European insurance midyear investment outlook: strong capital supports a broadly positive view

European insurers remain broadly confident in their investment outlook. We explore the key opportunities – and risks – they're facing at midyear.

By Vladimir Zdorovenin

Despite a turbulent 2022, insurers remain well capitalized and are broadly confident about their investments.

European insurers are faced with geopolitical and macro uncertainty, stubbornly high inflation, and elevated liquidity and credit risk, potentially leading to a dearth of high-quality investment opportunities in their familiar markets. We believe that this environment calls for a more active approach to portfolio management and greater geographic diversification of insurers' corporate portfolios. Pursuing the full set of investment opportunities across all geographies and asset classes may require partnering with specialist asset managers that could complement insurers' in-house investment capabilities.

While some insurers may be tempted by the higher yields on their core fixed income investments, strong solvency and liquidity buffers for most insurers suggest that they are well positioned to pursue return-seeking opportunities created by the ongoing repricing in illiquid credit and real asset markets. These investments could help reduce balance sheet sensitivity to market shocks and provide some protection against prolonged inflation.

At the midyear point, we see the following key investment opportunities and risks for European insurers:

Corporate bonds: geopolitical and downgrade risks call for global diversification

Rising delinquencies, bank failures, and growing corporate default and downgrade rates are all making insurers rethink the credit risk in their portfolios. While a typical insurer's corporate bond portfolio is of very high credit quality, it is also often geographically concentrated, with significant overweight in the insurer's home country. Broader diversification with active management can help pursue opportunities across the full spectrum of corporate credit without compromising on quality and resilience.

Implementing a global fixed income asset allocation may require complementing in-house capabilities with those of external managers. These partnerships would set a high bar for the managers, given the need to incorporate insurance-specific objectives and constraints, such as liability-aware duration targets, risk-based capital efficiency considerations, and cost-of-downgrade analysis into mandate design and portfolio management.

Sector and Rating Composition of EEA insurers' Corporate Bond Holdings

Source: EIOPA Financial Stability report 2023; PineBridge Investment analysis and interpretation

As of fourth-quarter 2022, the median credit quality step (CQS) of EEA insurers' corporate debt investments stood at CQS 2, equivalent to an S&P rating of AA, with a negligible 2.6% exposure to high yield debt1. In their first-quarter trading updates, listed life insurers reported broadly stable credit quality in their bond portfolios year-to-date, with no defaults and rating upgrades outpacing downgrades.

This is no reason to be complacent. Corporate downgrades and defaults are expected to rise in 2023-2024, albeit from historically low levels. Downgrades would expose insurers to the double whammy of mark-to-market losses and significantly higher Solvency II capital requirements on instruments downgraded to high yield. The risk is particularly material for UK life insurers given the "BBB cliff edge" effect in their matching adjustment portfolios.

The growing credit risk necessitates a more active approach to portfolio management supported by thorough credit research. Many insurers rely on in-house teams to manage their fixed income investments. However, partnering with a specialist asset manager could expand the opportunity set and help build more efficient asset allocations without compromising on credit quality and portfolio diversification. For insurers with an appetite for credit risk, selective exposure to high-yield debt within the pre-allocated capital budget can further enhance the efficiency of Solvency II capital.

Many insurers have a strong home bias in their corporate bond investments. In aggregate, EEA insurers allocate three-quarters of their corporate bond investments to the EEA, putting insurers at risk of missing opportunities in the $7.8 trillion US corporate and $0.8 trillion Asian dollar corporate bond markets. Teaming up with a fixed income manager with an established presence in these less-familiar markets may help uncover new opportunities.

Illiquid credit: banking sector turmoil presents more opportunities than threats

Rising delinquencies, deposit outflows, and the daunting prospect of additional capital and liquidity curbs in the wake of the recent US bank runs and the fire sale of Credit Suisse are likely to weigh on banking industry profitability and creditworthiness in 2023 and beyond. In our view, this does not pose a direct threat to insurers' investments. EEA insurers' average exposure to banks – across deposits and investments in bank debt and equity – was 13% of total assets as of fourth-quarter 2022². Insurers' exposures are mostly to European banks, with the total exposure to US regional banks estimated at about €1.2 billion across 39 insurance groups, or 0.02% of the industry's total investments. During the recent emergency takeover of Credit Suisse, European insurers have also been keen to highlight the immateriality of their exposures to bank subordinated debt³.

A retrenchment in bank lending could create new opportunities for insurers to invest in private debt. To capture the full range of opportunities in this broad and fragmented universe, insurers may seek to complement their in-house origination capabilities with those of third-party asset managers. Given the growing regulatory and rating agency scrutiny of loans originated at the peak of the market, insurers are well advised to partner with experienced managers that focus on prudent underwriting, portfolio diversification, and durability to weather challenges.

Real estate: headline risks, niche opportunities

European real estate markets have had a rough year, with property values falling by 16% in the UK and by 11%-12% in Germany and France over the course of 2022 and continuing to trend down⁴. The pain has been even more acute for listed real estate, with the benchmark FTSE EPRA NAREIT Developed Europe Index falling 36.5%, wiping out virtually all its gains since 2016. The repricing is likely to continue in 2023. Based on risk sensitivities reported in large life insurers' 2022 Solvency and Financial Condition Reports, a further 15% decline in property values could reduce their SCR coverage ratios by up to 10 to 20 percentage points.

The value of EEA life insurers' real estate equity and debt exposures declined by almost 11% year-on-year, broadly in line with the property market. However, real estate allocation has been more resilient than fixed income, with the value of insurers' government and corporate bond holdings falling by 27% and 21% respectively over the same period. As a result, real estate exposures accounted for 10.3% of EEA insurers' general account investments as of the end of 2022, the highest year-end level since at least 2017⁵.

On average, home-country investments account for over 80% of EEA insurers' real estate exposures;5 we expect this number to be broadly similar for the UK. Concentrated, illiquid exposures exacerbate tail risk and can lead to contagion. These risks can be mitigated by broader diversification across geographies and investment styles – for example, by complementing the income-oriented home-country portfolio with an allocation to a pan-European opportunistic strategy.

While we do not expect a broad and uniform recovery in European real estate markets in the near term, there remain segments where overall economic growth is less of a factor and where inherent supply constraints can still create favorable supply-demand dynamics. These include opportunities in rental housing, green prime central city offices, and last-mile logistics. Uncovering these niche opportunities and structuring resilient deals against the backdrop of a marketwide repricing may require partnering with an experienced real estate investment manager.

Higher business volumes in the UK pension risk transfer market have insurers going more global Growing volumes in the pension risk transfer market, as well as reform of risk margin and matching adjustment mechanisms under the emerging "Solvency UK" regime, are causing British life insurers to increasingly look to international markets. In the UK, regulatory concerns about the risks inherent in funded reinsurance strengthen the case for pursuing global opportunities in illiquid credit through partnerships with external asset managers that offer structuring know-how, proven origination capabilities, and regulatory expertise.

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