• ​Insurance companies are responding to low-yielding markets and high capital levels with more aggressive asset allocations, including alternative investments.
• Interest is increasing in outsourcing non-core and even entire general account portfolios as companies merge and markets become more complex and less liquid.
• Regulatory changes are increasing the reporting burden on insurance companies and in some cases changing business models.

Low yields, industry consolidation and new regulation are all impacting the insurance industry and how firms manage their investment portfolios. We discussed how investment management is evolving in this space with PIMCO Managing Director and Head of the U.S. Financial Institutions Group Robert Young.

Q: How has the market environment led to changes in the insurance industry?
Young: There are several forces that are having an impact on insurance business models. Low returns in a low yield market, industry consolidation amid a significant amount of M&A activity, and regulatory changes are all having an impact on the industry and how insurance companies are doing business and managing their investment portfolios. We expect to see continued disruption and evolution in 2016.

Q: How are insurance companies dealing with the challenge of low yields?
Young: Low-yielding markets coupled with relatively strong capital levels are leading to more aggressive asset allocations for insurance companies. Their long-term liabilities can be considered the equivalent of “issuing” relatively long, illiquid promises. They are in a unique position to sell liquidity. So we are seeing increased interest in investments in private placements and commercial mortgage loans, as well as private equity and hedge funds.

For example, private equity and hedge fund investments have steadily increased over the last decade from $25 billion to $86 billion, a growth rate of 14% per year. And even with regard to private equity, the potential for high returns is viewed as acceptable compensation for the high capital costs associated with these investments. In some cases, insurers have been able to invest in higher return private equity vehicles with minimal capital requirements given the nature of other general account investments and the associated diversification treatment. Others have invested in private equity vehicles at the holding company level. To summarize, insurers are looking at alternatives to improve returns, and there may be ways to do it in a capital-efficient manner.

Q: What challenges and opportunities is the M&A wave having on insurers?
Young: Industry consolidation is causing some companies to recalibrate their investment models. As companies combine, one firm may have been relying on internal investment management resources while the other may have been more reliant on third party investment managers. This has led to a closer examination of the outsourcing model by many companies. As markets become more complex and less liquid, interest in outsourcing large blocks of non-core and even the entire general account portfolios is increasing. Investment management fees have migrated downward over the past decade making this decision less about costs and more about increased investment opportunities.

Many professional investment managers offer infrastructure and expertise that is designed specifically to satisfy the fiduciary and regulatory requirements of boards, shareholders, policyholders and regulators. The economies of scale of an investment manager can support a more rigorous investment process and resources (e.g., dedicated credit research, analytics and sector-specific portfolio managers) that can make it realistic to pursue a broader, more complicated investment opportunity set and potentially higher and more diversified returns.

Q: You mentioned regulatory changes. What is the ongoing impact on the industry?
Young: Regulatory changes are increasing the reporting burden on companies and in some cases changing business models. Solvency II has a much higher reporting burden, creating additional pressures for insurance company investment teams that investment managers can help to alleviate. In the U.S., specifically, we are seeing a change in the investment practices of health insurers due to the Affordable Care Act. Regulations on underwriting are creating uncertainties, putting pressure on profitability. And while insurers are increasingly inclined to invest more aggressively, larger companies may have the scale and diversification to invest in non-core sectors, which can offset the drag on underwriting income, while smaller companies without such flexibility may be forced to retrench and invest in liquid, low returning sectors due to less of a profit cushion. Outsourcing can offer them the opportunity to invest in sectors they don’t have the internal capabilities to evaluate and access efficiently and effectively.

Q: What are some specific investment opportunities that PIMCO would suggest insurance companies consider in the current environment?
Young: First, consider staying active in your core fixed income allocations. Early 2016 has reminded us how important it is to have a forward-looking investment process that combines top-down and bottom-up research. That is what gives PIMCO the perspective to balance fundamentals with valuations and market technicals and the conviction to add risk when valuations cheapen. The current environment also highlights the importance of active risk management. After the financial crisis, many insurance companies turned to PIMCO to improve how they navigate risk in their portfolios. Recent volatility has created opportunities for insurers that have maintained sufficient liquidity to add select credits at favorable levels.

Second, avoid an external rating bias. Many insurers exit investments downgraded below investment grade due to punitive capital charges, perceived impairment risk and/or optics. Insurers comfortable with liquidity risk should consider utilizing the entire quality spectrum to find value, as select high yield issuers with improving balance sheets may be a better investment than certain investment grade rated credits vulnerable to re-leveraging risks. PIMCO has its own rating system that aims to identify high yield credits that may be upgraded or investment grade credits that may be at risk for a downgrade.

Third, include a broader range of fixed income assets in your portfolio. Certain sectors like non-agency residential mortgage-backed securities, commercial mortgage-backed securities and municipals may offer attractive ways to diversify a fixed income portfolio beyond investment grade corporate bonds. The myriad regulations and capital measures imposed on global banks have led to stronger balance sheets, making bonds from banks potentially attractive as well. Many nonfinancial issuers have taken advantage of low yields to increase leverage and shareholder return potential, but these balance sheet dynamics are not always appropriately priced across industries and capital structures, offering compelling opportunities for investors who can identify optimal points of risk and return along the debt/equity continuum. An investment manager who has deep expertise in bank loans, preferreds, hybrids and other subordinated debt structures can identify opportunities in these sectors that can help improve risk-adjusted yield/return characteristics.

Fourth, be open to “alternatives.” Alternative investments, including unconstrained strategies and distressed funds, among others, can fill a gap and diversify a portfolio, and they are receiving increasing interest among insurers.