The insurance business rests primarily on two pillars: distribution, the liability side of an insurance company’s balance sheet, and investment management, an insurer’s ability to maximize returns by managing its assets relative to what the liabilities and the regulators demand.
With both sides of European insurance companies’ balance sheets currently under tremendous pressure, we see profound changes that are ongoing and even accelerating, particularly in the life insurance business, as the European yield curve flattens and Solvency II approaches. Given the secular – not cyclical – nature of these changes, what conclusions can we draw from current European insurance trends in investment and product development?
Current pressures and challenges
The pressure stemming from the low yield environment is the source of the most acute challenges facing European insurers’ management of their existing stock of assets as well as the generation of new business. This pressure has dramatically increased over recent months as the European Central Bank first telegraphed and subsequently implemented a full-blown quantitative easing program in March 2015, with adverse effects for Europe’s insurance industry. And it is no exaggeration to say that the European life insurance sector, in particular, started 2015 in a state of emergency, facing an environment of prolonged ultra-low bond yields.
The persistent low-to-negative yield environment, combined with the upcoming Solvency II regulatory regime, creates challenges on both the liability and the asset sides of insurers’ balance sheets. In general, medium- and large-sized European insurers with diversified business models and well-capitalized conglomerates will manage to deal with this changing environment, and may even benefit longer term from the heightened stress affecting the industry. However, with smaller and less well-capitalized monoline insurers already under stress, we expect the consolidation of the insurance industry in Europe to gain momentum.
In our view, the key challenges facing the European insurance industry, especially life insurers, can be summarized as follows:
- Delivering returns that match or exceed past promises. This is more a “stock” than a “flow” issue, and it tends to affect long-dated liabilities of life insurers that hold large legacy books of traditional insurance policies with both capital and yield guarantees, and with little – if any – scope for modification (Germany’s life insurance industry is a case in point).
- Delivering returns that participate in earnings generation. This is a challenge for all insurers as the income contribution to earnings from the investment portfolio is bound to be lower than historical standards in this environment of structurally lower rates of return across capital markets.
- Offering compelling retail life insurance solutions. Now and over the horizon, retail solutions will likely embed less capital or return guarantees than in the past – the traditional life insurance policies that many end clients remember and desire simply cannot coexist with the low yield environment and the punitive Solvency II capital charges.
- Balancing short-term risk management considerations and long-term profitability targets. When yields decline, duration and convexity mismatches between the asset and the liability sides of insurers’ balance sheets tend to lead to an increase in capital charges and a decrease in regulatory capital ratios. These, in turn, encourage the insurers’ risk management functions to direct investment transactions that are pro-cyclical, such as lengthening the duration of the bond portfolio when bond yields are at record lows. As my colleague Harley Bassman pointed out in his April 2015 Viewpoint, “An Open Letter to the Eurozone,” “Buying assets that yield less than the cost of liabilities may satisfy current statutes, but it almost certainly assures an eventual shortfall.”
How has Europe’s insurance industry responded?
Facing acute and profound challenges, European insurers have responded with clear regime shifts in insurance asset management as well as in the production of new life contracts. We have observed several key industry trends in Europe:
Key trends on the asset side of the balance sheet
- Increased asset allocation diversification away from traditional investments. The stock of European government and covered bonds should remain high for a while as these legacy positions typically have high coupons and show large unrealized gains. Insurers would typically avoid selling such positions as this would generate large gains as well as reduce the average book yield of the investment portfolio. The flow of new investments, however, has a greater global orientation (including allocations to emerging market debt, U.S. credit, etc.) or tilts away from traditional core investments toward alternatives, such as real estate, private equity funds and infrastructure (debt and equity).
- Greater propensity to sell liquidity than in the past. The world in which insurers maintained large pure cash positions belongs increasingly to the past. The low yield environment has encouraged insurers to revisit their asset allocation practices, including liquidity, which has not received much scrutiny in the past. Historically, insurers have gravitated toward investments with more liquidity than is actually required. More recently, however, insurers have focused on illiquidity risk premiums as a critical source of return. We also noticed that European insurers are increasingly implementing the “ongoing concern” principle, which results in a higher tolerance for duration risk on the asset side of the balance sheet. As a result, property and casualty (P&C), health and travel insurers with short-dated liabilities have tended to increase their asset duration and “sell” liquidity.
- Increased opportunities from volatility. As capital markets have become less liquid and potentially more volatile, we expect insurers, with their longer-term investment horizons, to benefit from their position as liquidity providers and to stand ready to benefit from spikes in market volatility. Practically speaking, insurers could sell volatility explicitly by selling options; but they could also sell volatility implicitly by investing in securities with embedded options or by extending duration. In general, insurers are increasingly seeking investments in illiquid, long-dated, high quality assets with attractive risk premiums.
Key trends on the liability side of the balance sheet
- Expectation for higher premiums. All else being equal, in a world of lower asset returns, the profitability on the liability side will be pressured, and we expect European insurers will likely respond by distributing higher-margin products.
- The potential demise of the traditional life insurance contract. The view that guaranteed capital and returns are no longer feasible in the current low-to-negative yield environment has reached consensus among European life insurers. Market returns are too low to offer retail clients attractive returns (net of fees), and the traditional life insurance business model is broken. Because of their guarantees, such traditional offerings are subject to higher capital charges under Solvency II, encouraging life insurers to terminate legacy contracts and cease selling traditional policies. Recent earnings releases by large European life insurers document the decline in the production of traditional guaranteed policies.
- Priority given to the distribution of unit-linked and multi-asset hybrid solutions, which combine both traditional life and fund investment features, with fewer guarantees to the retail client, yet with the potential for attractive returns. From a life insurer’s perspective, such “guarantee-light” products are less risky and exhibit lower Solvency II capital charges versus traditional life insurance contracts. For these reasons, many chief risk officers strongly encourage distribution of such products.
As a side note, we would question to what extent the disappearance of the traditional life contract is a good thing, and whether it is definitive. After all, the concept of pooling investments in a “general account” actively managed for a relatively low fee by a team of investment professionals and that targets asset diversification and long-term value generation would seem attractive in many ways, regardless of market circumstances. Pooled accounts may target liquidity and volatility premiums that are more difficult to attain for individual retail solutions. Hybrid products that combine the benefits of a pooled investment with individual fund solutions could appear particularly attractive in the current environment.
In the context of these challenges, PIMCO has been increasingly working with European life insurers on new products aimed at limiting regulatory capital charges and that are often multi-asset in nature, with a low level of guarantees by the insurer to the end client, if any.
In the final analysis, European insurers have demonstrated a high degree of agility and innovation on both the asset management and the liability side of their balance sheets.
Looking ahead, we believe innovation will remain an essential tool for Europe’s insurance industry and we expect the convergence between asset management and insurance underwriting to accelerate. In particular, life insurers are expected to increasingly offer solutions that seek to combine both insurance benefits and asset management solutions, and that are regulatory capital-friendly. Although these products tend to be “guarantee-light”, they should continue to attract retail demand in the context of an aging population in need of innovative savings solutions.