BlackRock’s annual insurance industry outlook suggests that insurers will face fixed income dilemmas in 2014. The outlook suggests that insurers are likely to re-examine their allocations to fixed income assets and invest in new financial instruments, in response to prolonged low interest rates, regulatory changes, and profitability worries
Insurers need predictable cash flows to meet underwriting liabilities, but are struggling to generate enough income through traditional fixed income investments to meet their liabilities and provide competitive products. Because of this squeeze on income streams, BlackRock believes insurers will relax investment guidelines and embrace more alternative investment products.
Patrick Liedtke, Head of BlackRock’s Financial Institutions Group in Europe, said, “This is a critical time for insurers. Profitability is being hurt by intense competition on the liability side, while poor returns from traditional fixed incomes assets and costs to comply with impending regulation are adding to the pressure.”
Alternative income sources
BlackRock predicts risks in traditional markets will prompt firms to increase exposure to alternative sources of income like collateralized bank loans and infrastructure debt, as well as real estate debt and mezzanine debt instruments. Insurers will have to embrace less liquid and alternative investment strategies that offer attractive risk-adjusted returns.
Conservative insurers have generally avoided these types of investments, but in the last three years the assets BlackRock manages for insurers in alternative fixed income products have increased fivefold to $11.4billion from $2.1billion. Additionally, a recent client study of 20 large insurers with $2 trillion of assets found 60 per cent intended to increase allocations to real estate, 50 per cent intended to increase allocations to real assets like infrastructure, and a third intended to increase allocations to private equity.
“Insurers are looking for uncorrelated returns in diversifying assets and are interested in harvesting proceeds from investing in less liquid asset classes. Being generally flush with liquidity, they are willing to take more illiquidity risk to get the returns they need,” Mr. Liedtke commented.
Regulation challenges
Preparations for regulations like Solvency II in Europe or the Own Risk and Solvency Assessment in the US will see insurers further upgrade risk management systems and add compliance staff to cope with increased regulatory and reporting requirements, BlackRock predicts.
Mr. Liedtke said, “Efficient use of capital and optimizing asset management strategies in a compliant fashion with impending regulation will undoubtedly be a theme driving activity globally; but this will have its costs.”
Profitability and business impact
BlackRock’s outlook also warns stronger demand for - and limited availability of - alternative capital like insurance-linked securities will pressure reinsurance pricing, mounting further strain on insurers’ profitability.
Consequently, BlackRock expects further growth in insurers’ use of exchange-traded funds for lower-cost, liquid exposures to many credit markets.
Mr. Liedtke added, “Ultimately, if insurers’ profit margins dwindle and the costs of doing business keep going up, then those players that do not fully exploit the return potential of their assets will have to stop offering some lines of less profitable business. This could mean less choice for end consumers of those products.”
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