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Pushing insurers further out the risk spectrum

| October 23, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Low rates have handed insurance companies an investment challenge for most of the last decade, and 2020 has only turned up the pressure. The gap between portfolio yields and reinvestment rates has ballooned, and the levers for closing it look limited. P&C companies with long liabilities and life companies have the most exposure. Annuity providers and others carrying policies with guaranteed minimum rates may need to burn capital. It seems that trends toward ‘BBB’ exposures, private placements, loans and partnerships should only accelerate.

An accelerating drop in portfolio yield

Both P&C and life insurance investment portfolio yields have declined for more than a decade. The average life portfolio yield has dropped 148 bp since 2007, and the average P&C portfolio yield, reflecting shorter and more liquid securities, has dropped 176 bp (Exhibit 1). With the average daily yield on the 10-year Treasury note as a proxy, the gap between current portfolio yield and reinvestment rates has widened this year. The median gap for life portfolios since 2007 has run at 228 bp but currently stands at 336 bp. For P&C portfolios, the median gap has run at 103 bp but currently stands at 196 bp.

Exhibit 1: Insurance portfolio yields have dropped for more than a decade

Source: CreditSights, Inc., All Rights Reserved, Amherst Pierpont Securities.

Low reinvestment rates have already started showing up in insurers’ portfolios. Reinvestment impact depends on maturing assets and available instruments, but portfolio yields for selected publicly traded P&C insurers have dropped between 130 bp and 330 bp (Exhibit 2). Yields for selected public life insurers have dropped in a more modest range between 0 bp and 100 bp.

Exhibit 2: P&C portfolio yields have dropped further than life yields in 2020

Source: CreditSights, Inc., All Rights Reserved, Amherst Pierpont Securities.

Trouble for some, less for others

Falling portfolio yields could spell trouble for some insurers but much less for others. A lot depends on the insurer’s liabilities.

P&C insurers with short liabilities should have the best chance at managing around falling yields. Any P&C insurer’s annual results depend primarily on a combination of investment and premium income net of claims and expenses. Insurers that write short contracts, such as auto and homeowners’ policies, can raise premiums as contracts renew to offset a drop in investment income. If all insurers in a particular segment face the same reinvestment opportunities, all should have incentives to raise premiums. Using portfolio holdings with fixed maturity as a proxy for liabilities, examples of companies with shorter liabilities include Progressive, Liberty Mutual and Allstate (Exhibit 3). These companies should be able to absorb low reinvestment rates and raise premiums, at least within the range allowed by competition.

Exhibit 3: Debt maturities reflect shorter P&C liabilities, longer life liabilities

Source: CreditSights, Inc., All Rights Reserved, Amherst Pierpont Securities.

P&C insurers with longer liabilities or life insurers do not have the luxury of quickly offsetting lower investment income with higher premiums. The original insurance contract assumed a return on investing premiums sufficient to cover claims, expenses and return on capital. With this year’s sharp drop in reinvestment rates, return on capital looks likely to take a hit. Insurers that have written policies with guaranteed minimum returns or minimum crediting rates may have to add reserves or dip into capital to cover obligations. Prudential, MetLife, Lincoln National, Brighthouse and AIG, among others, have all reported contracts currently at their minimum rates, with many of those rates between 3% and 4% or more.

Trends toward higher yielding, less liquid assets likely to accelerate

Both P&C and life insurers have battled declining yields for years by drifting down in credit. ‘BBB’ exposures between 2011 and 2019 in P&C portfolios rose from 24% to 32% (Exhibit 4). At life insurers, ‘BBB’ exposure rose from 37% to 42%. Since NAIC capital charges more than triple to go from ‘BBB’ to high yield, going further down in credit is an unlikely option. Instead, insurers are much more likely to build ‘BBB’ exposure at an even faster rate.

Exhibit 4: Both P&C and life portfolios have steadily added ‘BBB’ exposure

Source: CreditSights, Inc., All Rights Reserved, Amherst Pierpont Securities.

Insurers have also fought the yield fight by capturing the yield premium on less liquid assets. Private placements in recent years at P&C insurers have run from 9% of fixed income holdings to more than 16% (Exhibit 5). At life insurers, private placements have gone from nearly 28% of fixed income to nearly 36%. Life insurers have further capitalized on their long liabilities and their capacity to hold less liquid assets by building positions in CLOs, commercial mortgage loans and, in some cases, residential mortgage loans. Some have added term repo to the mix.

Exhibit 5: Both P&C and life insurers have also added private placements

Source: CreditSights, Inc., All Rights Reserved, Amherst Pierpont Securities.

Another area with room to grow is partnerships with private equity and hedge funds. For many insurers, these represent outsourced expertise in managing often less liquid assets or other investment strategies. Although capital charges for partnerships can run high and oversight can put demand on insurer management, the dispersion of partnerships across insurers as a share of investment portfolios suggests room to grow, at least for some (Exhibit 6).

Exhibit 6: Room at some insurers to grow private partnerships

Note: figures for P&C as of 2Q2020, for life as of 4Q2019.
Source: CreditSights, Inc., All Rights Reserved, Amherst Pierpont Securities.

Impact on markets

Unlike banks that are almost forced to reinvest as the Fed continues QE and deposits rise, insurers will likely need to respond to more mundane pressures for profitability. But like banks, low rates and tight spreads on risk assets make it a sizable challenge. Outside of insurers that can quickly reset premiums, the path of least resistance for others is to continue trends already in place: more ‘BBB’, more private placements and loans and possibly more partnerships.

* * *

The view in rates

The sharp steeping in the yield curve in the last week highlights rising sensitivity to inflation risk. The 2s10s curve has moved to 69 bp and the 5s30s to 126 bp, both near the steep end of their range this year. QE, the Fed’s flexible average inflation targeting and possible fiscal stimulus are all helping. With a Democratic sweep, the prospect of Biden’s proposed $4 trillion of additional federal spending over the next 10 years would add to the pressure. Some of the pressure toward higher, longer rates comes from supply, some from potential inflation. The market now bids 10-year breakeven inflation at 175 bp, up 4 bp from roughly a week ago and slightly below the 180 bp peak right after Jackson Hole.

The view in spreads

The next leg of tighter spreads should come after the conclusion of the coming elections. That conclusion may land well after November 3. At that point, an important element of uncertainty should resolve, and risk assets should rally. In the aftermath of elections, risk assets remain caught between Fed buying on one hand and heavy net supply of Treasury debt on the other. There is still fundamental risk in the most leveraged corporate balance sheets with corporate leverage going up through 2020, and only there might spreads continue lagging the rest of the market. However, expected inflation could help valuation of leveraged balance sheets and households by allowing repayment of nominal debt with inflated dollars.

The view in credit

Fundamental credit remains as uncertain as the economy, and the lack of new fiscal stimulus increases risk for households and small businesses. The downside in leveraged credit has outweighed the upside since March, and the imbalance without fiscal stimulus looks likely to get worse. Many investment grade companies have stockpiled enough cash to survive protracted slow growth, but highly leveraged companies and consumers are at risk. High yield and leveraged loans have nevertheless done well. But the hard part is about to start as winter approaches and some of the outdoor activity that sustained bits of the economy starts to go away.

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