Higher for longer: how insurers can navigate 2023

Things can change quickly in financial markets.

Not so long ago all the talk was of ‘lower for longer’ rates and the ‘hunt for yield’ in investment selection. Insurers adjusted their asset allocation and investment strategies accordingly. Their goals were, naturally, to match liabilities, mitigate the dilution of book yields and preserve operating earnings.

But now, with inflation at multi-decade highs, central banks have tightened monetary policy. Credit and equity markets have seen material adjustments while liquidity has deteriorated across asset classes. Recessions await – with potential for further volatility and market downturns.

There are chances to rebuild book yields, thanks to higher rates and risk premia, but the spectre of volatility disturbs asset liability matching and can hurt capital ratios.

In these markedly changed conditions, insurers will need to be agile in the way they manage their balance sheet and capture investment opportunities, in 2023 and beyond.

In its latest Global Financial Stability Report, the International Monetary Fund (IMF) warned “the global economic outlook has deteriorated materially”. It goes on: “global financial stability risks have increased” and “financial vulnerabilities are elevated in the sovereign and nonbank financial institution sectors, while market liquidity has deteriorated across some key asset classes.”

Global growth has been slowing and a consensus is building that the ongoing tightening of financial conditions, in combination with deteriorating real income and profit margins, point to recessions in 2023, with natural gas shortages adding to the risk in Europe.

Rates will remain higher for longer – driven by several themes, such as inflationary pressures related to energy transition and changes in the nature of globalisation. Rates may also be volatile.

However, higher interest rates and wider risk premia mean better opportunities for insurers to rebuild book yields and boost investment returns.

Rising interest rates can have a positive impact on insurers’ capital position, notably for life insurers with long-dated liabilities and a negative duration gap as the value of technical provision decreases relatively more than the assets, while reinvestments can be made at higher yields.

Conversely, non-life insurers who tend to have a positive duration gap can be squeezed by a combination of increasing claims and interest rates. Uncertainty is still high, and we expect interest rates to remain higher and volatile for longer.

In an environment where liquidity has become scarcer in bond markets and where rising rates have led to massive pockets of unrealised losses in fixed income portfolios, derivatives-based strategies can prove useful to manage asset portfolios and duration gaps.

In particular, interest rate derivatives are a valuable asset liability management tool but require financial engineering and execution expertise. They also require a robust liquidity and collateral management framework.

The recent stress faced by UK pension funds has put liquidity risk back on the stage.

We argue that insurers could consider two dimensions of liquidity risk. First, maintaining a sufficient level of cash and high-quality assets available can support fulfilment of commitments to policyholder and derivatives counterparties.

Second, assessing the impact of increased scarcity of liquidity in bond markets on their ability to manage portfolios and to deploy investment plans that can optimise risk-adjusted investment returns and liability matching.

In aggregate, European insurers have a relatively small exposure to derivatives. Yet, the use of interest rate swaps has increased over recent years and this could continue amid a growing need to strengthen asset and liability matching in a context where liquidity has become tighter in fixed income markets.

The European Insurance and Occupational Pensions Authority (EIOPA) has recently highlighted worries about liquidity – in its risk dashboard and financial stability report. The organisation states a relatively stable median liquidity ratio of 47%, but the range is wide across insurers and EIOPA shows evidence that short-term volatility could potentially increase the pressure on the liquidity position of insurers stemming from margin calls.

Add in a rise in lapse rates, a measure of life policy redemption, and there are multiple implications for insurers. The chief issue is insurers’ growing allocations to private markets. With tightening financial conditions and potential further volability, insurers might see their liquidity needs grow just as liquidity reduces.

We think insurers should develop a robust liquidity and collateral management framework. This would allow them to optimise cash buffers and pockets of eligible collateral, generate the required liquidity without being forced sellers and minimise opportunity costs related to margin calls or client redemptions.

With investment-grade corporate bond yields at levels not seen for years, insurers have a huge opportunity to rebuild book yields. With liquidity conditions deteriorating, they should be very selective and make sure they can buy and hold as it may prove challenging to exit a position in case of stress.

An efficient partial use of interest rate derivatives for liability matching is one way to gain the necessary agility for such an approach. Short duration opportunities, where credit risk and capital adjusted returns may be higher, and diversifying away from their domestic market could both potentially provide more leeway.

Over time, and as we reach the peak in inflation and interest rates and turn into the next phase of the monetary policy, high-yield and emerging market debt are likely to become increasingly attractive and could represent a real investment opportunity.

We think insurers should definitely monitor signals of an inflection point and get ready to push the button.

Overall, we believe 2023 will be a year of execution with IFRS 9 and IFRS 17 standards effective from January. These standards will affect how assets and liabilities are classified and measured. They may also require adapting the way assets portfolios are organised and structured.

Insurers that display agility in the way they manage their balance sheet and capture investment opportunities are more likely to prosper in 2023 and beyond.