Insurers sink into riskier debts amid shrinking returns, big future payouts

INSURERS WORLD WIDE FACING shrinking returns and big future payouts are sinking increasingly into riskier corporate debt, potentially exposing themselves to defaults and more regulatory scrutiny, according to a recent Reuters report.

U.S.-based financial services firm, State Street Corp., found in a survey that 33 percent of insurers planned to expand private credit investment in the short-term

The risk now being taken is sending alarms out because insurers are believed to be among the most conservative of investors.

According to the report, insurers globally invest more than $20 trillion, but their investment positions, already perilous from years of falling bond yields, were left with large holes following this year’s coronaviruslinked slide in asset prices.

Markets have since recovered, but insurers face another conundrum — with interest rates close to 0% or less across the developed world, government bonds often no longer provide the returns needed to pay claims and pensions.

Taking more risk for higher returns seems to be the strategy; a recent survey by State Street found 33 percent of insurers planned to expand private credit investment in the short term.

“We are seeing that the move into negative interest rates is leading to a push into higher-yielding assets,” said Gerard Fitzpatrick, head of fixed income portfolio management at Russell Investments. “Credit is an area gathering more interest from insurance clients.”

Etienne Comon, EMEA head of insurance at Goldman Sachs Asset Management, said several of the firm’s large life insurance clients had upped allocations to corporate credit by as much as 10 percentage points in March and April.

European investmentgrade corporate debt — a category rated BBB-minus and above — currently yield more than one percentage point over safe-ashouses German government bonds on average. Riskier junk bonds yield on average around five percentage points more.

However, the move into credit comes as the pandemic fallout leaves companies vulnerable to rating downgrades and insolvency risk.

S&P Global predicts the ratings of $640 billion of European and U.S. bonds will fall into junk this year.

And default rates among European companies already rated junk rose in June to 2.8%, versus 1.2% a year earlier, according to Moody’s. Default rates could hit 6.2% next June, it reckons.

Rising risk

Low returns are prompting more investors to disregard the junk-rating barrier. But insurers, who need to make fixed payments to policyholders, have greater regulatory constraints on how much risk they can take.

A quarterly risk dashboard published in May by the European Union’s insurance regulator, EIOPA, showed insurers’ credit risk was high and rising.

Large UK insurers’ solvency levels are around 150 percent, according to the Bank of England. That’s a healthy buffer; anything above 100 percent indicates insurers have enough capital to run their businesses under European solvency rules.

The bank warned, however, “if an asset (on the insurer’s books) is too highly rated, a firm may be holding insufficient reserves to meet the risk of default or downgrade.”

Credit downgrades mean insurers must set aside more capital they could otherwise use for acquisitions or ploughing into the company. The riskier an asset, the more capital an insurer must hold against it.

So far, 4 percent of sterling investment-grade bonds have been downgraded, but 26 percent are on negative outlook, making them vulnerable to cuts, UBS notes. That could come after companies release first-half results.

Holding a BBB-rated 10year corporate bond would incur a 20 percent capital charge, rising to 35 percent for a junk BB-rated 10year bond under European rules, according to data supplied by Wells Fargo Asset Management (WFAM).

This year’s declines in asset prices have already had an impact. European insurers’ solvency ratios dropped around 20 percentage points in the first quarter and are likely to remain at those levels, Moody’s analysts estimate.

A three-notch ratings downgrade across corporate debt portfolios, requiring more capital to be held against the assets, would strip a further 30 to 50 percentage points from solvency levels, they added.

Insurers need to differentiate between corporates, said Henrietta Pacquement, head of investment grade, Credit Europe, at WFAM. “Credit work is going to be more intensive than in recent years.”

Legal & General, Aviva and Dutch insurer Aegon are among insurers whose portfolios and capital positions will be in focus when they release first-half results next month.