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Europe's insurers stock up on riskier assets to combat low interest rates

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Europe's insurers stock up on riskier assets to combat low interest rates

European insurers are taking more investment risk and seeking new asset classes as they try to squeeze more yield out of their investment portfolios to combat persistently low interest rates.

The shift toward riskier assets has been gradual and cautious and does not represent an existential threat to insurers' stability. But it is taking insurers, which are geared up for taking insurance risk rather than investment risk, out of their comfort zones and forcing them to change their structures.

"A lot of [insurers] have quite a lean structure for the investment team, but they are looking to either add new resources or outsource some responsibilities to external parties," said Andrew Epsom, insurance group principal at consulting firm Mercer. "We do a lot more with insurance companies now than we did 10 years ago, just to help them navigate a lot of those operational and skill challenges associated with moving into these new asset classes."

Insurance companies invest the premiums they collect from policyholders to ensure stable cash flows to pay claims and also to generate additional profit. The core of their portfolios has traditionally been government and highly rated corporate bonds, but returns from these portfolios have suffered because of low interest rates.

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Yields on 10-year U.K. government bonds were 1.50% on Jan. 31, 2018, up from 1.44% a year ago but down on 2.08% five years ago and well short of the 5% area in which they spent most of the decade leading up to the global financial crisis. Yields on 10-year German bunds increased to 0.76% from 0.43% year on year, but are still far below the 1.69% from five years ago.

Rate rises are expected, and an expected tightening of monetary policy has fed market volatility in recent days. Rising bond yields in the U.S. triggered turmoil in equity markets. But rising yields are not expected to help European insurers' returns any time soon.

"An increase in yields is positive, but the levels, at least in Europe, are still historically very low," said Dominic Simpson, senior credit officer in the insurance team at Moody's rating agency, in an interview. "That means that investment yields remain pressured."

The introduction of Europe's Solvency II insurance capital regime, which came into force Jan. 1, 2016, has made life tougher because of the hefty capital charges it imposes on some assets such as equities and hedge funds. One senior asset manager responsible for managing European insurers' investments said: "The confluence of the low-yield environment and the advent of Solvency II made it really difficult for insurance companies to position their balance sheets in order to have the asset side remain a driver of profits or even just break even."

Portfolio shifts

As the hunt for yield intensifies, the investment grade allocation of the top 10 European insurers' total assets has been shrinking, albeit gradually, in favor of non-investment-grade and unrated and other assets, data from S&P Global Market Intelligence shows.

Perhaps more notably, investments have also been shifting toward the lower end of the investment-grade category. BBB-rated assets made up 27.4% of the investment grade portion of the top 10 European insurers' portfolios in 2016, compared with less than 10% in 2009. Over the same time period, AAA-rated assets have fallen to 19% from just under 42%.

Although this is partly to do with the shrinking availability of AAA-rated assets — a reflection of both changes in ratings and overall availability given central bank asset purchases — the trend has also been driven by a quest for better investment returns, according to Andrew Bulley, a partner in consulting firm Deloitte's EMEA center for regulatory strategy.

"It is a mixture of the lower availability of triple-A but also some of the yield imperatives caused by the present interest rate environment," Bulley said in an interview.

Chris Price, head of U.K. insurance solutions at AXA-owned asset manager AXA Investment Managers, added: "We have seen insurers reduce cash holdings to a degree, reduce government bond holdings and probably move down the credit rating spectrum, taking a little bit more risk as they go."

Life insurers in particular have been investing in more illiquid assets, such as infrastructure and commercial property. Because life insurers hold on to such assets until maturity rather than trading them, they are happy to take the liquidity risk and capture the additional yield.

Moody's Simpson said: "We have certainly seen an increase over the last two or three years in illiquid assets or direct investments. Companies are investing more in infrastructure — both equity and debt, private loans and commercial mortgages."

Investing in unlisted assets can boost returns. Said Mercer's Epsom: "If you look at things like private debt and private fixed-income investments, you might get an extra 2% return above a comparable listed fixed-income instrument."

The trick to taking more risk in certain areas is balancing it out in elsewhere in the portfolio, so the company is not taking on much more risk overall, AXA's Price said.

"The key word is diversification," he said. "Insurers have been looking at asset classes they are not invested in and perhaps haven't been invested in in the past so they can take a little more risk in terms of the stand-alone asset classes but claw back some of the capital cost of that through the diversification benefits they might be able to get."

Next steps

With the interest rate environment showing little sign of improving quickly, the question is where insurers can turn next in their quest for yield. One option could be collateralized loan obligations, or CLOs, which are securitized bundles of loans.

Solvency II's standard formula — the one-size-fits-all capital model used by those without customized internal models applies heavy capital charges to structured products in general, including CLOs. But for those insurers that have adopted or are looking to adopt an internal model, CLOs in particular may become more attractive.

"Those who have internal models or who are moving to internal models have shown a lot of interest recently in CLOs," Price said, "and off the back of that, the underlying asset corporate loans has also been an active area of conversation."

Bulley said life insurers will also continue to push into infrastructure, noting: "Insurers [in the U.K.] have talked about plans to increase the proportion of annuities backed by infrastructure assets to about 40% by 2020."

But should interest rates improve, insurers could abandon the more illiquid assets and head back to more familiar territory. Bulley said: "We don't see a headlong rush towards any of this. It is a managed process. And it could yet turn on the overall interest rate climate and trends in the government bond market."

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Click here for a template providing key financial items and ratios for European insurance companies.