diversification benefits to their SCR. Qualifying infrastructure debt could also result in a reduction in the capital charge. For insurers under the internal model approach, managers that can provide a robust ‘internal’ ratings methodology can also add a lot of value.
Over the past few years, we have been working with insurers on the ways in which they can optimise their ‘core’ portfolio from adopting a more active management role to effectively adding private assets. Two particular assets that have been gaining appeal with insurers are residential mortgages and senior (commercial) real estate debt and these are discussed in detail in the next section. By investing in these assets, insurers are able to access opportunities that have the potential to generate income-driven returns, together with helping to optimise capital efficiency and diversification of risk within the core fixed income portfolio.
Directly investing in diversified pools of residential mortgage whole loans could offer myriad of potential portfolio benefits for institutional investors, including higher risk-adjusted returns versus corporate bonds as well as strong diversification potential.
Investing in a dedicated UK or pan-European mortgage income strategy with an asset manager that is acquiring performing residential mortgage portfolios across different geographies could offer potential for investors to gain diversified exposure to the asset class.
Managers that have the ability to source exposure in several ways, including acquiring existing loan portfolios from banks and entering into forward-flow arrangements with bank and non-bank originators to originate new loans, can help to achieve value and enhance sponsor/originator, country and asset type diversification within investment portfolios. Forward-flow agreements can be structured according to specific criteria and pre-defined characteristics. It’s worth adding that the asset class has great liability-matching properties as you can originate mortgages with amortising cashflows at different tenors to match your liabilities' duration.
Risk and return profile: Residential mortgages can provide strong risk diversification potential. Most European insurers have significant exposure to corporate risk via their corporate credit and equity portfolios, but typically have little direct exposure to high-quality consumer assets, like residential mortgages, in their existing portfolios – with the exception of Dutch insurers, who have been investing directly in (Dutch) mortgages for a number of years. Being ‘bank loans’ in nature, residential mortgage spreads are not driven by financial market dynamics, helping to insulate spreads from the day-to-day fluctuations in financial markets.
The rigorous lending practices and prudent underwriting assumptions employed by lenders across Europe go some way to explain the low level of defaults and historical loss experience of residential mortgages, with loss rates for UK and Dutch prime mortgages averaging an equivalent corporate loss rate of between AA and A-rated corporates over the past 15 years – while offering much higher returns for the risk.
Income driven returns with low effective duration: Residential mortgage portfolios can typically be sourced at higher yields than IG corporate bonds, despite a similar credit risk profile. As these are whole loan portfolio purchases, returns are driven by the interest payments on the underlying loans, so investors have the potential to receive regular, stable income streams as borrowers pay down their mortgages over time.
Security: Residential mortgages are long-term secured forms of financing secured against residential properties. European mortgages markets are quite different from US ones. In Europe, origination is bank-led whereas the US is more of a ‘market-based’ system with a greater share of non-bank originators and servicers. So banks in Europe lend to retain and have a vested interest in how loans perform over the long term. Also, European mortgages have recourse to borrowers unlike in the US.
Data-rich asset class: Data forms a key component of the investment process which enables very detailed risk-modelling and scenario analysis. We receive extensive, granular historical data on pre-originated back-books of loans, market data and data on consumer behaviours, to assess prior performance, including prepayment, default and recovery/loss rates. We run extensive stress scenarios on large volumes of raw loan data, which can extend into hundreds of millions of individual data points, to model the resilience of these assets under various ‘stressed’ scenarios. Direct residential mortgages are a very high quality investment, which have the potential to deliver positive returns even under the most severe, ‘AAA’ stress scenarios.
These high quality assets are a very good match for insurance balance sheets for several key, and unique, reasons. Adding residential mortgages to an investment portfolio can be a valuable diversifier, not just from a risk perspective but also from an SCR calculation perspective. The capital treatment of an investment in a portfolio of residential mortgage whole loans is particularly favourable for insurance companies relative to traditional fixed income investments of equivalent risk. Unlike almost all other investments, residential mortgages fall into the counterparty default risk module as opposed to the market risk module, giving investors additional diversification benefits to their SCR. Under the standard formula, SCR for mortgages is a function of the mortgage’s loan-to-value (LTV) ratio rather than duration and credit rating, as is the case for rated corporate bonds.
Calculating for mortgages with an LTV of 60% or below, the capital charge under the Solvency II standard formula is zero, and approaches 6% (assuming no diversification) for mortgages with an LTV of 100%. Although, in reality, mortgages are rarely originated at 100% LTVs, so it is sensible to assume the undiversified SCR for mortgage holdings is in the region of c.3-4%. The analysis in the following table analysis shows that allocating from corporate bonds to residential mortgages can help insurers effectively lower the overall SCR and increase the RoC, respectively – while maintaining credit quality.
Commercial real estate debt has attracted growing interest from income-seeking investors, including insurance companies, targeting higher risk-adjusted yields relative to equivalent-rated fixed income investments. Senior real estate debt is of most interest to insurance clients; which exhibits ‘core like’ characteristics and possesses many structural features that are highly suitable for insurer balance sheets.
Those operating under the standard model approach often invest in the asset class via a fund, while those operating under an internal model approach tend to invest on a loan-by-loan basis. An investment approach that offers whole loan financing solutions to borrowers could potentially offer value to borrowers and investors alike, with separate debt tranches, senior and junior/mezzanine, retained by different pools of investors.
Risk-return profile: Commercial real estate debt also provides risk diversification potential to core fixed income portfolios exposed primarily to corporate risk. Defaults generally remain low in the real estate finance market, with the weighted average default rate in the UK decreasing to 2.9%, as a percentage of book value.
In terms of loan quality, senior debt financings tend to have moderate LTV ratios – in the range of 40-60% LTV (UK average LTV across sectors: 55-58%) – which is significantly lower than pre-GFC, with UK senior prime LTVs more commonly underwritten at 80% LTV. Therefore, equity sponsorship in deals tends to be relatively high, offering a sizeable buffer for lenders.
Potential for attractive relative returns: Real estate debt investments typically offer attractive returns relative to equivalent-rated corporate bonds. Senior CRE lending margins have largely held up across sectors, and there appears to be sufficient headroom in terms of available premium over equivalent-rated corporate bonds even as public market spreads widen. Senior debt also has the potential to deliver stable cashflows suitable for institutional investors who are seeking high quality and predictable income streams.
Security: Senior-ranking commercial mortgages are secured against hard asset collateral, ie. commercial buildings, which acts as specific, ring-fenced collateral for the loan. Lenders can enforce their security over underlying properties and liquidate the property collateral to recover their loan – with the security from real assets delivering strong recoveries where defaults do happen.
Downside risk mitigation: Directly originating loans provides opportunity to negotiate covenant measures with respective counterparties and tailor structures and documentation accordingly. Contractual covenants can act as early warning signs of credit deterioration. Tightly-set covenant protections can enable senior lenders to engage with the equity sponsor/holder to take early action. Financial metrics are regularly tested for compliance, typically by annual revaluations of the underlying assets and quarterly cashflow statements, and are monitored throughout the lending term.
As real estate debt assets are private assets, they often do not have public ratings and are therefore classified as ‘unrated’, which gives them a spread charge of ‘BBB’ under the standardised formula. The average term of the loans is between three and seven years (average tenor: five years), giving them an effective spread charge of 15%. The analysis in the following table analysis shows that by allocating from corporate bonds to senior real estate debt can help insurers effectively lower the overall SCR and increase the RoC, respectively – while maintaining credit quality.
Changing market and macroeconomic conditions have inherently created challenges for fixed income portfolios to deliver stable and resilient investment returns for investors. Competitiveness within the insurance market is also forcing insurers to do more with their core portfolio and increase their allocations to private assets, which typically offer additional yield for equivalent credit risk.
The direction of travel looks clear as more insurers revisit their existing core fixed income allocations in the current climate and assess whether investment portfolios are set up to deliver on their long-term investment targets and help them balance a range of unique requirements along the way.
We believe that by changing the way they think about the role of private assets in their strategic asset allocation (SAA) and treating private assets as a way to diversify, insurance investors can fully optimise their core fixed income portfolio. Investing in suitable IG-equivalent private credit assets, like residential mortgages and senior commercial real estate debt, insurers could potentially benefit from lower volatility in risk-adjusted spreads compared to corporate bonds, and take advantage of the favourable capital treatment under Solvency II.
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.