Insurance Risk: Clouds on the Horizon?

EIOPA's latest quarterly risk dashboard underscores macroeconomic uncertainty and market volatility as primary concerns for insurers. The recent IMF Global Financial Stability Report identifies private equity (PE) firms’ escalating role in the life insurance sector as a growing risk to financial stability – a sentiment echoed in the recent Bank of England consultation paper on funded reinsurance. The report calls for enhanced supervision of life insurers’ valuation processes and for liquidity stress-testing.

To steer their ships safely across choppy waters, insurers are well-advised to diversify their investments broadly, consider their liquidity needs carefully, and choose their asset managers judiciously. For European insurers seeking to reduce home bias in their investments and to enhance the diversification in their portfolios, we see opportunities in developed- and emerging-market USD investment-grade bonds, as well as in specific segments of private credit, such as lower middle market lending and fund finance.

EIOPA risk dashboard: assessing key risks

In EIOPA’s evaluation, macro and market risks remain elevated. Credit and solvency risks are at medium levels, with a negative outlook (increasing trend) for credit risk. This aligns with PineBridge’s view that insurers remain resilient in the face of a decelerating economy.

According to EIOPA, decelerating growth, persistent inflation, a widening credit-to-GDP gap, and tightening monetary policies, as well as ongoing and escalating geopolitical conflicts, create an elevated macro risk environment. Persistent volatility in bond and equity markets means that market risks remain stable at a high level. Rising rates have generally benefitted life insurers’ asset-liability management (ALM) position, with narrowing in the sector’s median duration gap. At the same time, the relative spread between investment returns and guaranteed rate as of year-end 2022 (the latest available annual datapoint) has fallen to −25%, mostly driven by the unrealized-loss component of investment returns.1

Profitability and solvency risks remain stable at a medium level. Following a dip in 2022, EEA insurers’ profitability increased in the first half of 2023. Annualized return on the excess of assets over liabilities has doubled relative to fourth-quarter 2022, returning to pre-pandemic levels. General insurers’ net combined ratios have remained stable. The median solvency ratio for the insurance sector remained stable in aggregate, while the solvency ratios of most life insurers and groups improved.2

Private equity, life (re)insurers, and financial stability

Alongside elevated inflation, tightening financial conditions, and vulnerabilities in the real estate sector, the IMF’s latest Global Financial Stability Report, released in October 2023, singles out the growing footprint of private equity firms in the life insurance sector as a growing risk to global financial stability. In the IMF’s evaluation, “private equity-influenced life insurers appear to have significantly more exposure to less liquid investments than other insurers. These investments increase valuation uncertainty, credit risk, and liquidity risk through mismatches between assets and liabilities.” PE-owned offshore reinsurers allow “taking advantage of regulatory arbitrage at the cost of reduced transparency” while limiting the ability of regulators to monitor them.3

To address these risks, the IMF calls for the broad adoption of a globally consistent consolidated capital standard as well as an “ intrusive supervisory review of insurers’ valuation processes, and liquidity stress-testing.”¹ These concerns are shared by industry supervisors on both sides of the Atlantic, with growing focus on the lack of transparency and additional complexities and risks inherent in the operation of PE-backed (re)insurers from the US National Association of Insurance Commissioners (NAIC)4 and a consultation on funded reinsurance launched by the Bank of England in November 2023.5

What can insurers do in anticipation of more intrusive supervision? We believe that transparency is a powerful disinfectant. Clear communication between insurers and regulators, as well as with their asset managers, is crucial. Reducing reliance on related parties in structuring and executing insurance solutions, establishing equitable long-term partnerships with specialist asset managers, and aiming for consistency between the regulatory form and economic substance of insurers’ investments should all help insurers in their mission to create long-term value through prudent investing.

How can insurers navigate increased macro uncertainty?

We believe that the answer lies in more thorough geographic diversification. PineBridge continues to have confidence in investment-grade US corporate debt and USD-denominated emerging market (EM) debt. In addition, we believe that European insurers can benefit from diversifying their illiquid asset portfolios away from the home market, including a higher allocation to the US. Solvency II capital-efficient assets, such as direct lending, infrastructure debt, fund financing, and real estate debt, remain attractive for European insurers even after adjusting for the expected cost of currency risk hedging.

How can insurers insulate against heightened market volatility?

With elevated volatility in bond and equity markets, insurers may find a modicum of stability in the private markets. Given the uncertain macroeconomic backdrop and the inherent heterogeneity of private-market assets, we believe insurers should complement their in-house capabilities with those of external asset managers with demonstrable asset class expertise, as well as awareness of insurance-specific investment objectives and constraints. Given the increasing focus on liquidity and – in some market segments – liability-side lapse risk, insurers should have strong frameworks in place to ensure adequate liquidity in times of stress.

While broad credit conditions may continue to tighten, PineBridge is favorable on subsets of direct lending that are prudent in managing risk and provide strong covenants, low attachment points, and focus on cash-flow-producing companies. Additionally, fund finance is an increasingly attractive asset class for insurers that continues to evolve.