EMD and insurers: strange bedfellows?

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Emerging market debt strategies can offer a range of benefits to insurers, say Uday Patnaik and Mehdi Guissi of Legal & General Investment Management

Emerging market debt (EMD) is still not seen as a core asset class for many European insurers, due to concerns over its risk/return profile, credit spectrum and market capacity. We believe these concerns are misplaced.

EMD strategies can actually, in our view, help life and general insurers meet some of the challenges they face today, as a building block within liquidity, liability-driven investing (LDI) and growth portfolios.

Our research suggests that the astute deployment and implementation of the asset class can help to achieve excess returns versus conventional investment grade (IG) credit, enhanced diversification and balance-sheet efficiency.

Ratings and spreads

Investors understandably focus primarily on the risks when considering whether to hold EMD, prompted by memories of sovereign defaults and shaky economic fundamentals.

But the credit rating differential between emerging and developed market sovereigns has compressed by about six notches over the past 20 years, with global spreads tightening as a result.

This move has been partly driven by an increase in the ratings of emerging economies such as China, Chile, Slovakia, and the Philippines; indeed, around 50% of the $3.1 trillion or so in the hard currency, emerging market (EM) corporate and sovereign bond universe is now IG. There has also been a deterioration in developed-market risk in the wake of the global financial crisis – of which Italy's recent travails serve as a timely reminder.

At the same time, prudent fiscal policies adopted by many emerging economies have helped to keep public debt/GDP ratios from expanding at the fast pace seen in developed markets following the crisis, in a clear structural break from past behaviour.

This break is also reflected in the paradigm shift seen in the way emerging markets, led by China, contribute to global growth. In the 1980s, their economies generated 30% of global GDP growth, versus 70% for developed economies; today those numbers have flipped, with emerging markets now contributing 70%.

There are, of course, marked variations in the credit quality and economic positions of individual emerging markets. However, we believe that these idiosyncratic risks can be addressed – and turned into opportunities – through the analysis of issues such as corruption, income inequality and national politics and elections. As a result, we believe that an active implementation of the asset class can add significant value.

Against this backdrop, and given the potential excess returns offered by yield spreads, the EMD universe offers a compelling risk/return profile and the potential to enhance total returns on a multi-year horizon, in our view.

Hitting the liquidity buffers

Insurance liquidity buffers are usually required to meet short-term operational expenses, as well as the liquidity risks underpinning technical provisions. The latter could perhaps arise from the lapse of policyholders across with-profit and non-profit books, or the volatile nature of actuarial claims in healthcare and property and casualty insurance.

In the current low yield environment, we believe EM absolute return strategies could prove a valid alternative to increasing asset duration, and moving down the credit curve, within liquidity buffers. Indeed, these latter moves have led to situations whereby some general insurers seeking to boost operational profits have ended up with higher asset than liability duration – and were forced, following rising yields, to sell assets at distressed prices to meet their liquidity needs. This resulted in reduced profitability and Solvency ratios. EM absolute return strategies can:

• Offer excess returns over conventional liquidity strategies; e.g. money markets, short-duration sovereign bonds and investment grade corporate bonds
• Offer the potential for strong Solvency risk-adjusted returns also known as Solvency Adjusted Sharpe Ratio (SASR)¹ , and strong regulatory capital-adjusted returns also known as Return on Regulatory Capital (RORC)²
• Avoid structural duration biases – which may appeal to general insurers seeking to boost operational profits without increasing asset duration

Enhanced LDI

In the past, most European insurers have relied on euro-area sovereign debt and swap strategies to meet financial guarantees (life business) and non-life claims for which there are a strong cash-flow visibility.

Yet central banks' monetary stimulus – not least the introduction of negative interest rates – have pushed insurers to include larger amounts of IG corporate bonds and private credit as core components of LDI portfolios.

In addition, an increasing number of players have been further expanding the boundaries of traditional LDI portfolios by investing in IG, hard-currency EMD strategies. Beyond a solid credit profile, we believe such strategies could offer:

• Excess returns versus conventional LDI strategies; e.g. higher yields (net of FX-hedging costs) across the term structure than IG credit in more developed countries
• Diversification benefits through exposure to new geographies, a variety of economic models and countries at different stages of development
• The potential for superior RORC and SASR, which have been higher for IG emerging market corporates versus sovereigns as the excess returns usually compensate for additional market risk SCR (under Solvency II) and economic risk
• Potential matching-adjustment eligibility (under Solvency II) for annuity books, subject to the outcomes of the eligibility criteria – albeit implemented via a buy-and-hold approach, which does limit the opportunity set

Our analysis is based on a passive implementation of EMD strategies. However, we believe that the idiosyncratic risks posed by the asset class allow for significant value to be added by ongoing monitoring and risk-management. The skills, knowledge and experience of credit analysts, macro strategists and portfolio managers are critical to assess risks and opportunities across individual EM countries.

In addition, an active implementation can help insurers seeking to align with Pillar 2 of Solvency II, which requires companies to provide adequate governance, structure and processes to measure and manage balance sheet risks on a forward-looking basis.

Growth diversifier

Insurers' growth portfolios are usually utilised to generate growth on behalf of policyholders (with-profit business) and shareholders – as well as a buffer to fund future strategic projects.

Conventional growth portfolios typically include equities, high yield credit, private equity and other alternatives. We believe that EM total return strategies could be an attractive diversifier within growth portfolios by offering:

• Investment returns in line with insurers' targets. Depending on investors' risk appetite, a typical EM total return strategy could target an excess return in the range of 350-500bps over Libor
• Enhanced diversification and de-correlation versus traditional risk premia. Our analysis suggests that EM total return strategies tend not to lead to structural exposure to traditional risk premia over the long-term. Furthermore, correlation with traditional risk premia tends to be low and relatively unstable over time
• The potential for strong RORC and SASR

Taken together, we believe these points show that EMD strategies can offer a range of benefits to insurers, whether they are looking to meet their financial guarantees, boost medium-term operational profits or generate growth for shareholders.

1.  The ratio between the excess return (over the liability benchmark) of an investment strategy and its contribution to surplus volatility
2. The ratio between the excess return (over the liability benchmark) of an investment strategy and its contribution to market risk SCR

Important information:
The value of any investment and any income taken from it is not guaranteed and can go down as well as up, and investors may get back less than the amount originally invested. Past performance is not a guide to the future. Legal & General Investment Management Ltd, One Coleman Street, London, EC2R 5AA www.lgim.com
Authorised and regulated by the Financial Conduct Authority.