As we begin 2014, there is no doubt that insurers are faced with a set of challenges that will incline them to reexamine their investment portfolios and overall approach to asset allocation. Despite the real challenges posed by low yields, shrinking profit margins and regulatory uncertainty, we at BlackRock are seeing investment trends that, if executed properly, will position insurers for income growth this year.
Its no secret that the current low for longer fixed-income environment is further turning the screw for insurers that rely on returns from investment portfolios to fund daily business operations as well as support total earnings. Last year frustratingly low rates led insurers to report that investment income as a portion of overall corporate profitability fell to nearly half the level of historical averages. Faced this year with a very real need to generate more income, insurance and reinsurance companies are likely to continue to relax investment guidelines and take a more flexible approach to investing.
Duration management will continue to be a critical aspect of insurers investment strategies in light of changing monetary policies and the likelihood that rates will rise slowly in 2014 and more rapidly thereafter. We believe these factors will drive insurers to source assets with lower interest rate correlations and higher yields than they can achieve in their core fixed-income portfolios.
On the whole, insurers are finding that they tend to hold more liquidity than they truly require and are likely to reallocate toward assets such as infrastructure debt, real estate debt, bank loans, collateralized loan obligations and other income-producing alternatives that provide a premium over core fixed-income yields alongside diversification benefits. We also expect insurers to allocate more toward innovative investment opportunities that we see emerging as a result of the ongoing shift in banking and capital markets. The maturing lending market is an example of an opportunity for insurers to invest in loans outside the traditional banking model with the potential to receive attractive risk-adjusted returns combined with lower correlation to their existing portfolio.
Key to such strategies is due diligence, risk management and adequate scale to build a compelling portfolio. These requirements, however, have led more companies to outsource this part of the portfolio. For instance, at BlackRock, the assets managed for insurers in these nontraditional products have increased fivefold during the past three years.
A surge in the use of credit-oriented exchange-traded funds is expected as insurers continue to seek lower fees and access to less liquid, more nuanced markets that often complement core fixed-income assets such as municipals and high-yield and international debt. We expect insurers will continue to use ETFs to reach a host of investment objectives, including volatility hedging, tactical asset allocation and duration management. Further, more innovations in the ETF market will specifically target the insurance industry. For example, BlackRock offers term-maturity ETFs, which can offer steady yield, predictable cash flows and decreasing duration over time.
In 2014 insurers will also reconsider their equity allocations, paying more attention to controlling volatility and portfolio diversification to better manage downside risk. Minimum-volatility strategies are likely to become a core holding within equities, and more discussions are taking place around risk-based investing. To improve diversification, insurers might also consider shedding some of their home-country equity bias.
The last and likely most important consideration for insurers in 2014 is a capital-efficient and regulatory-optimized asset allocation process that will ultimately affect investing activities across asset classes and geographies. In the U.S. the Risk Management and Own Risk and Solvency Assessment will encourage more insurers to reevaluate and upgrade their investment risk management systems, similar to the trend we have seen in Europe in preparation for Solvency II. In contrast, there is a tide of regulation for insurers across Asia, encouraging those with sufficient capital to extend their investment universe to take advantage of higher-yielding nondomestic assets.
David Lomas is the global head of the financial institutions group at BlackRock in New York.
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