Investment executives at U.S. life insurance companies continue to lose sleep over identifying the best reinvestment opportunities for maturing debt in which they invested a decade ago. With interest rates much lower now than before the financial crisis, the challenge for life insurers is to find new investment classes that meet their yield requirements without taking on additional risk. To meet the challenge, insurers are increasing their exposure to classes to which they have traditionally shown scant interest. As a function of this, they continue to seek to acquire more internal resources, i.e. staff with the requisite investment skills, and to outsource investment in those classes.
When asked what is a difficult challenge for them currently, “the most frequent response you get from insurance investors is the challenge of investing in a low– or rising-interest-rate environment, according to David Holmes, managing director at Insurance Asset Outsourcing Exchange, a research unit established by Louisville, Kentucky-based asset management consultancy Eager, Davis & Holmes. “If you go back 10 years, interest rates were much higher. Longer term bonds were paying about 7% then. Now, as insurance funds look to reinvest those assets, it’s problematic. They can’t get the same rate now. Finding a way to earn a return that allows them to stay competitive and to remain profitable remains quite a challenge,” Holmes said.
“Yes, that is happening; we have data to verify that,” concurred Mark Snyder, global head of institutional strategy and analytics for J.P. Morgan Asset Management. The situation is primarily affecting life insurers, he explained. “The life insurance industry uses book-yield accounting as a key measure—and this is in most cases the purchase yield of bonds. Insurers buy bonds that generate sufficient interest income to allow them to pay their policyholders’ claims and generate profit,” he said. “What we’ve seen in the past few years is that from 2014 to the end of 2017, for a large representative set of life insurance companies, the book yield on their fixed-income portfolios fell from about 4.8% to about 4.2%–so it’s falling about 20 basis points per year. That’s the yield on all bonds as well as commercial mortgage loans. So, this is creating problems because life insurance companies generate their income primarily from their fixed income portfolios,” he explained.
U.S. life insurance companies aggregate approximately $3.9 trillion of balance sheet assets. Snyder noted that as a regulated industry in which life insures seek exposure primarily to high-quality investments, they do not have a wealth of investment options from which to choose.
Life insurers have typically weighted their portfolios 90-95% in fixed income, Snyder said. He pointed to trends that he has seen developing in insurers’ investment strategies, which include increasing allocations to:
- Emerging market debt;
- Taxable municipal bonds;
- Middle market commercial mortgage lending;
- Income generating alternatives, such as infrastructure equity and leasing strategies;
- High yield private credit.
He said that concerning emerging markets “it tends to be investment grade and U.S.-dollar denominated debt, both corporate and sovereigns. They are using the class to offset declining re-investment yields, which is due to both lower interest rates and tight spreads across the board. This activity is not unprecedented, but we’re talking about increasing allocations that used to be one percent up to three percent of their overall investments. Some companies have historically held allocations in the class around three percent or four percent, but now other companies are catching up with them, increasing these allocations.”
Due to changes to the U.S. tax code at the end of 2017, investing in certain long-duration tax-exempt municipal bonds is now favorable for life insurers, where historically they only invested in taxable municipal bonds, according to Snyder. “Their focus there is in diversifying their long bond portfolios and getting incremental yield, while still invested in high-quality fixed income.” Allocations to tax-exempt municipal bonds would be in addition to the recent increases in taxable bonds.
Historically, large life insurers have done a lot of commercial real estate lending, but primarily in large loans in very large markets, represented by the top-10 metropolitan statistical areas. Now, they are moving into the middle-market space, Snyder said, underscoring that investment grade emerging market debt, munis, and high-quality commercial mortgage loans qualify as investment grade fixed-income strategies. “Insurers have been increasing or considering increasing allocations to try to offset the declining yield in their portfolios.”
On the alternative investment side, there is more interest in high-quality real assets that generate income. “Because of high-regulatory capital charges on real estate equity investments, the industry has historically focused on private equity. But we have seen a more recent interest in high-quality infrastructure equity that generates income as well as leasing strategies around transportation assets,” Snyder said. He noted that in the below-investment-grade fixed income class, the investment activity has been broadly flat. “So, there is a tension where insurers do want to get more yield in their portfolios, but spreads are historically tight on high-yield bonds as well as the fact that some insures are worried about the end of the credit cycle, where default rates may increase.”
Snyder said he has also noticed in the last few years “indications” of an increase in high-yield private credit, such as real-estate mezzanine debt, corporate mezzanine debt and high-yield private placements. “We have seen an increase in the median allocation to this among life insurers, but it’s gone from one percent to one-point-five percent—so it’s quite small overall and allocations vary dramatically from insurer to insurer.”
Timothy Matson, chief investment officer, Reinsurance Group of America, said the group’s investment portfolio has almost no equity. “But, it’s difficult to get excited about fixed-income at the moment. We’ve been on strike for triple-Bs for almost two years at this point. We’d rather either trade up in credit quality or we’d rather put the money into mezzanine debt. I mention that because we see it as alternative to public high yield. But we also don’t think you are necessarily being paid for the kind of risk you are taking with public BBB corporate debt.”
He continued that his fund’s general thinking currently is to move into illiquid assets. “We can move into mezzanine debt or move into private equity. And if you look at our non-U.S. portfolio, in the U.K. for example, we are making an effort into reverse mortgages. It’s not a traditional product for us, but it’s actually quite high yielding.”
Where are the resources?
A healthy bi-product of the changes in investment strategies that insurers are making, in response to market conditions, is more diverse investment portfolios. “So, we would think that these strategies should persist for the long term, because they are better diversified,” Snyder said. Historically, these investors did not invest in asset classes beyond their traditional core asset classes because they didn’t necessarily have the capabilities, he said. “So, these may be permanent features once they become part of the portfolios and insurers become comfortable with them,” he said.
To accommodate these non-traditional investment classes, insurers are using a combination of expanding internal resources and hiring third-party asset managers for certain mandates. “Large companies have internal investment staffs. Now that they are looking to other types of investments, like structured products, real estate, infrastructure, private equity, bank loans and emerging markets—this is the kind of investing in which they don’t have the expertise, hence the rise in outsourced investing by insurance cos (companies). Most insurance cos, except the very largest ones, don’t have that kind of staff,” Holmes said.
The Insurance Asset Outsourcing Exchange has been tracking the market since the early ‘90s, said Holmes. Outsourcing has been going on for 25 years on a regular, substantial basis, but prior to the financial crisis, relatively smaller companies—those with less than $1 billion in assets—were the most likely outsourcers, he said. “Now that has changed, and you are seeing large insurance cos doing the same thing.”
Currently, less than 20% of life insurer’s assets are managed by non- affiliated asset managers, Snyder said.