IN BRIEF

Insurers face a vastly changed investing environment as we emerge from the post-crisis era. On the one hand, we anticipate that slow economic growth and the burdens of an aging world population will constrain sovereign and investment grade yields for the foreseeable future. On the other, a more stringent regulatory environment, for banks and insurers alike, could present sizable opportunities in private credit:

  • The contraction of the shadow banking system has created a funding void that insurers, with relatively predictable liabilities, are well positioned to fill.
  • As banks, in Europe particularly, seek to shore up their capital ratios through deleveraging, a large supply of private loans should become available, creating in effect a buyers’ market.
  • Capital adequacy rules, based on Europe’s Solvency II regime, should enhance the value to insurers of thoroughly researched and carefully structured private loan portfolios.

In sum, the private lending market offers insurers a means to diversify away from sovereign and investment grade debt and reap the liquidity premium potential of their liabilities.

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The recent financial crisis underscored three features of the global system of credit creation: the resiliency of traditional regulated bank lending, the inherent riskiness of lightly regulated shadow banking, and a chronic shortfall between the funding needs of long-term business borrowers and traditional bank funding sources.
 
The gap left by shadow banking’s sharp contraction offers an opportunity to insurers working through professional asset managers, though they face a vastly changed investing environment as we emerge from the post-crisis era.
 
The changed regulatory environment is likely to force banks to deleverage, just as shadow banking funding from hedge funds, middle market collateralized loan obligations (CLOs) and bank proprietary trading desks is drying up. This broad pullback opens a wide gap between loan demand and credit supply—a gap we expect to persist.
 
The structural changes in the lending markets are coming together to create an opportunity for insurers to pick up compelling yields across a range of private credit asset classes, each with varying levels of risk-based capital intensity. Insurance companies will not completely replace traditional bank lenders, but they are hardly new to the game.
 
The global financial crisis culminated a long, steady decline in interest rates worldwide. Economic growth rates in developed markets have been declining for decades; a trend that consensus estimates suggest will persist and foster chronically low rates. And although central bank efforts to promote growth by suppressing rates have made headlines, aging demographics may well have a more lasting structural effect.
 
We anticipate that policy efforts to bolster government finances and stabilize sovereign debt-to-GDP ratios will also suppress growth. This perfect storm of factors makes the challenge of securing a high and stable income extraordinarily difficult for insurance investors
 
In this post-crisis environment, safe assets come to seem less than safe over the long run. Although the efficacy of sovereign bonds against short-term tail risk remains robust, the bonds themselves pose a growing threat to long-term portfolio values and income.
In this post-crisis environment, safe assets come to seem less than safe over the long run.
Increasingly, insurance investors will have to vary the risk actors of their allocations. They will have to look beyond sovereign bonds to strategies that can generate additional portfolio income by taking advantage of higher credit spreads and capturing liquidity premia.
 
Crucial to formulating the insurance industry’s long-term yield enhancement strategies is its own regulatory environment. Capital adequacy rules, based on Europe’s Solvency II regime, should enhance the value to insurers of thoroughly researched and carefully structured private loan portfolios.
 
In sum, the private lending market offers insurers a means to diversify away from sovereign and investment grade debt and reaps the liquidity premium potential of their liabilities.
 
The pace may be uneven, but the supply of investable loan assets for the insurance industry is growing around the world, in contrast to the constraints we anticipate in the sovereign arena. The enhanced supply should allow insurers to be selective in augmenting their portfolios.
 

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