Regulators’ old ideas about what makes a sound investment are choking insurers’ profitability
Global economic growth has slowed. Europe is in a lengthy recession, and America’s modest GDP growth is artificially supported. Underlying economic activity and demand is weak. Developing markets are doing better, but even these have slipped of late.
Central banks have thus undertaken aggressive monetary policies. The US, UK and Europe have pushed interest rates down about 500 basis points since the beginning of the financial crisis and injected massive amounts of liquidity into their financial systems.
These actions by central banks have led to asset price appreciation around the world. Yields on 10-year government bonds have fallen to near-historic lows. Not surprisingly, stocks have rallied on central bank activity. Investors are deciding that equities may offer greater returns when fixed income yields are so low.
These trends are particularly worrying for the insurance industry. North American, European and Asian insurers’ portfolios have seen dramatic yield declines. What’s more alarming is the gap between old and new money yields. Insurers are faced with the prospect of replacing maturing bonds that yielded 5–6% with ones offering 2–3%.
As a consequence, the outlook for insurance company investment is alarming. Consider what would happen to a typical insurance company with a $5bn portfolio. Its investment income would have already declined by nearly 20% over the past five years, and could decline by more than 50% from 2012 levels in the next three to five years if interest rates remain where they are today.
Low interest rates are devastating for the profitability of non-life insurers. If an insurance company’s portfolio yield declines from 4% to 2% while just breaking even on underwriting, its return on equity would plunge from 8% to 4%. To achieve a return on equity of 8%-9%, a combined ratio of 93% or better would be necessary.
So how can insurance companies obtain sufficient yield and returns? There are generally five ways of increasing yield on a fixed income portfolio: duration, which is an increasing concern as interest rates stay low; leverage, which is discouraged by regulators; volatility, which is problematic because convexity is working against the industry now; liquidity, which must be a part of insurers’ portfolios; and credit, which can enhance yields,
but carries risk.
Non-fixed income classes of investment, such as real estate, infrastructure and dividend-focused equities, can also add to yield. Private equity, commodities and hedge funds can add to total returns over time, but not to current yields.
In this environment the options for attractive returns include: emerging market sovereign debt (lower indebtedness and greater growth than developed markets); emerging markets corporate bonds (higher yields and diversification benefits); structured finance and collateralised loan obligations (improving fundamentals and deeper markets); infrastructure debt (higher yields because of scarcity and illiquidity); convertible bonds (equity participation at lower capital charges; and equities (low correlation to bonds and comparably undervalued).
Unfortunately, regulators in most jurisdictions are using traditional concepts of risk and volatility in their assessment of insurance companies’ investment risk. They continue, in setting risk charges, to assume government bonds are the safest investments. And while regulators allow unlimited investment in government bonds, many of which are now understood to be volatile and risky, they punish companies that seek returns from other asset classes that have been shown to be no more volatile.
Regulator attitudes about insurer investment portfolios have not kept up with changes in the capital markets. By relying on outdated ideas about risk and volatility, regulators limit insurers’ flexibility, and their ability to appropriately invest in rapidly changing markets. In doing so, they undermine the financial security of the companies they are supposed to be protecting.
Brave new world
Global economic conditions promise to keep interest rates low for the foreseeable future. Even with an expected inflation uptick related to the aggressive stimulus programmes, rates will be much lower than insurers have based their profitability models on.
In many respects, the world’s troubled banks were rescued at the expense of the insurance industry. Regulators should remember that maintaining low rates will further compress margins and weaken the sector’s solvency, and that traditional investment strategies will not result in acceptable financial results. Maintaining old ways of investing may be the riskiest strategy of all.
The global economy has become increasingly complex. Insurers can no longer just hire staff to build a portfolio of highly rated government and corporate bonds, and expect their liabilities will be appropriately matched, or that their returns will be high enough. Insurers must raise their investment game.