Rising rates have been largely favorable for U.S. life insurer investment portfolios, driving higher investment income as reinvestment rates exceed book yields, helping to mitigate macroeconomic headwinds, market volatility and the heightened probability of mild recession in 2023, Fitch Ratings says.
Continued macroeconomic volatility and mounting recessionary pressures will challenge market-based returns, eroding variable-rate investment income and fee-based income. However, investment portfolios of Fitch-rated life insurers are largely comprised of stable, high-quality investments, with fixed income securities making up the bulk of invested assets. Offsets to recessionary scenarios include the industry’s strong liquidity position and cashflow matching of assets and liabilities.
Impairments are expected to rise modestly in 2023, but losses should remain benign across most asset classes. Credit fundamentals remain strong, with interest coverage and leverage at pre-pandemic levels, though market volatility is substantial, and the industry has material unrealized loss positions on fixed-income portfolios.
Insurers continued to increase exposure to less liquid, more esoteric asset classes such as private placements and commercial mortgage loans in search of yield and to capture illiquidity premiums during persistently low-rate environments, while maintaining 94% investment grade portfolios.
Liquidity in credit markets initially declined during the pandemic as default expectations rose, widening credit spreads and resulting in opportunistic purchases. Widening spreads, while positive and often reflecting market illiquidity or investor aversion to long-duration assets, can also represent repricing of risk and heightened probability of a recession.
Improving investment yields largely benefit the industry, but rapidly rising interest rates can result in disintermediation risk which can trigger material policyholder surrenders and lapses if yields on existing portfolios lag those offered on non-insurance or new money products offered by competitors. While surrenders and lapsations have increased YTD given the rising interest rates, the uptick has been manageable thus far and partially curtailed by surrender charges and market value adjustments.
Alternative investment income is expected to continue to normalize from record results in 2021. The increasing role of alternative investment managers in the life insurance industry has been largely neutral for insurers. However, regulatory/accounting changes and challenging macroeconomic conditions are driving major shifts in product strategies, with changes in the competitive landscape that may have longer-term credit implications for the industry.
Buying opportunities amid market volatility will depend in part on the asset class, product structure, and yield curve positioning. Insurers have been focusing on liquidity and capital, often buying into higher-quality asset portfolios amid increasing recessionary pressures. In volatile or weakening markets, sufficient liquidity is necessary to take advantage of attractive buying opportunities, while exposure to asset classes that offer protection or hedge risks within investment portfolios protection can stabilize returns and truncate downside risks. Insurers have generally underweighted emerging market debt, which has tended to underperform during rising rates and a strong USD.
The favorable upgrade/downgrade ratio of investment opportunities since 2021 is expected to normalize into 2023. “Real assets” that traditionally offer inflation hedges such as residential and commercial real estate could be less effective, given higher financing costs, but this could moderate if interest rates stabilize. Distressed commercial properties may see material market devaluations, including in commercial properties in central business districts in major metropolitan cities.