Insurance supervisors should scrutinise insurers' corporate bond portfolios as the evaporation of liquidity in the market has changed the risk profile of the asset, the International Association of Insurance Supervisors (IAIS) has said.
The IAIS, which represents insurance regulators and supervisors of more than 200 jurisdictions, believes that "supervisors should re-examine the liquidity of insurers' asset portfolios and how those assets match with insurers' liabilities."
Cash flow management should also be looked into, the association said. If liability is not properly matched, they may have to sell their bonds, and sell them in a hurry, in which case insurers "may be able to do so only with a large price concession."
The corporate bond market is a $10trn market that has doubled in size in the past decade, fuelled by low interest rates and ensuing cheap money. But while this market is growing, banks, the traditional corporate bond dealers, have reduced their bond inventories because of stricter bank regulations.
In its recent Global Insurance Market Report, the IAIS said that life insurers are among the largest participants in the corporate bond market, holding between 20% and 40% of the world's corporate bonds.
Corporate bonds' better yield is not the only attraction; the higher quality ones can also be a potential source of liquidity. When insurers need to sell them, they use dealers in the secondary bond market. The latter usually hold a substantial inventory of corporate bonds to facilitate trading, as the corporate bond market is general illiquid.
Those dealers' role of providing liquidity in the corporate bond market has been bought into question, IAIS noted. Since most of them are banks, the bonds they hold are subject to Basel III rules on capital and liquidity. So banks must meet the higher level of capital to hold against bonds, as well as liquidity rules, all of which are bound to increase the cost of holding bonds.
Then there is the Volcker Rule in the US that limits proprietary trading: dealer banks cannot trade corporate bonds for their own gain. According to IAIS, those rules "may have contributed to the sharp drop in the corporate bond inventories at dealer banks." In the US, inventories decreased from $235bn in 2007 to $56bn in 2013, and the number of primary dealers decreased from 41 in 1990 to 22 in 2013. Furthermore, the average trade size for corporate bonds has been decreasing since the financial crisis.
According to findings in the Bank of England's latest Financial Stability Report, published last summer, dealer inventories of corporate securities in the US have fallen since 2008.
"In the past, many financial markets, including corporate bond markets, have relied upon the activities of core intermediaries, such as dealers, to provide liquidity through their market-making activities," said the report.
"But, in response to regulation necessary to bolster their resilience, there is evidence that dealers have become less willing to expand their inventories and to take directional positions, particularly in less liquid assets. For example, while in the five years preceding the crisis US primary dealers' holdings of corporate securities increased almost fivefold, these now stand at around 2002 levels."
But transaction volumes have remained unaffected, and so inventories have worked harder. Meanwhile, corporate bond liquidity risk-premia remain below historical average, suggesting "risks associated with this more fragile secondary market liquidity may not be fully reflected in market prices."