The hunt for returns

Insurance companies continue to revise investment expectations downwards and review allocations. Limited returns from traditional fi xed income, coupled with the desire to diversify economic risk, are leading insurers to increase their allocations to high yield, US corporate, real estate, emerging markets debt, private equity and bank loans.

Insurers are increasingly using third-party asset managers as they seek access to asset classes beyond traditional core fixed income.

The current low yield environment remains the overriding investment issue facing insurers, although concerns about rising interest rates and widening credit spreads, particularly in the Americas, Europe and the Middle East and Africa (EMEA), persist.

New regulations are forcing insurers to review their investments, while adding additional costs and complexity.

Market conditions drive outsourcing trend

Regulation, volatile markets and economic uncertainty lead more insurers to outsource

Outsourced non-affiliated insurance assets grew by 4.5 percent to reach $1.8 trillion in 2011, according to the Institute of AssetManagement’s preliminary 2012 survey. General account assets rose to $1.22 trillion from $1.16 trillion, while sub-advised assets grew to $572 billion from $558 billion. Three-quarters of the overall increase came in the fi rst half of the year, prior to the market shocks triggered by the US downgrade and European sovereign debt crisis.

Recent research suggests that 17 percent of insurers intend to outsource more in the near term, with large insurers outsourcing only a proportion of their assets and smaller companies outsourcing most of their portfolios.

More insurers are considering partial fi duciary management for the return-seeking portion of their portfolios, a trend being driven by more volatile and complex markets.

The hunt for returns outside of core fi xed income fuels the use of external firms

The share of new mandates outsourced to broad fi xed income and alternative investment roles declined in 2011 relative to the past fi veyear average, while those allocated to specialised fi xed income and ex-US fi xed income increased.

Outsourcing to emerging markets debt accounted for much of the increase in ex-US fi xed income roles.

Asset management competition likely to intensify; performance is key

The insurance outsourcing market is likely to result in greater competition driven by managers and consultants looking for opportunities beyond the declining defined benefit pension space. Consulting firms continue to expand their insurance investment consulting practices on the back of Solvency II and insurers’ growing interest in alternative asset classes.

Performance is the main criterion used by insurers when selecting a third-party asset manager; this is significantly ahead of other selection criteria in terms of importance to investors. Other key attributes include fees, knowledge of the industry, client service, strategy, and risk analytics, according to a recent survey by Goldman Sachs Asset Management.

Asset allocation trends

The hunt for yield drives insurance allocations to riskier asset classes

Yield remains elusive, leaving insurers concerned about current returns and the impact of future rate rises. Low yields and risk premiums across investment-grade capital markets have made many risk:reward tradeoffs in the fixed income markets unattractive. Insurers see the biggest returns coming from US equities and private equity in the next 12 months.

New regulation will force insurers to review the risk:return ratios within their portfolios. Towers Watson estimates that about 56 percent of companies are already planning to invest in a wider, more diverse range of assets in order to take full advantage of Solvency II rules.

Insurers are likely to increase risk: globally, 26 percent of insurers expect to increase overall investment risk, while 14 percent expect to reduce risk, according to a recent survey of insurance chief investment officers. Increased diversification and better risk management systems are expected to mitigate the impact of higher risk investment strategies.

Current market volatility related to political and economic uncertainty in Europe is likely to mean that investments in US corporate credit and emerging markets debt increase further.

Product-specific allocations

Bonds rated BBB or lower— These could fall out of favour with investors under the new Solvency II requirements; the additional marginal cost for such holdings may be considered excessive in proportion to expected returns, a new study by EDHEC-Risk Institute found.

Covered bonds—These are expected to gain ground at the expense of asset-backed securities due to lower capital charges under Solvency II, reports Fitch Ratings. The capital charges for AAA-rated covered bonds range between 0.7 percent and 6 percent compared with prohibitively high capital charges of between 7 percent and 42 percent for AAAsfrated securitisations.

Private equity—This is still favoured by insurers. More than half of insurers (60 percent) plan to make new commitments to private equity in 2012, according to research from Preqin; mid-market funds are expected to be most popular. The study also found that nearly onethird of insurance companies (30 percent) are currently below their target allocations to the asset class, and 88 percent plan to maintain or increase their allocations to private equity over the longer term.

Insurance client trends

Premiums edged down in 2011; growth in emerging markets

Overall global premiums declined 0.8 percent in real terms in 2011, according to the latest Sigma study from Swiss Re. While non-life premiums expanded 1.9 percent “on solid economic growth in emerging markets and selective rate increases in some advanced markets, global life insurance premiums fell 2.7 percent. Capital and solvency remained solid despite costly natural catastrophe events and historically low interest rates that lowered insurers’ overall profi tability”.

Life—Premiums declined by 2.7 percent in 2011, with developed markets recording a net decline despite premium growth in two of the largest markets, the US and Japan. In emerging markets, new regulations in China and India hindered premium growth. “The profi tability of the life insurance industry has stabilised, but remains low. Low interest rates remain the key issue for the sector, affecting investment returns and eroding the profi tability of guaranteed products.”

P&C—Overall premiums grew by 1.9 percent in 2011 with all regions, with the exception of North America which reported a 1.1 percent fall in premium volume, recording premium growth year on year. Latin America and South East Asia both reported impressive year on year growth with premium volumes increasing by 10.7 percent and 10.2 percent, respectively.

Challenges faced by insurers multiply

Towers Watson’s European Actuarial Directors survey found that 58 percent of respondents expect the next two to three years to be extremely diffi cult, citing challenges such as the rising cost of capital and the advent of Solvency II.

This view is shared by insurers in the US—in Towers Watson’s recent chief fi nancial offi cer survey North American life insurers said that the current low interest rate environment was their primary business concern, with almost half of survey respondents indicating that protracted low rates are the greatest threat to their business. In addition, respondents were not optimistic about the economic outlook. Eighty-seven percent of respondents believe there is a 50 percent-plus likelihood of a major disruption to the economy in the next 12 to 18 months.

Difficult market conditions are forcing insurers to review their strategies. Seven out of 10 insurance CEOs are planning changes in strategy over the next 12 months as they try to contend with the diffi cult economic and regulatory backdrop. Longer term challenges, such as shifts in government policy and shareholder expectations, are having less infl uence on strategy, according to PwC.

On a positive note, however, in the fi rst six months of 2012 Standard & Poor’s reported that it had downgraded three insurers while upgrading nine. Insurers in Italy and other eurozone countries have been under particular scrutiny by the ratings agencies as a result of the sovereign debt crisis.

Meeting the challenges of new regulation

Risk management—Many insurers intend to invest more resources into their risk management infrastructure, in light of the changing regulatory environment, particularly Solvency II.

Board education—The majority of fi rms are not currently doing enough to bring their boards up to a suitable level of Solvency II understanding, jeopardising their opportunity to gain a competitive advantage and their ability to ensure regulatory compliance, according to a new report from KPMG. The report shows that 80 percent of boards have received less than 15 hours of training and only 19 percent are planning to increase the level of training over the next 12 months.

Data management—Managers will be faced with issues related to data management, data delivery and look-through data, a study by KPMG found. “The required level of granularity in data reporting is high and the need to provide data for each asset on a security-by-security basis will present a major challenge for insurers, particularly where they hold large, diverse investment pools across multiple service providers.”

Reporting—A recent survey by BearingPoint found that only 16 percent of insurers are prepared to deliver the required quarterly and annual reports to the respective EU supervisory authorities, and also revealed that around 40 percent of participants underestimate the complexity of Solvency II reporting, with 60 percent of companies expected to decide on a packaged solution provider in the next few months.

M&A activity—mega deals out of favour

Small and medium-sized M&A transactions are expected in the insurance market but a wave of large transactions is unlikely, KPMG says. There have been only two large transactions in the sector ($10 billion+) since 2007: Allianz’s purchase of the remaining shares of AGF and MetLife’s purchase of AIG’s American Life Insurance, according to Dealogic. Transaction trends are likely to be driven by underwriting losses, regulatory pressure and weak investment returns, which will result in both consolidation among underwriters and divestitures of non-core operations such as asset management or claims processing.

Regulation

G-SII ‘too big to fail’ rules still work in progress

Under the International Association of Insurance Supervisors (IAIS) criteria, whether an insurer is categorised as posing a potential threat to the financial system depends on five factors: size, global activity, interconnectedness, non-traditional activities and substitutability. Insurers deemed to be high-risk could be forced to hold extra capital under safeguards being drawn up by the Financial Stability Board. A group of 48 big insurers will be examined to determine whether they should be placed alongside leading global banks on a list of ‘systemic’ financial institutions.

Solvency II

The Solvency II rules are still being finalised by the EC, the European Insurance and Occupational Pensions Authority and local regulators. The deadline has been moved to June 2013 because the final draft was unlikely to be ready by the end of October 2012, as originally planned, due to delays in the EU legislative process. The final implementation deadline, January 2014, has not changed but may be pushed back to give insurers more time to adapt to the new rules. Ongoing discussions include:

• Revision of the rules under which all government bonds within the European Economic Area are regarded as risk-free. This could incorporate some differentiation, possibly using country ratings.

• Phasing-in of the new capital rules for life insurers over seven years, which would require the separation of old and new policies. This separation is likely to result in discrepancies in risk management and create a raft of new problems, according to Towers Watson.

• Several market participants are concerned that Solvency II could encourage some insurers to take on more risk. A provision allowing insurers to ignore market volatility they were not exposed to when calculating capital requirements would lead to non-performing assets being ‘locked in’ as held-to-maturity investments, according to Deloitte.

• Investing in alternatives via managed accounts rather than traditional fund structures could allow insurers to meet Solvency II reserve requirements while still using alternative investments, a paper from French business school EDHEC claims. Utilising such structures would allow for sufficient transparency and liquidity to carry out reliable risk/return analysis, it notes.

• Policy-makers have been urged to adjust Solvency II’s treatment of bonds, after a study found that the current calibration of the standard formula does not adequately reflect the risks associated with very high-risk bond types. The EDHEC research also found that the standard formula underestimates losses on high-risk bonds during periods of crisis and does not reflect the differences in geographical risks of bonds.

Other regulation

US insurance reforms

The insurance industry is waiting for recommendations from the Federal Insurance Office (FIO), established under the Dodd-Frank Act, which has been tasked with modernising and improving insurance regulation in the US. The National Association of Insurance Commissioners (NAIC) remains opposed to the centralisation of insurance rules, which it believes will undermine the position of individual states.

Asia

In India, the Insurance Regulatory and Developmental Authority is considering relaxing the 10 percent ceiling on equity investments in a company by insurers. The move is expected to offer greater investment flexibility to insurance companies and bring long-term funds into equities.

China’s insurance regulator is expected to announce policies expanding and diversifying insurers’ investment scope, in a bid to ease restrictions on the sector. The China Insurance Regulatory Commission is considering moves to allow insurers to conduct margin trading, short selling and trading in financial derivatives both abroad and domestically. Chinese insurers, which invest most of their assets in bonds, have been seeking to widen their investment scope to improve returns.

Regional developments

In mature markets such as the UK, insurers are increasingly looking at pension transfers as an opportunity to expand for life companies, which have seen net outflows every year for the last 10 years. This business is expected to grow as more corporate pension funds seek to reduce risk, a trend that is likely to intensify if Solvency II rules are applied to pension schemes.

Insurance companies and other institutional investors are considering mortgage lending opportunities in European commercial real estate, in a bid to fill part of the gap left by bank deleveraging, Fitch says. It notes that insurance companies in particular are exploring the use of ratings in order to meet capital adequacy rules prescribed under forthcoming Solvency II regulations.European insurers face increased lapse rate risk as consumers squeezed by the tough macroeconomic environment seek the early return of their money from guaranteed savings products, Fitch Ratings says. This problem has been compounded by penalties for redeeming life insurance products early falling.

"A group of 48 big insurers will be examined to determine whether they should be placed alongside leading global banks on a list of 'systemic' financial institutions."

Opportunities are opening up in China—the Insurance Regulatory Commission there has identified 25 developed countries and 20 emerging markets nations, including Brazil and Korea, in which insurers will be permitted to invest. Chinese insurers currently hold about 35 percent of their assets in cash and deposits, according to Keefe, Bruyette & Woods. The new rules allow insurers to use fund management companies and brokerages to manage bank deposits and to invest in equities, bonds and mutual funds, provided the firms have at least $1.57 billion in assets under management (AuM). The 15 percent limit on assets insurers can invest overseas has not been affected.