The European Central Bank's €1.1tr ($1.3tr) debt-buying spree will further erode insurers' returns and force a major reallocation of asset portfolios, investment experts predict.
The ECB said it is going to pump €60bn a month into financial markets until September 2016 through purchases of government and corporate bonds, in a desperate attempt to fend off the risk of deflation in the euro zone.
The injection of liquidity will pull interest rates down and cause spreads to tighten, further hitting insurers exposed to reinvestment risk in a protracted low interest rate environment – a risk that stood out in the last round of stress tests by the European Insurance and Occupational Pensions Authority (Eiopa).
Analysts say this will accelerate a shift in asset allocations, as firms hunt for yield. A major trend is the investments into illiquid assets, in move that will also help firms to extend duration. Dollar-denominated investments and alternative asset classes also feature high on the list of options.
Three analysts share their initial thoughts below:
Erik Vynckier, CIO insurance EMEA at asset manager Alliance Bernstein
"Over time, the reallocation will amount to sizeable share of the balance sheet. Early movers may go to approximately 40% of balance sheet invested in alternative assets such as smart beta and direct lending. Companies that cannot play the advantage of illiquid liabilities may not surpass the 5% mark or forgo asset strategies as a source of income altogether.
"I believe global sourcing of the best bonds, including some long-dated investment grade US issuers and investment-grade emerging market corporate bonds might be where they will look. Sophisticated FX hedging (rolling forward, or preferably, cross-currency hedging) is required to do this and bring back the asset exposure to the domestic liability currency, otherwise capital charges may become punitive. With accurate FX hedging in place, the capital charge is reduced to the standard level for domestic bond investment.
"Alternative assets could also be a place of better returns. Direct lending for longer terms, where banks are increasingly cutting back because of Basel III capital constraints, can be accepted by insurers with long-dated, non-lapsing liabilities. Expertise in liquidity planning and in the asset strategies themselves needs to be developed.
"Liquid alternatives and approaches to smart beta investment with a total or absolute return focus are another opportunity. Here, it is essential to achieve look-through reporting, both for pillar 1 and pillar 3 treatment. With look-through reporting and capital calculation driven by line items, it is possible to get out of the 49% capital bucket for alternatives and achieve a more realistic capital requirement.
"I expect the low rate environment to be the dominant issue for the European insurance sector for the next ten years or so. Even after a future exit from QE, inflation and rates may remain low for a very long time, and the insurance industry holds its legacy investments for a very long time."
Benjamin Serra, vice president at rating agency Moody's, in Paris
"We expect European insurers to use broadly the same strategy in this low interest rate environment. This strategy consists of a combination of actions, including reducing the guarantees on new business, increasing the promotion of unit-linked products, reducing rates credited to policyholders or changing asset allocation to chase yields.
"We expect insurers to chase yields by increasingly investing in illiquid asset classes, such as real estate, mortgages, infrastructure loans or corporate loans. However, in the short-term, this strategy will be constrained by the lack of availability of these assets. Illiquid asset classes are not necessarily more risky than other asset classes, but insurers generally lack expertise in many of these asset classes and run the risk of being left with the lowest quality assets within these classes. Furthermore, if new investments are purchased directly from banks or through funds, insurers may face asymmetry of information and challenges in terms of assessing the quality of these investments.
"The efficiency of these measures will be different between countries. In France or Italy, where the level of guaranteed rates is relatively low, insurers face less risk if they behave rationally and reduce credited rates. In countries like Germany or the Netherlands however, where guaranteed rates are higher, reducing credited rates become less and less an option as insurers cannot give less than the guaranteed rate to policyholders.
"German insurers also have on average a high duration mismatch, which exposes them significantly to reinvestment risk. Therefore, we could also expect more regulatory intervention. The German regulator, Bafin, has already indicated that a small portion of life insurers would not comply with Solvency II capital requirements and Eiopa reminded in its stress tests conclusions that undertakings not meeting the capital requirement thresholds require supervisory intervention in advance of Solvency II implementation.
Prashant Sharma, portfolio manager for insurance solutions at JP Morgan Asset Management
"There are two main ways in which the ECB QE impacts life investment portfolios. In the near term, as the ECB buys government bonds it pushes up the price of financial assets. The impact would be to tighten the credit spreads on fixed income investment such as Italian, Spanish government bonds and European investment-grade and high-yield corporate credit. In the longer term, the impact will depend on the ability of ECB QE to generate inflation and, eventually, push shorter-term risk free interest rates higher. The jury is out on that and will play out over a longer time horizon. At an overall level, liquidity as provided by the central banks will continue to remain abundant and should be supportive of risk assets such as equities and corporate bonds.
"For life insurers' fixed income portfolios there are three major considerations. Insurers need to continue to build and manage diversified fixed income portfolios, in particular incorporating a global opportunity set for your investment portfolio. They need to ensure they understand the risks in their portfolio and are comfortable with those risks. Finally, as yields are still at low levels on a historical basis, insurers should look at which of the five levers – credit, liquidity, duration, leverage, structure – they need to pull to get the right levels of returns in their portfolios."