Europe may have left behind the worst uncertainties of the COVID-19 crisis, but the investment landscape remains challenging. We are in many ways in the midst of a perfect storm.
It is a storm fuelled by escalating geopolitical tensions, volatile yields, rising rates and the threat of recession. For insurers, arguably above all, it is a storm fuelled by the far-reaching impacts of inflation on their business foundations.
In this article, we examine the specific risks insurers face on both sides of their balance sheets. We also outline a number of potential issues – both for the short term and the longer term – and explain why many insurers could now benefit from investments outside their traditional asset allocations.
The COVID-19 pandemic and the extraordinary fiscal and monetary responses it provoked have led to the 21st century’s first substantial and sustained erosion of purchasing power. Inflation has taken hold around the world, reaching a 40-year high in some countries.
The effects in Europe have been severe yet uneven. In July, according to official European Union (EU) statistics, annual inflation in the EU hit 9.8%, compared with 2.5% a year earlier. The lowest rate was registered in France and Malta at 6.8%, and the highest in Estonia at 23.2%1.
The situation in the UK has gained notable attention, with one projection claiming inflation could exceed 18% by January 2023.2 Earlier this year the Bank of England predicted a peak of 10% in Q4 2022, but in August it revised this figure to 13.3% and forecast a recession.3
Of course, such levels will not endure forever. Historical analysis of the relationship between money growth and inflation indicates the most serious impacts of the latter are generally experienced for between 12 and 24 months.4
Nonetheless, investors of all kinds need to protect their portfolios from the damage inflation can inflict – whether over the short term or the longer term. Insurers are no exception in this regard.
The insurance industry is in some ways unusually vulnerable to inflation. Irrespective of whether it is a life insurer or a non-life/general insurer, almost all of a company’s assets are affected – either directly or indirectly – by inflation expectations.
Many insurance liabilities also have direct or indirect links to inflation. These might relate to future administrative expenses or to claims – for example, payment protection orders, life annuities or medical/legal claims.
As a result, unlike many other market risks, an increase in inflation expectations can cause both sides of an insurer’s balance sheet to suffer. For instance, high inflation might lead to a fall in asset values and a simultaneous rise in liability values.
Another important difference between inflation and other market risks faced by insurers is that it is often partly obscured. It might be linked to a particular component of the technical provisions rather than to a commonly used benchmark such as the Retail Price Index or the Consumer Price Index (CPI).
Relatedly, insurance companies tend to measure inflation only indirectly. The risks associated with it are not even directly accounted for under Solvency II, which has no specific inflation capital requirement.5
Source: Trading Economics.
Traditional fixed income assets can appear to be safe bets in an inflationary environment. Insurers tend to be big buyers of high-quality ESG bonds – which are often rated equal to or above A-rated bonds – and investment-grade (IG) bonds. These assets form the foundations of the general accounts’ yields.
Yet these high-quality ESG bonds might be regarded as expensive, and their yields have been insufficient to compensate for the year-on-year inflation of goods – unlike yields from private credit, as we will discuss later. More broadly, inflation fuelled a rise in fixed income yields, creating sizeable unrealised losses in insurers’ balance sheets. Looking back, you could argue that many IG bonds were too expensive during the first half of the year. Furthermore, their yields have fallen short of the levels needed to compensate for inflation.
Casting the net a little wider, insurers might see value in inflation-linked bonds. These can present a viable option for diversifying portfolios and hedging liability risk. However, it may be useful to bear in mind some potentially important nuances.
Choosing inflation-linked bonds essentially represents a bet that central banks will lose the battle to control inflation and that inflation, in turn, will remain a longer-term concern. The negative real yield of these bonds in the current scenario is not especially compelling – unless, that is, an investor has particular liability considerations in mind. Inflation-linked bonds are a very vague hedge against the inflation of claims reserves, which is very different from CPI variations.
Given all of the above, which options might exist beyond traditional fixed income? This brings us to proxy inflation hedging and the likely benefits of adopting a multi-asset approach during times of radical uncertainties.
The debt universe is home to a number of assets that can perform better in an inflationary environment than a typical IG bonds strategy. A key aim for insurers should be to compensate for inflation and have higher investment yields than savings competitors.
An introductory example is the Senior Secured Loans (SSL) asset class – private debt obligations issued by companies, often in the course of leveraged buyouts, mergers or acquisitions. These loans are syndicated and publicly rated.
Senior Secured Loans aim to combine high income with protection against both interest rate increases and credit risk in case of a recession. A key strength of SSLs is that, despite their classification as non-investment-grade investments, they offer several mechanisms that can help creditors mitigate the likelihood of default or, in the case of insolvency, strengthen their position with regard to all other capital providers.
Going further into private markets, insurers may benefit from a beneficial capital treatment of unrated debts under Solvency II6. In addition, the significant illiquidity premia they can capture in private credit markets, generally compared to SSL, could allow you to keep up with the levels required to offset inflation’s effects. Last but not least, private assets valuations can deliver cheap protection against market volatility.
Looking further afield, most insurers have significant exposure to real estate. This is an asset class that has long been seen as a relatively reliable inflation hedge, in large part because corporate rent levels are closely tied to inflation benchmarks such as the CPI.
Housing costs, for example, are a substantial CPI component. Lease income is often subject to inflation-linked adjustments, which is why particularly attractive opportunities can be found in rented properties, hotels, multi-family living and other arenas in which short-term leases are common.
Yet being already exposed to the equity of commercial real estate, insurers tend to protect against the economic risk by investing in the most senior part of the real estate projects’ capital structure: senior and whole loans opportunities.
Similarly, with many projects involving government entities, infrastructure is also strongly linked to the CPI and other benchmarks. It is in this sector that explicit contractual CPI adjustments are most often found.
As the events of recent months have underlined, commodity prices are another key driver of inflation volatility. Risk could therefore also be hedged by investing in this asset class, although it is right to note that its capital treatment under Solvency II is quite punitive (49%). Gold in particular has long been viewed as an effective inflation hedge over the long term.
Effective inflation protection demands an evaluation of risk exposure and the identification of suitably mitigating assets. For insurers, as for investors of all kinds, diversification is likely to prove central to the necessary response.
As Invesco’s Global Investors’ Forum on Inflation recently observed, the challenges of the current economic environment are not limited to seeking returns in testing circumstances. They also encompass defending against what might or might not happen in the months and years ahead.
Taking a multi-asset approach, we believe the private credit space can provide insurers with an attractive combination of higher yields and credit risk mitigation. It offers a good example of the complexity premium, where particular skills are needed to navigate a situation that is complicated in terms of access, risk and opportunity.
In tandem, we believe real assets that have direct links to inflation can serve as a strong complement to other elements of insurers’ investment portfolios. Insurers might especially consider increasing their exposure to real estate, infrastructure and commodities.
For insurers, as for investors of all kinds, diversification is likely to prove central to the necessary response to inflation.
2024 should mark the beginning of the end for reforms to Solvency II. Having fired the starting gun in February 2019, almost four years later the Commission, European Parliament and European Council are negotiating the final contours of the reform package.
After having to endure many years of meagre yields in fixed income, and one of the worst total return performances in 2022, we believe 2023 presents us with as generous an outlook as we have seen in ten years.
1See, for example, European Union, Eurostat: “Annual inflation up to 8.9% in the euro area”, 22 August 2022.
2See, for example, Financial Times: “UK inflation to hit 18.6% next year, according to Citi”, 22 August 2022.
3See, for example, Bank of England: Monetary Policy Report – August 2022, 2022.
4See, for example, Invesco: “Anticipating inflation: historical and multi-asset perspectives”, 17 March 2021.
5Inflation could be considered part of Solvency II’s interest rate risk module, under which insurers are required to create an action plan under their Own Risk and Solvency Assessments (ORSAs).
6Solvency II is a Directive in European Union law that codifies and harmonises the EU insurance regulation.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.
