Francesco Martorana: The Covid-19 pandemic has undermined the medium to long-term profitability outlook of LDI investors, which by definition predominantly hold fixed-income assets: coupon payments and redemptions will have to be reinvested at lower yields.
Falling yields and inflows make it tougher for insurers to maintain high and stable S2 ratios while trying to preserve decent portfolio returns.
Under Solvency II, penalties for ALM mismatch being quite high, most of the industry targets a strong reduction of mismatch. But falling rates put upward pressure on liability duration, forcing insurers to buy even more long-term (scarce) assets.
Insurers will need to continue to adjust to the related regulatory environment, which is likely to become tougher, not looser. As the Life business profitability declines, economies of scale will be of the essence: size matters.
"Insurers will need to continue to adjust to the regulatory environment,
which is likely to become tougher, not looser."
Companies will undertake more credit and liquidity risks, e.g. by moving into alternative asset classes and emerging markets. This requires strong focus of liquidity risks and credit losses.
Insurers are structurally suited to carry more liquidity risk, but careful selection of the underlying assets and good managers is paramount.
In the EU, insurers face tougher regulation ahead. The revision of discount curve and interest rate shocks in Solvency 2 will expose bigger ALM mismatch, especially for mid and small sized insurers used to target more the regulatory capital rather than the economic one.
On this backdrop, demand for long dated highly rated bonds and receiver swaps will increase further.
"Downgrades and related impairments could hurt insurers'
reported earnings and capital."
Credit risk management will be key. Insurers have increased their holdings of 'BBB' rated bond – more so in the US; while the count of fallen angels has surged.
The COVID pandemic will generate an increase in bankruptcies, albeit lower and slowly than in previous recessions thanks to the massive monetary and fiscal policy stimulus.
Downgrades and related impairments could hurt insurers' reported earnings and capital. This requires strong patrolling of sector and single name exposures, by using also artificial intelligence to detect early warning signals of credit deterioration.
Francesco: Given the current environment where the industry must deal with negative rates, insurers are mainly keen on picking up yield and closing duration gap, which has broadened further by the exceptional decrease of interest rates.
Lengthen duration of FI portfolios and, even better, improve cash flow matching between assets and liabilities can fulfil this purpose.
The reduction in ALM interest rate risk can free up regulatory capital to sustain yield enhancement via increased credit risk, by purchasing lower rating issues and hybrid bonds (which are subordinated liabilities in the capital structure of issuers).
"Given the current environment where the industry must deal with negative rates, insurers are mainly keen on picking up yield and closing duration gap,"
When capital requirements are satisfied, insurers, as long-term investors, should also catch illiquidity premium embedded in private and real assets (private debt, private equity, infra debt and real estate) or just perform re-risking across the capital structure.
Geographical diversification within fixed income portfolios has increased and will grow further. EM debt can offer opportunities both on sovereign and corporates, able to carry out higher yields with manageable risks if volatility can be sustained.
For a Euro based insurer, non-EUR assets can provide yield pick-up versus Euro denominated assets, but a robust FX risk hedging policy is needed and requires the usage of longer term hedges to limit roll risk (e.g. long dated forwards and cross currency swaps.
The experience of Japanese insurers can be leveraged in this respect, albeit they operate in a different regulatory and accounting environment.
"Securities lending is set to rise, because insurers sit on large
holdings of long dated high quality assets."
An example of the opportunities ahead is represented by Chinese fixed income. China represents 2.5% of global bond index while being 15% of global GDP. USA is the opposite: 25% of global GDP and almost 50% of global bond index.
China fixed income is a 15trn market with only 2% foreign ownership. And cannot be approached passively: specialized skills are needed, especially in the corporate area.
Also Securities lending is set to rise, because insurers sit on large holdings of long dated high quality assets used to match long dated liabilities.
Francesco: Global central banks will maintain an accommodative policy stance for longer. Amid the muted inflation outlook and the lasting economic fallout from the Covid-19 crisis, a significant increase in government bond yields is not around the corner.
Government (and corporate) bonds became a fully-fledged monetary policy tool. Looking at the other side of the coin: the risk of a further noticeable decrease in yields appears manageable as well.
Life insurers, especially those having back books of policies with recurring premiums, can invest through the cycle and benefit from higher reinvest yields if rates would eventually rise.
Infrastructure debt and real estate equity can be an effective way to hedge against long term inflation risk, while offering yield enhancement versus inflation-linked bonds or swaps.
"Global central banks will maintain an accommodative
policy stance for longer."
Credit risk is twofold: default and rating migration. We think that the extraordinary fiscal and monetary will keep default rates way below 2009 levels. We expect them to peak in Europe between 5% and 6% for sub-investment grade bonds by end of 1Q21.
Indeed, the fiscal support to corporates will be gradually withdrawn over the second half of 2021, with potentially challenging impact on zombie companies.
Recovery rates could also fall below the long-term average of 40%. On rating migration, post-Covid, rating agencies have mostly downgraded HY while they put IG on negative outlook. 50% of names within HY benchmarks have been downgraded by one notch since March this year, while one-third of the BBB- space is now on negative outlook.
Hence we see rating migration more a threat to IG than to HY from here, although we have seen a slowdown in downward rating revision recently.
