Interest rates drive renewed interest in public fixed income

Volatility is normally an unwelcome, disruptive guest when insurers are carefully crafting their investment strategies. With millions to invest, insurers crave stable returns that can smooth out the ups and downs of the less predictable underwriting cycle.

That stability has been in short supply over the last year, ever since Russia’s military forces poured over the border into Ukraine, sparking a series of consequences that have left western economies reeling. For once, the unwelcome waves of uncertainty that have been unleashed in financial markets have brought some good news in their wake, at least for the world’s property and casualty insurers.

The reason is simple.

As central banks respond to the need to get to grips with inflation by driving up interest rates, the landscape for core fixed income assets, the bedrock of insurer investment strategies, has changed dramatically. Not since the global financial crisis almost 15 years ago have gilts and government bonds been so attractive.

“In general, the rise in interest rates and the weakening economic environment has meant that public fixed income is starting to look attractive for the first time in ages, especially after the torrid performance last year, which created significant pockets of value. That is true across the insurance industry and will be particularly interesting for P&C”, says Dr Bob Swarup, principal of Camdor Global Advisors, specialists in institutional investment strategies.

“The pressure on the investment side will be less currently, with rates hardening, so they can afford to take a little less risk while also harvesting decent yield.”

This will let chief investment officers play in their comfort zones and allow them to resist the blandishments of asset managers offering yield enhancement through a more diversified portfolio of alternative assets. These sprung to the fore over the last decade as a means of squeezing a few additional percentage points out of investment portfolios while interest rates were on the floor.

P&C insurers and reinsurers were never tempted to head too far down the diversification road. Many of the assets on offer, such as infrastructure bonds, real estate and a range of private assets, do not offer the liquidity that P&C insurers need with the prospect of having to pay large claims always hanging over them.

Life insurers have always been quicker to integrate alternative assets into their portfolios, with the larger firms sometimes having up to 40% of their portfolios in non-public assets. The lack of liquidity for many of these assets does not worry them because they are matching long-term liabilities.

The short term perspectives of P&C insurers mean they have been much less enthusiastic and typically commit between 5% and 15% to potentially illiquid assets. Those insurers with long-term liabilities on their books, say from structured settlements for catastrophic personal injuries that could be paying out for 30 or 40 years tend to be at the upper end of that range.

Consequently, alternative assets “have always been at the margins when it comes to P&C insurers shaping their portfolios”, says Andrew Torrance, chair of the board at Tokio Marine Kiln Syndicates and former chief executive of Allianz Insurance plc.

“This doesn’t mean they did not look hard to see where they could get some yield enhancement but this has tended to be limited to looking at investment grade corporate bonds and sovereign bonds, usually denominated in US Dollars as that allowed sensible currency risk market”.

Real estate has always featured in insurer investment strategies but few will be looking to add to their holdings, says Torrance.

“Most insurers are not in the game of increasing allocations to property in 2023 as there has been some pull back in valuations. That will probably continue in 2023”.

In addition to the need to maintain liquidity, there are the heavy capital charges attached to many alternative assets which also diminish their attractiveness. This is unlikely to change with regulators on both sides of the Atlantic cautioning insurers about diluting the quality of their investment portfolios. They are also concerned about the level of expertise that is needed when selecting non-core assets, says Dr Swarup.

“The one thing I would note is that there will be more scrutiny. P&C historically has had a reputation of being weaker on investment matters than life, particularly given the small sizes and therefore, weaker resources. While that may be changing for some, the reality is that their portfolios are not as simple as they once were and are now embodying a wider palette of risks. I am not sure everyone fully understands them.”

In response to these concerns, the US National Association of Insurance Commissioners is considering changes to capital charges, reporting requirements, and definitions to improve transparency and better align investments with underlying risks.

In particular, the NAIC is cracking down on investment vehicles used by private equity groups over fears that rating agencies are downplaying the products’ dangers, exposing insurers to undue risks which they do not fully appreciate.

The European Central Bank has also fired a warning shot across insurers’ bows in relation to alternative assets, saying the “growing share of alternative investments in insurers’ portfolios also raises financial stability concerns.

“The low credit quality and high leverage in some segments of the private corporate sector result in elevated exposures of insurers to risky assets. The returns on these investments may come under pressure should the weak growth outlook materialise or be worse than expected”, a reminder that the performance of investment portfolios is rooted in the real economy.

The ECB also echoed the US regulator’s fears over transparency: “Some of the alternative instruments – such as alternative and private equity funds as well as structured products – are highly complex and opaque, potentially making it difficult for insurers to manage these risks effectively.”

In the UK, Charlotte Gerken, executive director, insurance supervision at the Prudential Regulation Authority, spelt out her expectations in a recent “Dear CEO” letter sent to insurers in the wake of the recent stress tests carried out by the regulator:

“Insurers need to adapt to changes that threaten to disrupt business models, while maintaining high standards of governance, risk management, and resilience that result in their continued provision of vital insurance services to the real economy. Our main focus for 2023 will be on: financial resilience; risk management; implementing financial reforms; reinsurance risk; operational resilience; and ease of exit for insurers.”

The letter says P&C insurers need to factor in claims inflation and the potential for major claims shocks when structuring capital allocations and investment portfolios.

“There is uncertainty in the severity and duration of claims inflation expected, and there may also be a lag before it materialises. Consequently, this gives rise to additional uncertainty around future claim settlement costs. Therefore, we expect general insurers to factor general and social inflation risk drivers into their underlying pricing, reserving, business planning, and capital modelling”, she writes.

These pressures will inject a spirit of caution and conservatism into P&C insurers asset management and investment strategies. Most chief investment officers are likely to be very comfortable with that.