Insurers are uniquely positioned to profit from the uncertainties in global fixed income today:
In markets where secondary trading has dried up, they have the size and scale to capture new issue discounts.
In markets where the liquidity crisis is still shaping investment decisions, they can take advantage of their relatively predictable liabilities and their status as buy-and-hold investors to capture sizable premiums.
To command the discount insurers need deep and dependable relationships with large fixed income asset managers. To capture a liquidity premium they need a statistically robust and mathematically exact procedure for distinguishing between the default risk and liquidity premium embedded in credit spreads.
By the standard of the apocryphal Chinese curse, insurers find themselves in interesting times indeed. The bond yields on which their general accounts depend have evaporated; when they will reappear is anyone’s guess. The safest investments relatively speaking—government securities—seem to offer the riskiest value, and the only certainty about the unsettled regulatory environment for banks and insurance companies is that it will be more stringent.
Insurers today have little choice but to accept more investment risk to secure the long-term survival and prosperity of their strategic business model.
So insurers today have little choice but to accept more investment risk to secure the long-term survival and prosperity of their strategic business model. To sustain their investment income over these “interesting times” of rock-bottom interest rates and rising uncertainty, they can reach for yield by reducing the credit quality of their portfolios or lengthening portfolio duration and exposure to rate volatility. Or they can reap the benefit of their long-term perspective by offering the excess liquidity in their portfolios to nervous markets willing to pay a hefty premium for it. We believe this last course holds the best risk-adjusted way forward for insurers. But navigating the current environment successfully requires an understanding of the radical changes taking place in fixed income dealing, an exact measure of the liquidity available in their own investment accounts and a strategy for gaining the optimal premium by putting that liquidity to work.
Size counts and illiquidity pays
The fixed income turmoil that in large part caused the financial crisis and that reverberates today has by any measure strained insurance company investment portfolios. Even so, we believe that insurers can benefit from the changes taking place. They have portfolios large enough to matter to the asset managers that regularly reap new issue discounts. And their strategic buy-and-hold approach affords them the long-term perspective to look past the ups and downs of a protracted global recovery. Better yet, steady premium flows and their long and locked-in liability structure give insurers the capacity and capability to profit as the central banks withdraw their extraordinary support, rates normalize and markets stabilize. Combined with an analytical tool kit proven to reliably dissect the constituent risks implicit in credit spreads, it positions them, perhaps uniquely, to put their liquidity to work acquiring solid bonds at bargain prices in outbreaks of market volatility.