UK insurers are unlikely to significantly increase their investment risk in the near term in an attempt to boost returns, despite the threat to earnings created by persistent low interest rates, Fitch Ratings says. We expect the proportion of risky assets on UK insurers' balance sheets to remain broadly stable, and in some cases they could decline as new regulations come into force.
Persistent low interest rates are a challenge for insurers because they both limit the returns they can generate on investments and can also increase their liabilities. A speech by a UK Financial Services Authority official recently highlighted a concern that insurers may chase yields via riskier investments. While we do not expect a significant increase, we monitor investment risk as part of our ratings and have investment ratio guidelines for the level of risk suitable for different credit ratings.
In general, the median ratio of equity assets to the firm's own equity we consider suitable for a 'AA' rated life insurer is 27% and for an 'A' rated firm 45%. This includes positions in derivatives, hedge funds and private equity vehicles, although we would view these types of investment more cautiously. The overall proportion of risky assets (which includes non-investment-grade bonds and investments in affiliates, as well as the equities category above) to equity consistent with a 'AA' rating is 50%, while for 'A' it is 75%.
Most major UK life insurers have reduced these ratios in recent years and are comfortably within the ratios suitable for their current ratings. UK insurers have also written less guaranteed business than those in other countries, reducing their need to obtain high returns to make guaranteed payments.
For example, Legal & General ('A'/Stable) cut its ratio of risky assets to equity from 53.9% in 2008 to 34.9% in 2011, and its ratio of unaffiliated equities to equity from 35.3% to 17.8% over the same period. We expect these ratios to continue to drop because of the higher risk charges that are likely to be applied to these assets under Solvency II rules, although this will depend on the final timetable for implementing the new rules, which could be delayed from the current 2014 target.
If insurers did start to increase their holdings of risky assets, we would particularly be on the lookout for unusual investment strategies, such as those involving esoteric instruments and less liquid investments, or any increased concentration by name or sector.
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