We are living in a world where interest rates will remain low for a considerable time and where the pandemic recovery will likely be uneven and volatile for issuers.
Regulation and accounting regimes are constantly evolving while insurers are also expected to be at the forefront of the transition to a new era of sustainability.
Insurers are complex organisations, which compounds the difficulty of the strategic challenges they face. In order to protect policyholders, they must balance economic, regulatory, accounting and, increasingly, sustainability considerations.
That has led them to build portfolios comprised mainly of bonds for investment returns and liability matching, backed by other asset classes for diversification and yield enhancement. To give a sense of the dependence on fixed income, European life insurers in 2019 held 32% of their portfolios in government bonds on average and 34% in corporates.
For the past 10 years, the pressures have been building as bond yields have fallen even further along with other adverse changes, creating a perfect storm of challenges for insurers to address.
On the investment side, insurers have been slowly revising their asset-liability management and investment strategies. Both European and US insurers have lengthened asset duration, which increases income yield and contributes to the closing of duration gaps.
They have also diversified portfolios into illiquid alternatives such as private equity, hedge funds and real estate in the US, as well as private equity and loans in Europe. Further, some large insurers have increased their use of interest rate derivatives to manage the duration gap and risks.
We believe there is a key opportunity still though for insurers to tackle some of these challenges and improve overall portfolio diversification by expanding their allocations to non‐domestic credit.
For many this will mean reassessing a considerable home bias across their huge debt holdings, most obviously in that of government bonds, but also in corporate bonds.
French insurers, for example, invest more than 60% of their government bonds and 40% of corporate bonds domestically. By contrast, Japan’s insurers, which have been living with low interest rates for 30 years, have learned to diversify their portfolios far more geographically.
One reason for this could be a lingering – and we believe misplaced – perception that diversification away from domestic markets carries a complexity that is difficult to manage.
While adjustments should always be measured and gradual, we do believe that insurers who take this route will reap the dividends from it.
Taking Europe and the US as an example, US credit spreads over government bonds tend to be wider. The asset‐swap spread on US investment grade corporate bonds can be more than 40 basis points (bps) higher than in Europe.
This is illustrated by the spread curves, which demonstrate the opportunities that might exist to capture wider spreads, and exploit differences in the shape of the curve between markets.
We see potential advantages beyond any spread differential.
First, investors can massively increase their credit universe. The US accounts for about 60% of the global corporate bond market. It also hosts around three times more individual bond issues, giving greater scope for diversification.
The chance could also be there to extend duration, with the US average at about eight years against five years in Europe.
Other things to consider include the possibility to adjust a portfolio’s risk profile more easily – as well as the simple observation that the scale of the US market implies there can be opportunities here with no equivalent elsewhere.
For investors pursuing ambitions linked to environmental, social and governance issues, or seeking a better climate profile for portfolios, diversification should be able to assist with that process, too.
With the benefit of global credit research coverage behind them, we think that insurance investors can potentially gain more by seeking out the differentials at the level of individual names and in the variety – in terms of both duration and currency – that may be available from larger issuers.
Of course, in order to make this efficient from an asset liability and regulatory (SII) standpoint, foreign interest rate and currency risks must still be managed appropriately when moving into non-domestic credit markets. Hedging non-domestic corporate bonds to maturity with cross-currency swaps however will allow insurers to capture a spread pick-up while maintaining the necessary duration in the domestic currency.
The sheer scale of the US and emerging credit markets opens up unique opportunities alongside well‐known improved access to longer duration assets and the potential to better manage the risk of impairments or defaults.
