By Cyril Tuohy
Insurance carriers can enhance risk-adjusted returns by diversifying portfolios into nontraditional and alternative asset classes, according to Conning research.
Since the financial crisis, yield spreads on many sectors of the bond market, including corporate bonds, have narrowed dramatically. But carriers that manage to squeeze higher yields from their fixed income portfolios have the potential to increase profits.
Mike Haylon, managing director at Conning, said that over the past five years within the investment-grade bond portfolio, insurers have increased their exposure to BBB-rated corporate debt, the lowest investment grade rating assigned by debt ratings agencies.
“BBB bonds are about 32 percent of the life insurance industry’s aggregate bond portfolios but in 2007 they were 26 percent,” Haylon said in an interview with InsuranceNewsNet.
Wall Street analysts who cover the nation’s largest publicly traded life and annuity carriers say that as interest rates decline, insurance companies that rely on spread businesses are being hurt as cash flows are reinvested in bonds that pay lower rates of interest.
BBB-rated corporate bonds typically pay higher rates of interest than A-rated or AAA-rated bonds, but they also expose carriers to more risk.
Insurance carriers that diversify out of BBB-rated corporate bonds and into other nontraditional asset classes such as emerging markets debt, fee-based master limited partnerships or even insurance-linked securities can often enhance portfolio yields and increase diversification.
Haylon said certain emerging markets — such as Mexico — for instance, are far less “emerging” today than they were 20 years ago and that makes them a safer place to invest than in the past.
Political unrest, inflation and other issues that hammered emerging economies at the end of the last century aren’t nearly as prevalent as they were back then.
“Many of these countries have implemented economic and fiscal reform and lowered their budget deficits and are not benefiting from higher credit ratings,” said Haylon, a bond expert. “About 70 percent of emerging market debt indices are represented by investment grade issues.”
Conning research shows that the life insurance industry has less than 1 percent of invested assets in emerging market debt even though emerging market countries are contributing to over 50 percent of global gross domestic product (GDP).
Government debt in developed countries consists of 106 percent of GDP, while debt in emerging markets only represents 40 percent of GDP as of the end of 201.Meanwhile, the ratings of emerging markets debt issuers have been increasing.
“Higher allocations to investments beyond certainly nontraditional alternative sectors can result in higher portfolio returns for a given amount of risk,” Haylon said.
The American Council of Life Insurers reports that in 2013, U.S. insurers held 32.1 percent of assets in corporate securities, but only 1.3 percent of assets in foreign government securities.
Haylon said that despite surveys showing that more than 80 percent of insurance company CEOs claim to be diversifying portfolios beyond traditional fixed income assets, the industry’s allocation to bonds has been increasing over the last five years.
“We haven’t seen evidence of higher levels of diversification in many life company portfolios,” Haylon said. “In many cases we’ve seen more concentration.”
“The allocation of the portfolio to corporate bonds is ticking up relative to mortgage-backed securities, and within the bond category, the allocation to BBB-rated bonds is ticking up relative to A-rated and AAA -rated bonds,” he said.
In fairness to insurers, which are heavily regulated, portfolio managers have more to think about than yield.
They need to grapple with earnings volatility, the impact on risk-based capital ratios and the impact of their investment decisions on the ratings agencies, he said.
“Many times you have to educate companies to the advantages of other asset classes,” Haylon added.
“They also need to be comfortable about the impact from a regulatory and from an accounting standard.”
InsuranceNewsNet Senior Writer Cyril Tuohy has covered the financial services industry for more than 15 years. Cyril may be reached at [email protected].
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