Insurance investors are facing a number of issues that could well mean a change in investment approach with portfolio adjustments. These include higher treasury yields, so called risk premium compression, and the drive to maximize yield, meaning insurance investors may well benefit from reassessing their portfolio balance.
Christian Thompson, director of insurance solutions at M&G, agrees that now, and over the past 18 months, a re-evaluation of insurance portfolios has been brought to the forefront.
“Tightening spreads in investment grade credit, but higher yields in government bonds, both of which make up the lion’s share of core portfolios, has encouraged insurance companies to re-evaluate their strategic asset allocation under these new market conditions,” Thompson says.
“Ensuring the key components of the core portfolio are t for purpose is, and will continue to be, front and centre of insurers’ thoughts,” he says.
Thompson also notes that incorporating the additional illiquidity and complexity premia that typically come from investing in alternatives has taken a back seat over the past 18 months.
“However the start of 2024 has seen risk-based capital investors like insurers re-prioritise non-core assets with the ambition to add asset diversification and improve portfolio yields – most notably, via senior secured private credit.”
Indeed while cash and short-duration fixed income assets are yielding significantly higher levels of income than they have over the past decade, insurers may benefit from strategies that lock in appropriate yields for longer within the risk tolerance of their primary business.
Key considerations include being mindful of liquidity needs, the duration of an insurance company’s liabilities, its sources of liquidity and the strategic prioritisation of sources when raising capital – much for insurance investors to ponder.
Liability profile
But it could be said that being mindful of liquidity and duration in the context of an insurers specific liability profile has always been critical to insurance asset management.
On this, Thompson adds: “Looking to add diversifying sources of yield from alternative asset classes into the invested portfolio is increasing. This migration comes with risk, and it is more important than ever for insurance companies to partner with managers who are able deliver everything that is required by highly regulated, conservative investors.”
In addition, Thompson says robust internal credit rating methodologies, best in class reporting capabilities, and high-quality underwriting credentials are just a few examples of capabilities that are no longer nice to have, but in fact essential, to ensure the management of alternative assets on behalf of insurers is done at the highest standard.
Moreover, by locking in attractive yields for the long term by using alternatives is good until there is a problem with the underlying asset, Thompson says.
“The key therefore is to make sure to go in eyes wide open with good and demonstrable asset selection and structuring credibility and the ability to work through any potential issues should they arise,” Thompson adds.
“In short, huge variety of great opportunity for insurers to diversify, improve invested portfolio yields and mitigate solvency capital requirement volatility but, proceed with caution,” Thompson says.
Investment strategy
For Chris Howells, head of international insurance solutions at Macquarie Asset Management, looking from an insurance investor perspective and indeed other institutional investors, when considering market-driven investment decisions, it is important to draw a distinction between longer-term strategic investment objectives and shorter-term tactical tilts.
“Tactical asset allocation can, and arguably should, exploit advantageous market conditions through judicious and well- timed tilts to harvest return,” he says. “Insurers will want to ensure they are being compensated for any risk they are taking relative to their longer-term liability management objectives in setting their strategic asset allocation.”
Indeed, when risk premia are compressed, insurers will have to look harder to achieve additional returns, which could mean investing in unfamiliar territory by asset class, geography, or industry. “A retreat to more familiar markets if they can meet in-force, or new business pricing needs, can be tempting,” Howells adds.
Furthermore, Howells says: “If the objective is to build a new or restructure a buy-and-maintain bond portfolio, and sufficient yields to maturity can be achieved without taking on excess credit risk, this could have the additional advantage of being highly capital efficient from a Solvency 2, or other risk- based capital, perspective.”
That said, strategic asset allocation is of course not solely driven by return. There will inevitably be competing requirements to invest according to risk appetite and risk capacity in a manner best suited to the nature of the liabilities and the capital adequacy position, while aiming to maximise the returns.
“This is where consideration of other factors play a part in the asset selection and portfolio construction process, including the nature of the liabilities, risk management through diversication of exposures, and portfolio resilience under stressed market conditions,” Howells says. “Also important to consider maintaining an appropriate level of liquidity – not too much nor too little.”
Yield enhancement
On insurance investor trends, Ken Griffin, head of insurance solutions at Barings, identifies one where life insurers are continuing to move toward less liquid securities: “Which provide the potential for yield enhancement – while simultaneously de-risking from a credit perspective,” he says.
Overall, he notes that life insurers are seeking capital efficiency by allocating toward higher-rated securities, unless spread levels compensate for higher capital and risk.
“2023 saw continued movement toward less liquid securities which provide compensation for insurers that can afford the illiquidity risk, allowing for potential yield enhancement while simultaneously de-risking from a credit perspective,” Griffin says.
There are four key themes that he believes are shaping asset al- locations for life insurers. First is related to the upping in credit quality. Allocations to the highest rated class [A- and higher] have continued higher since 2022 – “When the industry broke a string of five years of declining allocations,” Griffin says.
“In particular, allocations increased by 1.7% from the year prior, to 59.1% of total bonds.” Interestingly, high-yield allocations have also been declining since hitting a peak in 2020, he says.
The second point is a rise in insurers private bond allocations. Allocations to public bonds have continued their long trending descent by dropping 2% year-over-year. While still the predominant asset class for life insurers, their allocations have fallen by 8% over the past five years to 39.3%.
Meanwhile, private bonds continued their trend higher, increasing 1.5% year-over-year to 15.1%. However, non-privates – also confusingly known as true privates – fell for the first time in five years, slipping 0.7% over the past year.
Structured assets
Third, is a shift toward select structured assets. Given the attractive current yields on offer and capital efficiency, residential mortgages – also known as non-securitised whole loan mortgages – logged the biggest yearly gain of all asset classes, Griffin says. Though a seemingly small 0.4% overall allocation increase, it represents a 42% increase within the class.
That is not all, certain structured asset classes also saw an increase in allocation led by collateralized loan obligations (CLOs), asset-backed securities, and non-agency residential mortgage-backed securities.
Fourth, concerns about the commercial real estate market softened the allocation to commercial mortgage-backed securities, Griffin says. CLOs continued their march higher as the fastest growing asset class over the past five years with an allocation of 4.1%, up from 3.8% last year.
Bank loans, which includes portfolio finance, that is net asset value lending, held steady year-over-year after strong growth in the last few years. Public corporate bonds fell by 1.4%, which was by far the biggest reduction of any class.
Fifth is the increase in lower-rated commercial mortgages. “Commercial mortgage allocations had a slight uptick year- over-year,” Griffin says. “Within commercial mortgages, the life industry continued to rapidly reduce exposure to the office sector given concerns about vacancy rates post-Covid.”
One also has to look at the wider context to assess movement within insurance investors trends. Pension funds for example have traditionally been some of the more enthusiastic investors in the private credit space, and within private credit, in corporate direct lending.
In recent years, solvency in defined benefit schemes has improved, allowing more schemes to look to sell off their pension liabilities to insurance companies.
Insurance context
Insurance companies have historically covered these bulk annuity liabilities with low risk, fixed income investments, but in a higher inflation environment, these pension scheme liabilities were typically inflation-linked, they are now seeking higher levels of return than that afforded by many traditional fixed income investments.
“After the rapid interest rate rises of 2022 and the consequential attraction of a oating rate investment, insurers that took on pension liabilities increasingly turned to corporate direct lending, where higher returns could be locked in for longer as part of an investment in a closed-ended fund,” says Howard Sharp, managing director at Alcentra.
Additionally, as defined benefit schemes gave way to defined contribution (DC) schemes, with their generally younger underlying workforces, trustees have looked to offer higher yielding investment opportunities, given the longer period to payout of pensions.
“Insurers who took on liabilities were therefore able to better match these longer-term liabilities with illiquid assets such as direct lending, where the premium to liquid loan markets has traditionally been 200 basis points to 300 basis points,” Sharp says.
Underlying portfolios
Insurers are also attracted by four factors, Sharp says.
One, the lack of mark-to-market in underlying portfolios versus high-yield bonds and liquid loans, two, a quarterly cash yield, that can be reinvested, three, generally greater levels of control exercised by the lender, leading to higher recoveries in case of default, and four, relatively significant fees at the time of loan issuance, passed entirely on to the investor by the lender.
“General partners have been quick to provide the solvency, carbon and other reporting required by insurers, as well as running sustainability-linked funds under Sustainable Finance Disclosure Regulation,” Sharp says.
Overall, in a normalised interest-rate environment, the foregoing elements provide insurers with a viable and increasingly large asset class with which to match their liabilities.
In another development, James Charalambides, partner and head of European private credit at Adams Street Partners, says insurance investors have shown a great deal of interest in private credit. “We see a lot of appetite from insurance companies in private credit. It has been the case for some time,” he says.
“There are a few things that make private credit more appealing. The key components of that are: yields are up and private credit is all floating. So when base rates rise, private credit yields rise an equal amount,” Charalambides adds.
Equity cushion
The second element is that debt multiples, so the amount of leverage on companies in these private credit transactions, have reduced. “Part of that is the function of the higher interest burden companies can afford less debt from a cash service perspective.”
At the same time, there has been some compression in purchase price multiples, but, not that much. “Which means that the equity cushion, that amount of equity versus debt, going into a transaction has increased. And at other times the loan to value (LTV) of the loans is lower,” Charalambides says.
“That means that at the same time as yields have gone up in the private credit space, the LTV and the overall risk have gone down,” Charalambides adds. “This makes it particularly compelling. And when you compare the returns to other liquid forms of credit, private credit outperforms pretty meaningfully, compared to leverage lends, high-yield bonds and investment- grade bonds.”
It does mean that insurance investors are not only just dealing with an investment environment which presents numerous challenges, but more than rising to those challenges.
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