Five Questions for European Insurance Investors

29 August 2023

5 min read

As we assess the investment landscape for insurers, it’s helpful to revisit the key themes we laid out at the beginning of 2023.

Despite 2022’s tumble in asset valuations—reducing insurers’ investment portfolios by more than EUR 1 trillion—European insurers actually entered 2023 on solid footing. The same forces that punished assets also affected risk margins and liability values, reducing solvency capital requirements and bolstering balance sheets—especially in terms of investments relative to technical provisions (Display).

European Insurance Balance Sheets Remain Strong

Insurance Industry Asset, Liability, Investment and Technical-Provision Levels

Historical analysis does not guarantee future results.
As of June 30, 2023
Source: European Insurance and Occupational Pensions Authority

As many of us return from—or finish up—well-earned summer vacations, it’s a good time to revisit key themes we believed would matter to insurance investors this year. We can do this by examining a series of questions for insurance investors.

1. Do Private Markets Still Have the Same Allure in an Environment of Higher Rates?

Central banks are making progress in their fight against inflation, but the exact path forward is unclear. For insurers looking to put their next dollar to work, higher rates have presented an opportunity to increase new money book yields in 2023.

The reshuffled yield landscape also raises questions of where the next dollar should go as private market exposures grow. We’ve discussed our view of private allocations and the attractiveness of increasing them over the long term. But even with private-debt fundraising back above trend levels in the second quarter (Display), insurers should ask a few key questions about their private allocations over more immediate horizons:

Does the return still fully compensate me for the added risks? Private spreads increased slower than their public counterparts, but as we’ve settled into the higher-rate environment, we’re once again seeing private markets offer yield premiums over public equivalents. So, we believe that insurers will have more instances to answer “yes” to this question than they had at the start of the year.
Does the private asset diversify and fortify my balance sheet? Genuine diversification is very valuable in volatile times. If diversification in some segments isn’t commonly available through public markets, it will drive demand for private assets. We believe that this is still very much the case.
Do I still have capacity to take on illiquidity today? The answer to this question will depend on how insurers’ liability profiles have been altered, a topic we’ll examine next in the asset-liability matching (ALM) section.

Private Debt Fundraising: Rising and Above Trend

Institutional Capital Committed to Private Debt Funds

Institutional capital committed to private debt fundraising since mid-2017

Past performance does not guarantee future results.
As of June 30, 2023
Source: Preqin

2. Within ALM positioning, are there any second-order impacts from rising rates?

At the start of 2023, we called for insurers to be mindful of positive convexity in liabilities. The concern was that when rates rise, liability convexity can magnify declines implied by duration alone. Policy lapses are the culprit, as policyholders face a broader set of attractive products when rates are higher. Higher day-to-day living costs may also spur customers to surrender policies as a way to fund basic needs. We didn’t expect this to be a significant draw on liquidity, but we’ve seen evidence of policy lapses crystallizing, particularly in the property and casualty space, with customers facing higher renewal costs.

We continue to recommend scrutiny with ALM positioning, particularly focusing on dollar-value approaches over duration alone, given that asset and liability values are still more volatile than they’ve been in years. Insurers should also revisit their liquidity stress-testing scenarios, ensuring they’re still appropriate and considering a suitable range of plausible scenarios. It’s also important to consider where to source liquidity and ensure that asset managers have robust systems and processes to raise needed liquidity in a cost-effective and timely manner.

3. What’s the best way to take advantage of opportunities that emerge in volatile markets?

So far, 2023 has been volatile for most markets, and while equity volatility is down, interest-rate volatility is still very high relative to the recent past (Display). This has opened up opportunities for insurers, though capitalizing on them as they appear can be easier said than done.

Equity Volatility Is Down, but Rates Are Still Volatile

Equity and Interest-Rate Volatility

Past performance does not guarantee future results.
Equity volatility is represented by the VIX (Chicago Board Options Exchange Volatility Index) and interest-rate volatility by the MOVE (Merrill Lynch Option Volatility Estimate).
As of July 7, 2023
Source: Bloomberg

For instance, internal governance processes on strategic asset-allocation positioning, regulatory-capital considerations, operational expertise and managing accounting impacts must be addressed before gauging appetite and shifting opportunistically among asset classes. That’s why we think it makes sense to carve out part of an overall fixed-income allocation for dynamic multi-sector approaches, incorporating solvency and accounting considerations, to help exploit market dislocations quickly.

Our view entering the year was for insurers to be selective in fixed income, emphasizing quality and diversification as the market shifted its focus from inflation concerns to recessionary worries. We haven’t yet seen the ultimate outcome of central bank actions and their effect on bonds, so we continue to lean toward quality, keeping portfolios highly diversified.

The diversification toolkit includes tactically diversifying allocations and tapping the full universe of investable asset classes, risk profiles and geographies. It's not uncommon to see vast dispersion across fixed-income segments (Display), so the ability to analyze these distinctions and invest flexibly can help position portfolios optimally—an aspect of portfolio construction we think will be critical for insurers going forward.

Why Multi Sector? Because No Bond Sector Leads All the Time

Yearly Returns (in US Dollars)

Past performance does not guarantee future results. These returns are for illustrative purposes only and do not reflect the performance of any fund. Diversification does not eliminate the risk of loss. All returns in USD. An investor cannot invest directly in an index or average, and they do not include sales charges or operating expenses associated with an investment in a mutual fund, which would reduce total returns. US high yield (HY) is represented by Bloomberg US Corporate High Yield; EMD (Emerging Markets Debt) USD is represented by JPM EMBI Global; bank loans are represented by Credit Suisse Leveraged Loan; US investment-grade (IG) corporate is represented by Bloomberg US Corporate Investment Grade; Developed market (DM) gov’t debt is represented by Bloomberg Barclays Global Treasury Index; Global high yield (HY) is represented by Bloomberg Barclays Global High Yield Index; Global investment-grade (IG) corporate is represented by Bloomberg Barclays Global Corporate Index; Cash is represented by Bloomberg Barclays U.S. Treasury Bill Index; Euro investment grade (IG) is represented by Bloomberg Barclays Euro Corporate Index.
As of June 30, 2023
Source: Bloomberg, Credit Suisse, J.P. Morgan and AB

4. What impact will International Financial Reporting Standard (IFRS) 9 have on my strategy?

At the beginning of the year, we pointed out that the International Accounting Standards Board’s implementation of IFRS 9 might spur insurers to review equity allocations to make sure they’re optimal.

Under the new accounting standard, listed equity will most commonly be treated as fair value through profit and loss statements. That’s different for insurers who previously accounted for equity as Available for Sale, with unrealized gains/losses reflected through Other Comprehensive Income. The change could bring more financial statement volatility.

As insurers think through rotating out of listed equities, we still believe high yield can offer a compelling replacement. Over the long run, it has around half the volatility of equity and about half the return but comes with less than half the capital requirement. Under the new standard, fixed-income assets will require a determination of whether cash flows represent solely payments of principal and interest (SPPI), and with that a new impairment approach. We believe it’s a relatively straightforward process to structure a mandate that includes a vast majority of assets that pass the SPPI test.

This rotation helps insurers from an accounting perspective, and we also think the current environment presents an attractive entry point. At the end of June, the global high-yield market yielded more than 9%. Our research shows that current yields are one of the most reliable indicators for five-year forward returns. Lastly, with the yield curve inverted, shorter-duration high yield seems like an attractive equity substitute without taking on significant interest-rate risk.

5. Will geographic diversification become more cost-efficient?

Over the course of the year, we’ve continued to keep an eye on trends in currency-hedging costs, specifically in the context of European insurers’ ability to diversify core portfolios by using non-domestic debt markets. Costs are still high, but they’ve continued to trend down during the year and are now at their lowest level in the last couple of years (Display).

Lower Hedging Costs Bolster Geographic Diversification Opportunities

US Dollar to Euro Three-Month, One-Year and Five-Year Hedging Costs (Percent)

US dollar to euro three-month, one-year and five-year hedging costs in percent

Past performance does not guarantee future results.
As of June 30, 2023
Source: Bloomberg and AB

In the second quarter of 2022, euro-denominated investors would have given up an annualized 2.67% to hedge US-dollar asset exposure back to euros on a three-month basis; by the second quarter of 2023, that cost had fallen to 1.85%, given the change in relative interest rates. As that cost continues to decrease, opportunities for geographic diversification should grow more attractive—the dollar may give back some of its gains as the Fed approaches its terminal interest rate.

We’re seeing doors open for European insurers to include exposures with strong relative value based on spread over the solvency capital requirement, including investment-grade emerging-market debt and global corporate credit.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

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