2012-07-23 – Edinburgh
Insurers are planning to increase their exposure to high-risk assets over the next year according to a comprehensive survey of 152 of the world’s largest insurers, with a combined total of almost $4tn of assets under management. A survey conducted by Goldman Sachs in May 2012, shows that underwriters are planning to increase their exposure to high-yield bonds, emerging market debt and private equity over the coming year, whilst reducing their exposure to cash, short-term instruments and European financial credit.
In our previous MDP European Insurance Capital Update report, we forecast that insurers would move from credit and other capital intensive investments towards EEA government bonds which, under the Solvency 2 rules, carry no capital charge. However, the forecast did not assume that the expansive monetary policy or quantitative easing would be extended indefinitely.
Standalone standard formula asset shocks by class
As a result of this expansive monetary policy, the current low yield environment has become the main source of concern for underwriters. Consequently, insurance companies have been forced to search further and wider for increased yields, rebalancing their portfolio towards higher-yielding asset classes given their own liability requirements. For example, the swap spread in the US remains at historically low levels, especially in longer maturities that are traditionally dominated by insurers.
This investment strategy is moving underwriters away from their traditional asset allocation strategies, which in our opinion could have very negative effects.
Firstly, insurers continue to be exposed to ever-increasing credit risk. Hedging this credit risk continues to become ever harder. This is as a result of the ever-increasing counter-party risk and new financial regulations demanding increased capital to be held in respect of selling credit risk protection.
Secondly, the risk characteristics of these products are remarkably different from insurers’ liabilities, making them more difficult to include in Liability Driven Investment (LDI) strategies.
In addition, the shapes of the future cash-flows of these asset classes are more volatile and also difficult to model, which means that successful Asset Liability Management (ALM) strategies will become harder to implement. This will, in turn, increase capital requirements further. Insurers have predominantly not been active investors in the high-yield market segment and might struggle to manage these assets as, unlike sovereign bonds, they are closely correlated to economic events.
Thirdly, European governments and financial institutions might continue to struggle, worsening the current debt-crisis as insurance companies are among the biggest institutional investors in Europe with total holdings of over €7tn.
The strategies of most central banks have been to firstly avoid a major collapse in the financial markets, without much thought of the secondary effects on asset prices. These actions are negatively affecting the over-all efficiency and accurate capital allocation within financial markets. So-called risk-free assets (US Treasuries, UK Gilts, German Bunds) are becoming more and more affected by central bank decisions rather than inflation expectations and risk free returns, thus directly undermining the capital market’s most important basic assumptions.
