Reallocation opportunities for insurers under Solvency II
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'Cash is king' remains at the forefront of many investors' defensive allocations. However, ultra-low cash rates, rising bond yields and inflation are proving a material drag on portfolio returns.
This is particularly evident in the insurance sector where, due to the stringency of Solvency II capital requirements, hundreds of billions of euros in cash are thought to sit uninvested on insurers' balance sheets.
"Cash may be the safest asset class, but there are others that can potentially offer a modest, but still significant, premium while keeping expected default and credit risks low."
Insurers have good reasons to stay cash rich. Liquidity is essential for meeting liabilities and, against an uncertain financial, macroeconomic and geopolitical backdrop, adding risk goes against many instincts. But rising inflation suggests that hoarding excessive cash is a likely way to lose serious amounts of money in real terms over the long term.
Fortunately, there are degrees of risk one can take. Cash may be the safest asset class, but there are others that can potentially offer a modest, but still significant, premium while keeping expected default and credit risks low.
Out-of-cash options for insurers
The first step out of cash for many investors is usually government debt. Short-dated yields are already pricing in anticipated central bank rate rises. However, these securities present material duration risks, which means investors should be prepared to hold them until maturity.
Short-dated corporate bonds may offer some potential additional opportunities to earn a yield premium, although arguably not at an aggregate level, given the outsized weighting of lower-rated issuers in many investment grade indices. A notable feature of corporate bond markets is spread dispersion – that is, a relatively wide range of spreads available on bonds with identical credit ratings – which can help investors to manage relative risks and rewards.
And often overlooked are alternatives, such as AAA asset-backed securities (ABS), which offer the additional feature of floating rate coupons alongside a comparable level of income to lower-rated corporate bonds.
It is worth noting that European ABS do not share the historical default experience of their US counterparts. European residential mortgage-backed securities (RMBS), for instance, have averaged defaults of 0.3%pa across all credit ratings (including high yield) since inception – a period that includes double-digit interest rates in the 1990s and the 2008 global financial crisis – compared to 4.9% in the US.
For a full analysis of the options, read our 'Cash dethroned: reallocation opportunities for insurers under Solvency II' paper.
For Investment Professionals only. The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.
