3. The Year Ahead
As we turn the page on the calendar once again, it is time for us to look both
forward and back. One year ago, we presented our inaugural Insurance Industry
Outlook, which detailed the most important trends that we felt would shape the
industry in 2013. The response from our clients was overwhelmingly positive, so
we have prepared a fresh outlook that captures our highest-conviction thinking
for the year ahead.
But before we jump into 2014’s trends, we felt that it was appropriate for us to take
a look back at last year’s predictions, in order to see what we got right, where we
were off-base, and what we learned in the process.
Overall, we are pleased with the results of last year’s efforts. We were right on
track with several of our predictions, many others began to play out and just
one proved largely off-base. For a complete look at how we fared, see the
scorecard that precedes this year’s predictions.
With regard to the year ahead, we expect that an environment in which rates are
likely to remain low for longer will drive insurers to take a more flexible approach
in their search for income. At the same time, pressure to enhance shareholder
value will compel insurers to deploy their capital more efficiently in order to
maximize profitability, and global regulations will continue to evolve and force
insurers to refine their business strategies.
As financial markets and monetary policy continue the slow march to
normalization in the post-crisis world, many unique challenges await insurers.
But, as always, the well-prepared can find opportunity in those challenges.
In order to help you prepare for the road ahead, we offer seven predictions,
which lay out our view of how the world of insurance investing is likely to
unfold this year.
I look forward to discussing these ideas with you in the months ahead, and to
hearing your feedback, as we work together to help you achieve your goals for
2014 and beyond.
Sincerely,
David Lomas, ACII
Head of BlackRock’s Global Financial Institutions Group
within the Institutional Client Business
david.lomas@blackrock.com
The opinions expressed are those of David Lomas as of January 2014, and may change as
subsequent conditions vary.
4. 2013 Predictions Scorecard
WHAT WE SAID
Insurers will increase
their use of ETFs to
gain immediate access
to credit markets.
As highlighted in a Greenwich Associates report, insurers are broadening their
use of ETFs. Nearly 50% of insurers indicated their intention to increase use of
ETFs by the end of 2013 while 42% said they plan to maintain their current usage.
Firms are utilizing ETFs in a variety of ways, from gaining exposure to less-liquid
TCERROC
sectors to tactical allocation and cash equitization.
In 2013, municipal, high yield and corporate bond ETFs all experienced significant
growth. We expect that growth to continue, and we also believe that the recently
introduced Term ETFs—which carry a maturity date—will prove particularly
useful for insurers, further cementing ETFs’ place in their portfolios.
GNORW
WHAT WE SAID
The variable annuity
market will experience
innovation and
evolution in 2013.
Insurers pursued a variety of innovative approaches to help manage annuity risk. Tactics
included de-risking GLBs by reducing benefit rates, suspending 1035 exchanges,
cutting wholesaler commissions, managing sales through repricing, offering contract
buy backs, developing and marketing investment-only variableE R R O C (IOVA) products
T C annuity
and pursuing focused investment options into risk-appropriate solutions.
Going forward, we believe that more VA providers will dedicateIresources to building
LA TRAP
out new IOVA platforms and will seek new ways to improve the risk-adjusted
performance of their installed VA funds.
GNORW
WHAT WE SAID
Passive management
will begin to supplant
active in guaranteed
funds, including variable
annuities, with managed
volatility strategies
dominating the list of
new funds coming to
the market.
WHAT WE SAID
Deleveraging in the
financial sector will
create income
opportunities for
insurers, particularly
in the illiquid space.
The process of deleveraging continued to play out, and a number of insurers
demonstrated their willingness to embrace illiquid assets. Commercial real estate
debt (senior and mezzanine), infrastructure debt and mortgage servicing rights all
saw notable asset flows within the less-liquid space.
WHAT WE SAID
As insurers reappraise
their hedge fund
allocations, they will
increasingly focus on
risk factors and manager
selection rather than
investment style.
[2]
5
Insurers introduced a great number of managed-volatility funds in 2013. One large
insurer cut ten mutual funds from its VA lineup in a move geared at reducing costs and
enabling the insurer to manage risk more easily. Eight of the funds it dropped were
actively managed and three of the six funds that replaced T C E Rwere index-based.
them R O C
While some insurers have embraced the concept of risk-factor investing as a better
approach to overall portfolio risk management, implementation has proceeded
slowly because of the opaque nature of position-level data in many alternatives,
the lack of robust analytical tools and the fact that regulatory capital charges are
still based on investment vehicle, not investment style.
2 0 14 : T he Y e a r A he a d
Other firms added managed-volatility strategies as underlying funds in their risktargeted fund-of-funds models in an effort to control volatility risk and increase
risk-adjusted returns. We believe that efficiently managedL A I T R A P
passive funds, including
ETFs, will continue to gain market share within advice-wrapped funds, and that
managed-volatility strategies will become a cornerstone of the VA landscape.
GNORW
While financial institutions did shed some significant assets, deleveraging has much
LAITR
further to go—with several trillion dollars in assets likely to come A Pmarket over the
to
next few years. We expect to see a continued flow of mortgage servicing rights from
US institutions, and in Europe there is a significant volume of legacy loans—both
performing and non-performing—that should eventually come to market.
Given the potential of a risk-factor approach to deliver superior risk-adjusted
returns, we expect that insurers will seek to improve their analytical capabilities
and will work with asset managers to gain greater transparency from alternatives
providers in order to access the level of detail that the approach requires.
5. WRO N G
C O R R EC T
One year ago, we presented our inaugural Insurance Industry
Outlook, which detailed the most important trends that we felt
would shape the industry in 2013. Here’s a scorecard to show you
W R O panned out.
P A R T I A L predictions N G
how our
WHAT WE SAID
Emerging markets willEC T
CORR
drive business growth,
P
M&A activity, and A R T I A L
investment returns
for insurers.
WRONG
WHAT WE SAID
Changes in regulatory
capital rules and
PARTIAL
enhancements in O R R EC T
C
risk management will
impact asset allocation
decisions and drive
more robust reporting.
WRONG
C O R R EC T
CORRECT
PA R T I A L
INCORRECT
We have seen both acquisitions and dispositions, sometimes as two sides of a
single transaction. Significant deals saw insurers expand their operations through
acquisitions in countries including Turkey, Thailand, Malaysia and Mexico. On the
other hand, insurers also sold businesses in Russia, Ukraine, Belarus, Kazakhstan
and South Korea.
In terms of investment returns, these markets generally lagged developed market
equities and fixed income in 2013. Going forward, insurers will primarily focus on
their core markets as a source of growth, but given the higher return on equity that
many companies in the developing world display, insurers will continue to make
strategic acquisitions and long-term investments in emerging markets.
This is a trend that will take years to unfold but there are many signs that a shift
is under way. For example, a number of firms have been designated Global
Systemically Important Insurers (GSIIs), resulting in uncertainty around capital
and risk management requirements and precipitating a review of the asset
exposures on their balance sheets. Dodd-Frank is impacting the way in which
US insurance companies use derivatives. Many insurers are rethinking their
enterprise risk management (ERM) and asset liability management (ALM) systems
in light of potential future regulatory reporting and risk management requirements,
especially with Solvency II and ORSA on track.
As regulatory rules continue to evolve, insurers will adjust their asset allocations
and risk management accordingly, and data quality and reporting will take on even
greater importance.
WHAT WE SAID
Rumors of Solvency II’s
demise are greatly
exaggerated—itP A R T I A L
is
on track and insurers
should prepare for it.
On October 21, 2013, the implementation date for Solvency II was formally delayed until
January 2016. The European Insurance and Occupational Pensions Authority’s (EIOPA)
Long Term Guarantee Assessment did not find universal support, particularly in the
areas of the Matching Adjustment and Volatility Balancer. However, significant
progress towards a compromise was subsequently made with the result that the
trilogue of November 13, 2013, reached agreement on the key elements of Solvency
II. A path has been cleared for a vote in the European Parliament in early 2014, with
implementation by 2016. It appears that Solvency II is now on its way to implementation.
WHAT WE SAID
Insurers will broadly
reduce the number of
PART
outsourced managers I A L
that they use and will
engage in non-core
M&A activity in order
to reduce costs and
increase income.
As a whole, insurers continue to outsource—particularly in the alternatives space,
where many of them lack the capabilities to manage assets in-house. In 2013
we saw many insurers look to outside companies to help customize investments,
while others forged strategic agreements with asset managers.
WHAT WE SAID
There will be a
large shift of core
assets into hold-tomaturity portfolios.
We have not seen such a move into hold-to-maturity. Our thesis was predicated
on insurers’ likely reaction to rising interest rates. While interest rates did start
to move higher, the rise in 2013 was relatively modest and forward guidance
from the leading central banks was largely dovish.
WRONG
While consolidation still appears to be at an early stage, we expect that insurers will
continue to concentrate assets with a smaller number of investment managers, and
will demand more from their asset-management partners.
Looking ahead, we may see some insurers switch core portfolios to hold-to-maturity
status, although perhaps not at the level that we had initially envisioned.
BL ACKROCK
[3]
6. At a Glance
2014 will present insurers with a host of challenges, both old and new. Interest rates in much of the
world will remain significantly below long-term averages, and the intense pressure to maximize value
for shareholders will continue. At the same time, the implementation dates of sweeping new
regulations covering US and European insurers are rapidly approaching.
To help confront these challenges head on, we’ve tried to identify the investment themes that are
likely to take shape this year, and we have some concrete advice on how to harness these themes
to maximize income, increase profitability and keep up with the shifting regulatory landscape.
The table to the right summarizes the broad themes (and attempts to answer the timeless question
“So what do I do with my money?”) while the pages that follow delve more deeply into seven
predictions that we believe will unfold in 2014.
Read on to find out more of what we see in store for the year ahead.
[4]
2 0 14 : T HE Y E A R A HE A D
7. INCOME
INVESTMENT THEME
A “low for longer” fixed income
environment will drive insurers to
reevaluate and ultimately relax certain
investment guidelines.
Insurers will realign their investment
portfolios in order to earn adequate
income, provide principal protection,
and deliver diversified sources of return
while managing correlation risk.
W H AT D O I D O W I T H M Y M O N E Y ?
Take a more flexible approach to fixed income. Consider an allocation to high yield, bank
loans, mezzanine debt, infrastructure, collateralized loan obligations (CLOs) and other
less-liquid, non-core assets in order to minimize risk, enhance yield and reduce duration.
Reevaluate your allocation to alternatives, and consider a holistic, multi-asset
solution. Take risk factors into account when constructing an alternatives portfolio.
Take advantage of disintermediation in the lending markets to gain access to
issuances that do not come to public markets and that may earn attractive
risk-adjusted returns and reduce correlations.
Adjust your allocation to equities. Minimum volatility strategies, factor-based
allocations, and dividend-paying funds can help provide growth, income, and
downside protection.
PROFITABILITY
INVESTMENT THEME
Pressure to enhance shareholder value
will compel insurers to become more
efficient with their capital deployment.
In response to this pressure, insurers
will need to adjust their product lines,
operational processes, capital
allocations and investment portfolios
in order to improve efficiency and
maximize profitability.
W H AT D O I D O W I T H M Y M O N E Y ?
Focus on optimizing risk-adjusted yield/return on capital charges.
Take a critical look at your entire business structure and processes and find areas
to innovate.
Consider making bold changes like exiting overly competitive lines of business and
redeploying capital in new markets. Build investment processes and structures
that support these new businesses.
Blend alpha and beta strategies to improve efficiency, flexibility and cost-effectiveness.
REGULATION
INVESTMENT THEME
W H AT D O I D O W I T H M Y M O N E Y ?
Changes in global regulatory regimes
will force insurers to refine their
business and investment strategies.
Focus on embedding diversification within portfolios and consider marginal
regulatory capital charges rather than the standalone regulatory capital charges
when making allocation decisions to new asset classes.
Capital deployment, asset allocation
and risk management are all likely to
be impacted.
Work with your asset manager to understand the drivers of risk and return in new
asset classes so that they become eligible investments to drive an increase in
diversification and expected returns.
BL ACKROCK
[5]
8. INCOME
1
With interest rates likely to remain low for longer, insurers will relax some of
their investment guidelines and demonstrate increasing flexibility in their
fixed income allocations.
While central bank policy in the US is set to become less accommodative, and
interest rates appear likely to continue their gradual ascent from historic lows,
we don’t expect core rates to move dramatically higher in 2014. Managing
investment risk in this environment will prove complicated, and insurers will
need to both refine and complement their core fixed income exposures.
As insurers globally adjust to the reality of a challenging fixed income environment,
they will continue to review their investment guidelines. Many are likely to initiate
policy changes that will provide them with greater flexibility to adopt a defensive
stance in their portfolios and to protect unrealized gains. The current trend of
shortening index duration and reducing extension risk in sectors with embedded
options will also likely persist. Some insurers will consider implementing simple
derivatives strategies as part of their overall risk management efforts.
Many insurers will look to increase asset class flexibility within their core
portfolios through simple steps such as the addition of floating-rate and BBB
securities and the widening of gain/loss and turnover budgets. Beyond their core
holdings, insurers will be particularly drawn to assets that offer higher yields,
protection from rising rates and duration reduction. A combination of emerging
market debt, high yield bonds and bank loans may prove attractive.
[6]
2 0 14 : T HE Y E A R A HE A D
9. The search for uncorrelated returns will drive interest in non-core assets.
This will lead insurers to review and redefine liquidity within their portfolios
and to seek exposure to risk factors other than rates.
2
In pursuit of uncorrelated returns in diversifying assets, such as infrastructure,
mezzanine debt, and CLOs, insurers will take a more holistic approach to
portfolio construction. As part of this new approach, they will reexamine their
assumptions around liquidity and will redefine what is liquid and illiquid. By
utilizing liability profiling and advanced cash-flow modeling, insurers can gain
a better grasp of their cash-flow requirements and construct liquidity ladders
that allow them to take advantage of a variety of longer-term, less-liquid assets.
Given the challenges inherent in building a cohesive set of alternative
exposures, multi-asset alternatives portfolios that dynamically allocate
across strategies are likely to prove increasingly attractive to insurers. These
portfolios will be structured cost-effectively, will be optimized for regulatory
capital, and will target a broadly diversified, opportunistic set of liquid and
less-liquid alternative investments.
Managers will follow an “informed investing” process wherein insurers and their
managers nurture a continuous feedback loop that addresses evolving client
requirements, exposures and limitations. For more esoteric instruments, risk
analytics that allow insurers to discuss capital, transparency and liquidity with
their regulators will be essential.
3
Disintermediation and the shifting landscape in lending markets will provide
insurers with new opportunities to earn attractive risk-adjusted returns.
Newer participants, such as peer-to-peer lenders, have reshaped the lending
markets by bypassing the traditional intermediaries and have transformed the
dynamics between borrowers and lenders, resulting in increased access to
capital for the former and more attractive rates for the latter.
By partnering with direct lenders that are providing funding to consumers, small
businesses and middle-market institutions, insurers will be able to take advantage
of this evolution in credit and will gain access to a higher-yielding set of assets.
As the lending market continues to mature, there will be increasing opportunities
for insurers to invest in loans that were originated outside of the traditional
banking model, and that offer attractive risk-adjusted returns and low correlations to many core fixed income holdings. But accessing opportunities in these
new and esoteric markets will prove challenging and will demand a nuanced
approach to asset selection and risk management.
BL ACKROCK
[7]
10. As part of an overall move to improve the risk-adjusted returns of their
investment portfolios, insurers will review and adjust the equity allocations
within their general and sub-advised accounts.
Minimum-volatility strategies are likely to become a core holding within equity
portfolios as insurers look to reduce downside risk while still participating in the
majority of long-term equity market appreciation. Factor-based allocations,
which strive to capture equity risk factors in an efficient and cost-effective
manner, will also find a home with insurers seeking a strategic approach to
maximizing long-term risk-adjusted returns.
In addition, we expect that insurers will continue to find value in dividend-paying
strategies, as both a reliable stream of income and a defensive allocation to
equity markets. And finally, in order to increase diversification and reduce
correlation within their equity portfolios, we may see insurers shed some of
their home-country bias and more fully embrace a global equity opportunity set.
4
PROFITABILITY
5
The availability of alternative capital will put pressure on reinsurance pricing.
Much of the new capital will prove to be permanent and will not flee even after
a major catastrophic loss.
There has been a huge influx of alternative capital into the reinsurance market,
owing to the increased appeal of insurance-linked securities, sidecars, and
catastrophe bonds. Investor demand is expected to be high for these uncorrelated, high-return assets, signaling that supply will continue to increase.
The entrance of this alternative capital allows property and casualty insurers
to cede catastrophe risk off their balance sheets. Although the market is
currently concentrated in select lines of catastrophe risk, we can expect
pricing pressure to filter through to the larger P&C reinsurance market as
the boost to capital increases primary insurers’ underwriting capacity. We
expect to see this take place during contract renegotiations throughout 2014,
beginning with the first round of negotiations in January.
As a long-term result of the competition that new providers have brought to the
reinsurance market, many traditional reinsurers will reevaluate their operations
and consider shifting capital into alternative lines of business in order to remain
competitive. As they deploy capital into new areas, insurers will need to design
and implement investment strategies that support these new business structures.
[8]
2 0 14 : T HE Y E A R A HE A D
12. Insurers will expand their use of ETFs, embracing both new products and
new strategies.
Innovation has long been a hallmark of the ETF market, and the recently introduced term maturity ETFs—which carry a maturity date, like traditional bonds—
are the latest evidence of this. Because term maturity ETFs can offer compelling
yield, predictable cash flows and decreasing duration over time, we believe that
insurers, specifically those in the US, will be among the early adopters.
We also expect that insurers will maintain their high current utilization rates of
traditional credit ETFs and will utilize their efficient structure to accomplish a
range of investment objectives from tactical asset allocation to duration management. ETFs that provide exposure to less liquid, more nuanced markets,
such as municipals and international debt, are likely to see increased interest
as complements to core fixed income assets. For smaller accounts we expect
to see many insurers utilizing ETFs as core holdings, as they can provide an
operationally efficient means to build a well-diversified portfolio.
6
Finally, insurers will find new strategies for harnessing the technological power
of ETFs. The most liquid fixed income ETFs allow buyers and sellers to transact
without having to access the underlying bond market, thus facilitating executions
that can fall within the bid/ask spread of the underlying bonds. And in less liquid
fixed income sectors, investors can utilize ETFs’ unique creation/redemption
process to quickly and efficiently gain a desired bond exposure or to exit an
illiquid bond position.
“..insurers will find new
.
strategies for harnessing the
technological power of ETFs.”
[10]
2 0 14 : T HE Y E A R A HE A D
13. REGULATION
7
Capital-efficient and regulatory-optimized investing will become increasingly
prevalent and will drive activity across asset classes and geographies.
For US-domiciled insurers, the 2015 compliance requirement of Own Risk and
Solvency Assessment (ORSA) is likely to drive large- and medium-sized insurers
to reevaluate and, in many cases, upgrade their enterprise risk management
processes and systems. Adequately quantifying investment risk under stressed
scenarios will be challenging for much of the industry.
In addition to preparing for the implementation of Solvency II and ORSA,
the largest insurers will also be grappling with Global-Systemically-ImportantInsurer (G-SII) and Systemically-Important-Financial-Institution (SIFI)
designations and the enhanced regulatory reporting and capital requirements
that accompany them.
In Europe, increased certainty around the implementation of Solvency II will
lead insurers to start adjusting their asset allocations in order to align them
with the upcoming regulatory framework.
In contrast to the US and Europe, where insurers will be grappling with a new set
of regulations, there seems to be a tide of deregulation throughout much of Asia.
Loosening restrictions on foreign investment will continue to drive Asian insurers
with adequate capital further afield from their home markets in the search for
yield and diversification. As a result, we are likely to see increased demand for
higher-yielding non-domestic assets.
BL ACKROCK
[11]
