A new report from Fitch Ratings has found that European insurers' investments are becoming riskier and that although the increase in risk is small and likely to remain so, it could ultimately have negative rating implications.
Fitch believes that generating sufficient investment yield in the current low interest rate environment is the biggest challenge currently facing the European insurance sector. One possible way for insurers to compensate this is to shift asset allocations out of bonds and into asset classes with potentially higher investment returns; ie, equities, real estate or alternative assets. However, most European insurance companies have not adopted this strategy. Exposure to equities and real estate has actually declined on average in the European insurance sector over the past five years, and alternative assets still play only a minor role.
While there has not been a huge shift by insurers from bonds into riskier asset classes, credit risk exposure within bond portfolios has materially increased. There has also been a tendency for insurers to invest for longer durations. Although the increase in risk within bond portfolios has not reached a level that would result in downgrades, Fitch views this development as potentially credit negative.
Fitch believes bond prices look high across the entire risk and duration spectrum. If interest rates rise, credit spreads would likely also rise. Thus, the value of higher-risk bonds would suffer more than low-risk bonds, and that of longer-duration bonds would suffer more than shorter-duration bonds. Overall, the value of insurers' bond portfolios is now more vulnerable to interest rate rises.
Although insurers' focus on alternative assets has increased over recent years, actual investment allocation in this asset class represents only a small proportion of total invested assets. Limited investment opportunities and complex due-diligence processes are partly responsible, with investment in these asset classes generally limited to large insurance companies with the necessary skills and resources. Unfavourable treatment under Solvency II is also an obstacle.
However, Fitch expects the situation to change. There is a clear need for more investment in infrastructure and alternative energy projects, and governments are limited by budgetary constraints. Consequently, alternative investment opportunities will increase over the next few years, and some insurance companies may be suitable investors given their need to match long-term, illiquid liabilities.
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