Insurance stocks have generally outperformed the broader European equity market over the last decade and continue to offer a high dividend yield that can seem particularly compelling in the current low interest rate environment. However, we believe this lower for longer rate environment could spell trouble for the sector.
Insurance companies can derive some of their income from the premiums paid by policy holders. If in any given year, payments exceed the cost of any pay outs made, the insurer can make a profit.
However, if the claims exceed the value of the premiums collected, the insurer will make a loss. There is no way for insurers to guarantee that the first scenario will always prevail, and that is why they invest the premiums they receive in the capital markets.
The income they derive from these investments allows insurers to finance their operation, offer policies at low rates and pay out claims. A large amount of an insurer’s investment portfolio consists of interest rate-sensitive assets, such as long-term fixed interest assets.
Should interest rates rise, insurers can gradually re-invest maturing investments at higher yields, which should provide them with a higher investment income. However, should interest rates fall, the opposite would apply.
Insurers employ a variety of ‘immunization’ strategies to reduce the risk of loss in a changing interest rate environment, such as investing in assets that match the long-term nature of their insurance liabilities.
However, a perfect hedge is difficult for insurers to attain, as the duration of their liabilities are often longer than the maximum duration of assets available in the capital markets. This exposes insurers to some level of interest rate risk.
Another challenge insurers face when interest rates change lies in their need to estimate future investment returns and make assumptions on long-term interest rates. This allows them to plan ahead – decide what rate they can guarantee to policy holders, determine what premiums to charge or how much to set aside to close the asset-liability mismatch in their balance sheets.
However, should their estimates diverge dramatically from reality, problems can arise. It could, for example, become more difficult for them to keep promises on guaranteed returns made long ago when rates were high.
Equity investors tend to extrapolate how changes in the investment landscape could affect their holdings. Hence, given the insurance sector’s sensitivity to interest rates, share prices of insurers tend to rise and fall in concert with interest rate rises. Recent years have seen insurers buy more corporate bonds to help them generate higher yields. As can be seen in Figure 1, this has also made them more sensitive to changes in credit spreads.
Following the global financial crisis, interest rates in the developed world have fallen to record lows, and it is now believed they will remain lower for longer. In Europe, our view is supported by slow growth with no catalyst for change in sight.
The amount of negative-yielding bonds in the region has been rising, which means European insurers are likely to face significant reinvestment risk as existing investments mature.
This dynamic will weigh on the solvency and profits of European insurers, putting downward pressure on their share prices, as evidenced by the negative earnings revisions over the past year (see Figure 2).
We can also see further headwinds. The state of the German pension fund industry, for example, is an issue for the European economy.
A large majority of employees in Germany have defined benefit pension plans, and as with insurers, German pension funds apply a discount rate on their liabilities, which is currently around 3%. However, they are holding around 70% of their assets in fixed interest assets that generate little to no yield. Corporate sponsors may therefore need to divert cash flow towards pension contributions, which could prove very painful as profits are already being squeezed in the current downturn.
We believe there is value in holding a short position in European insurers. Our ‘Equity – Short European Insurers vs Market’ idea pairs this view with a long position in the broader European equity market, which should help cushion the idea when equity markets climb.
Taking a short position on insurers is essentially a long duration position, which means we expect our position to advance as interest rates decline. However, due to their large corporate bonds holdings, shorting insurers is also a proxy for a short credit position – we expect to benefit from the widening of credit spreads.
We have implemented our idea by selling total return swaps on the European insurers sector index and buying exposure to the broader European market index.
Where to look for opportunities when ‘cash is king’
The Multi Asset team frequently risk test their portfolios against a scenario in which ‘cash is king’ with bonds and equities providing no diversification. Fund Manager Dave Jubb underlines why the risks of this becoming reality are higher now than in the last 20 years.
There may be trouble ahead…
Our fund manager Dave Jubb sees a more balanced market in government bonds after the recent rally. But is there potential for higher levels of volatility?
