EMEA Insurance Investing: Bruised, But Not Blindsided

• Bruising losses on bonds and equities hit European life insurers’ assets hard in 2022, but rising rates have hit their liabilities harder –we expect most insurers’ Solvency II capital ratios to strengthen year-on-year. The question now is whether to use excess capital to seek higher returns on new investments (but take accounting losses) or wait for rates to normalize and for pull-to-par on fixed-income holdings to restore investment flexibility and stabilize asset allocation (but miss out on higher investment returns).

• General insurers, and motor insurers in particular, have been jolted by a sharp rise in short rates, runaway claims inflation, weather-related claims, and downward revaluations on their real estate investments. Reinsurers are seeing a glimmer of hope on the horizon, with brokers reporting increases in catastrophe pricing on January renewals.

• A host of regulatory changes this year will bear watching. The UK Solvency regime reforms aim to introduce more flexibility to life insurers’ matching-adjustment investment portfolios and to reduce administrative burdens. Wider rollout of SFDR and TCFD disclosure requirements will create additional reporting burdens for insurers and their asset managers.

The insurance industry withstood another turbulent year in 2022, and more clouds are brooding on the horizon. The growing likelihood of a recession and policy error concerns are keeping many investors up at night, while geopolitical tensions are driving dislocations in energy and commodity markets, and a seismic shift in China’s Covid policy is now playing out in the world’s second-largest economy. Insurers will have to navigate higher rates and elevated volatility against this tough and uncertain backdrop.1

What does the subdued outlook imply for insurers’ investments this year?

We continue to view investment grade debt as attractive, despite the turbulence of 2022. Given the challenges heading into 2023 and economic conditions facing Europe in the next six months, we have more confidence in US dollar investment grade debt (hedged to euros or pounds sterling), both in terms of spread returns on regulatory capital for buy-and-maintain life insurers and on a total-return basis over the medium term.

We see longer-term value in emerging market (EM) corporate debt, tempered by near-term macro uncertainty and risk-averse sentiment. Emerging market debt presents a wide and heterogenous opportunity set for insurers, with additional efficiencies to be reaped from partnering with specialist asset managers on customized solutions that would incorporate insurers’ asset-liability management, regulatory and rating capital efficiency, and sustainability considerations.

For internal-model firms and for globally active insurers seeking to allocate from their non-Solvency II balance sheets, we believe the highest-quality tranches of collateralized loan obligation (CLO) debt, rated AAA and AA, are offering outsize yields relative to risks. As floating-rate instruments, CLOs are also well positioned in a volatile rising-rate environment.

Regulatory changes continue to shape insurers’ investment portfolios. For UK life insurers, matching adjustment and risk margin reforms are likely to bring some capital relief, as well as an opportunity to build better-diversified illiquid credit portfolios. Forthcoming changes to the symmetric adjustment to equity capital charge put a spotlight on insurers’ investments in listed equities. Elevated public-market volatility can make a diversified allocation across real estate equity, private equity, and private credit a more resilient alternative. While these regulatory changes are yet to be enacted in 2023 and beyond, insurers would be well-advised to address them in their investment strategies.

Life insurance

2022 was a dire year for European life insurers’ investments, but not for their capital. With double-digit losses on bonds2 and listed equities3 only partly offset by the relative resilience of private credit,4 many insurers witnessed nearly a decade’s worth of unrealized gains wiped off their balance sheets, giving way to unrealized losses. At the same time, life insurers’ Solvency sensitivities reported in year-end 2021 SFCRs (Solvency and Financial Condition Reports) suggest that rising rates have put most of them on track to stronger Solvency II ratios at year-end 2022.5

The conundrum for life insurance CIOs is market timing. Should excess capital be used now to realign asset allocations and take advantage of higher returns on new investments, at the cost of realizing accounting losses? Or is it better to wait for rate normalization and pull-to-par on their fixed income holdings to help restore investment flexibility and stabilize asset allocation and risk, but miss out on higher reinvestment returns?

Answering this question would require a careful analysis of the many objectives and constraints that insurance investors face. Given the complex interplay between economic performance, regulatory capital requirements, and the accounting impact of their investment decisions and portfolio management actions, insurers need to design tailored solutions to their investment challenges – whether at the level of strategic asset allocation under a rapidly evolving market outlook, or at the level of capital-efficient security selection and identification of trade opportunities aimed at minimizing accounting impacts under a tight regulatory capital budget.

General insurance and reinsurance

Compared to their life insurance peers, general insurers – and motor insurers in particular – have been jolted by a more immediate and painful shock, with the shorter-end rates hammering their fixed income investments, and runaway claims inflation and substantial weather-related claims squeezing their combined ratios. Moreover, cracks are starting to show in the valuations of their domestic real estate investments.

For reinsurers, there is a glimmer of hope on the horizon, with reinsurance brokers reporting increases in catastrophe pricing on January renewals.6

Deteriorating underwriting results and shrinking capital buffers are putting more pressure on investment performance and market risk capital efficiency. While higher yields are a net positive for new investments, we expect that non-life insurers will remain hard-pressed to find unconventional pockets of diversification and resilience. These may range from actively managed capital-efficient emerging market debt investments to high-quality private credit to targeted investments in focused listed equities strategies and in liquid alternatives.

For globally active general insurers and reinsurers, we expect more shareholder pressure to maximize balance sheet efficiency across all countries of presence. Evolving capital regulations and reporting requirements outside the Solvency II perimeter will introduce an additional layer of complexity.

Financial reporting: IFRS 9 and 17

On 1 January 2023, IFRS 9 Financial Instruments and IFRS 17 Insurance Contracts became the mandatory reporting standards for listed European insurers.7 These standards do not have a direct impact on the economics of insurers’ business (i.e., the timing of cash flows on assets and liabilities comprising a balance sheet), but they do change the rules for when and how these cash flows (and thus profits or losses) are recognized in accounts. This, in turn, impacts insurers’ reported equity and other key financial indicators – calling for changes to how analysts and investors read and interpret insurers’ financials.

We do not expect the new reporting requirements to have a material impact on insurers’ asset allocations.8 However, they may become a consideration when selecting suitable vehicles for delegated investments (e.g., funds versus separately managed accounts or special-purpose vehicles) and put new operational, reporting, and modeling requirements on insurers and their asset managers. Some of these burdens may be eased by partnering with specialist asset managers that benefit from a good understanding of insurance accounting and reporting requirements.

IFRS 17 improves the alignment between an insurer’s accounting and Solvency II balance sheets: in both instances, liability valuation is derived by discounting expected future cash flows (adjusted for uncertainty) using a discount rate reflective of the current market rates. However, the two valuations are generally not identical, with differences in both the projected cash flows and the discount rates used.

IFRS 9 allows insurers to align the valuation of liability-backing fixed-income investments with that of insurance liabilities. For both debt assets and insurance liabilities, changes in fair value can be recognized either through profit and loss (“fair value through profit and loss,” or FVTPL) or through other comprehensive income (“fair value through other comprehensive income,” or FVOCI), subject to making the relevant accounting elections and meeting the qualifying requirements for debt investments. Insurers can also opt to hold qualifying debt investments at amortized cost.

IFRS 9 also introduces requirements for quantifying impairment on debt investments, putting additional requirements on debt investors. Under IFRS 9, impairment is based on forward-looking expected losses rather than on realized past losses; an allowance for impairment is required even for debt holdings with zero losses. Quantifying expected losses, especially on non-core or private-market debt assets, may be facilitated by partnering with an investment manager with expertise in the asset class acquired over multiple market cycles.

Regulatory developments

Sustainability remained in the front of regulators’ minds in 2022, with the ongoing rollout of Sustainable Finance Disclosure Regulation (SFDR) guidelines in the EU, Taskforce on Climate-related Financial Disclosures (TCFD) in the UK, and the European Insurance and Occupational Pensions Authority (EIOPA)’s ongoing review of insurers’ measurement, management, and reporting of sustainability risks.

In the EU, Solvency II amendments developed in course of the 2020 review are on track to be enacted in 2023, with draft regulation currently making its way through the legislative process.9 If enacted in its current form, it will increase the volatility of capital requirements for insurers’ equity investments and create new requirements for insurers to address liquidity, sustainability, and macroprudential risks in their business and investment planning and decision-making.

In the UK, the government has completed a round of consultations in preparation for legislating changes to the Solvency UK regime. These changes aim to create a more competitive regulatory environment for insurers (especially those relying on the matching adjustment mechanism) and promote investment in the real economy. We see this as a positive development and an opportunity for insurers to create globally diversified portfolios of stable-value, high-quality income-generating real assets and reduce their reliance on the UK property market.

Sustainability disclosures: SFDR and TCFD

Starting from 1 January 2023, life insurers managing savings and investments products in the European Economic Area (EEA) will be required to disclose sustainability-related information and publish Principal Adverse Impact (PAI) statements following the template established in the SFDR’s Regulatory Technical Standards (RTS) enacted in July 2022.10 The first PAI statements are due on 30 June 2023 and will comprise a long list of qualitative and quantitative indicators covering greenhouse gas emissions, biodiversity, human rights, governance, and social and employee matters, among others.

From 6 April 2022, the largest UK insurers are also covered by the required TCFD standards; for other UK-based asset owners and asset managers, the requirements will be introduced over the next two years. The disclosures comprise a set of qualitative (climate-related scenario analysis) and quantitative (scope 1, 2, and 3 greenhouse gas emissions, total carbon emissions, and carbon footprint) at the entity and product level.

The new disclosures are putting additional operational and reporting requirements on insurers and require even closer collaboration with asset managers, especially when investing in nontraditional or private-market assets. Insurers’ ambitious sustainability targets also create opportunities for investments in emerging markets,11 sustainable real estate, socially responsible private credit, and green infrastructure.

Implementation of the 2020 Solvency II review

On 22 September 2021, the European Commission adopted a comprehensive review of Solvency II rules following the conclusion of the 2020 Solvency II Review. At the time of this writing, legislative proposals are awaiting the first reading in the European Parliament. We expect them to be enacted in the first half of 2023.

Wider range for equity symmetric adjustment

The main change introduced into the regulation is to allow the symmetric adjustment to the equity risk charge to fluctuate within ±17% instead of ±10%. This will lead to a more volatile capital requirement for equities in periods of extreme bull or bear markets, which – in theory – should help compensate for the volatility of capital resources driven by mark-to-market on insurers’ equity investments.

In practice, insurers with material equity exposures (including many Nordic insurers) are likely to be hit with an amplified basis risk: Volatility in capital resources will be driven by the change in value of domestic equity and global private equity holdings and changes in capital requirements driven by returns on EIOPA’s reference equity index basket. A solution for insurers could be to rotate from volatile listed equities to stable value private-market assets, including real estate and, potentially, private credit – especially given how the expected returns on private credit have been edging higher in the current high-rate environment.

Prudential treatment of sustainability risk

When enacted, Solvency II amendments will require insurers to incorporate climate scenario analysis into their own risk and solvency assessment (ORSA) by assessing their exposure to climate change risks, specifying at least two long-term climate change scenarios, and regularly assessing their business impact.

In addition, the 2020 Solvency II review mandated EIOPA to explore a dedicated treatment of exposures to assets or activities associated with environmental or social objectives, potentially paving the way to a preferential capital regime for qualifying sustainable or socially responsible investments. To this end, on 29 November 2022, EIOPA published a discussion paper on prudential treatment of sustainability risks, outlining the scope, methodologies, and data sources for assessing the impact of sustainability risks (and energy transition in particular) on insurers’ investments and underwriting.12

Solvency UK

On 17 November 2023, the UK’s HM Treasury announced forthcoming changes to Solvency II’s risk margin calculations and matching adjustment (MA) mechanism. The changes are part of a broader transition to a “Solvency UK” regime following the country’s departure from the European Union.13 The aim of the reform is to introduce greater flexibility in UK life insurers’ matching-adjustment investment portfolios and to reduce the administrative burden on insurers.

The proposed changes to the risk margin calculation method are expected to reduce risk margins by around 65% for life insurers and by 30% for non-life insurers, releasing Solvency II capital that can be used to support higher allocation to return-seeking assets or more underwriting.

The main change to the MA mechanism is a shift from “cash flow fixity in time and size” to “high cash flow predictability” as the main requirement for MA-eligible investments. Once the reform is enacted, UK insurers will benefit from a broader opportunity set of MA-eligible investments across private credit, real estate, and infrastructure debt, both domestically and abroad. This should help UK life insurers build more resilient, globally diversified portfolios and to reduce their reliance on the increasingly volatile domestic real estate and infrastructure market.

The proposed reforms – and the recent LDI debacle affecting UK pension funds – will give a shot in the arm to the UK life insurance industry: Analysts forecast that up to £600 billion of defined-benefit liabilities will be shared across a small club of life insurers that dominate the pension risk transfer league tables.

With new-money target allocations for illiquid and private market assets of up to 50%-plus, the challenge for these insurers will be to deploy even greater volumes of new money at speed without compromising on asset quality and yield. Looking beyond the home turf and considering a full spectrum of illiquid asset strategies, currencies, and geographies – and complementing in-house origination with the expertise of specialist insurance asset managers – could be part of the solution.