European re/insurers are increasingly relying on equity investments to maximise their returns in the current low interest rate climate, despite the inevitable rise in exposure to market risk, according to A.M. Best.
The rating agency analysed the 500 largest European re/insurers over a six-year period, finding that there was a 2-3% shift from investments in fixed-income products to quoted equity, representing around €200 billion.
Low interest rates over the past few years have made it increasingly difficult for companies to generate returns from traditional fixed-income assets.
European re/insurers have responded by moving to riskier assets, like equities, despite the higher capital charges now imposed on them by the EU’s Solvency II capital rules, which came into effect in January 2016.
Thomas Bateman, Financial Analyst at A.M. Best, said: “Insurers and reinsurers operating in the region are considered to be well-capitalised, hence there is limited pressure from a capitalisation perspective for companies to de-risk their investment portfolios. In addition, companies in Northern and Western Europe tend to use sophisticated asset liability management techniques, which form a core part of the strategic allocation process.”
As a result of the growing exposure to global equity markets, A.M Best expects re/insurers to experience some unrealised losses due to the considerable market drops in February 2018.
Nevertheless, it recognised that re/insurers taking a longer term view on their investments will be accustomed to such short term volatility, and noted that the impact for European companies will be minimal, as their investment portfolios continue to be focused towards cash and bonds.
Cheap borrowing remains prevalent in the current market, and most companies with long-term liabilities will be welcoming a rise in interest rates so they can take advantage of additional discounting on the market value of their technical provisions.
Although investment returns may benefit marginally from a rise in interest rates, inflation could put pressure on re/insurers’ earnings, leading to higher cost of claims and forcing companies to be prudent in their pricing and underwriting approaches.
However, A.M. Best suggested that a rise in interest rates would benefit those re/insurers that maintain negative duration gaps, where the average duration of a company’s insurance liabilities is longer than its assets.
A.M Best concluded that credit rating outlooks and actions will be dependent on each individual company’s level of asset diversification, as well as how effectively they implement specific risk management practices and tools.