The last two months have been a challenging time for insurance companies, with many confronting issues that impact both their business operations and investment portfolios. Below are some of the questions we’re discussing with clients and prospects and our views for how insurers can preserve the short and long-term health of their balance sheets.
What implications can corporate downgrades have on my portfolio?
Since the global financial crisis, there has been record issuance in BBB-rated bonds, which now comprise roughly 50% of the U.S. Bloomberg Barclays Corporate Index. This migration to lower quality within the benchmark, coupled with depressed rates and the search for yield, has led many insurers to increase their exposure to BBB-rated credits within fixed income portfolios portfolios (see chart A).
BBB Bonds as a % of Invested Assets
There are a few reasons we are concerned about the growing presence of BBB in the current market environment. There is more leverage today among BBB issuers than there was five years ago (the median leverage is currently 2.6x versus 2.2x in 2015) and economic slowdowns can increase the risk of downgrades and defaults. In fact, the BBB downgrade/upgrade ratio has surpassed 2009 levels (see chart B). Fallen angels, or securities downgraded from investment-grade to high yield, have historically experienced significant price declines and volatility during economic downturns and this can have negative implications for insurers.
BBB Downgrade/Upgrade Ratio Above ’09 Levels
Downgrade/Upgrade Ratio by Amount Outstanding (x)
For Property and Casualty (P&C) and Health insurers, fallen angels need to be reported as the lesser of amortized cost or fair value in statutory filings, which can force repricing of securities. Mark-to-market repricing and equity market volatility can lead to higher than anticipated surplus losses in a stress scenario. Additionally, insurers with Investment Policy Statement’s that require liquidation of sub-investment grade bonds could see forced sales and impairments at a time when the market lacks liquidity.
How should we be thinking about our allocation to private assets?
We currently view investment grade private assets favorably when compared to the risks facing BBB-rated issuers in the public markets.
Investment-grade private credit has proven to be a resilient asset class during economic downturns, providing diversification and excess returns relative to similarly-rated public corporate bonds. Financial covenants and security in the form of collateral that typically includes critical assets of the issuer serve as lender protections during stressed scenarios, while small lender groups help lead to faster recoveries in the event of a default.
How should we be thinking about our allocation to real estate equity?
We’ve been receiving many questions about how COVID-19 might impact the future of real estate markets, particularly if work-from-home becomes the new normal and reduces the need for office and retail space.
Within the real estate market, we have seen a compelling pocket of opportunity in the core-plus segment. Core-plus strategies haven’t gotten the same level of attention from investors as traditional core or value add and opportunistic strategies (since 2012, we have seen value-add funds hit record fundraising levels of roughly $50 billion per year, versus $3.9 billion in the core-plus sector). The limited amount of capital chasing in this space, along with the unique technical aspects of the core-plus segment, present a compelling risk adjusted return opportunity for investors.
The government has been providing meaningful stimulus to support the economy – are there opportunities for insurance companies?
On March 23, 2020, in an effort to re-energize the credit markets, the Federal Reserve and Treasury department jointly established the Term Asset-Backed Securities Loan Facility (TALF). TALF is designed to encourage private investments in asset backed securities (ABS) by providing federal government loans to investors through the New York Federal Reserve.
The TALF was previously launched in 2009 during the last financial crisis to help support the flow of credit to consumers and businesses. The program was successful in helping capital markets return to normal. Investors in the TALF 2009 program experienced strong returns, with early participants typically seeing the greatest benefit, as initially high spreads tightened in line with the roll-out of the program.
What actions are regulators and rating agencies taking?
Life, P&C and Health insurers each face unique circumstances and may be subject to rating agency and regulator developments. AM Best recently released a statement emphasizing the importance of stress testing to gauge the impact of the pandemic on risk-adjusted capital, investment portfolios, reserve adequacy and other potential risks. They emphasized that access to liquidity and the laddering and maturity structure of debt securities in the capital structure of insurance companies will be areas of focus.
As we continue to stress test client portfolios, we are modelling a range of asset and operational risk variables to better understand potential liquidity needs. Is the client experiencing reduced premiums, implementing forgiveness programs or being mandated to reduce premiums by regulators (as in California)? Is the client mandated to provide coverage that would typically be excluded? The primary modelling variable on everyone’s mind seems to be: how long does the pandemic and subsequent shut-down last?
What are additional sources of liquidity?
We continue to work with clients to help them access the benefits the Federal Home Loan Bank System (FLHB). The FHLB provides members with low-cost funding (“advances”) that insurers can use for daily and contingent liquidity, including back-up or emergency liquidity. Advances are secured by pledging mortgage loans or other eligible collateral held in insurers’ portfolios and often come with terms that are more favorable than those available in the broader market.
As we continue to navigate through the current market uncertainty, we remain focused on helping insurers effectively manage risk, stay abreast of new developments and take advantage of opportunities arising from market dislocation and government programs. We look forward to discussing these and any additional questions that are important to your insurance enterprise.
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SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association.
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