After more than a decade of ultra-low interest rates, most central banks globally have started to tighten their monetary policy to fight high levels of inflation. And, even though not all central banks in the Asia-Pacific region have started to aggressively hike interest rates, many insurers in the region are still affected by the sharp rise in interest rates in the US given their significant exposure to the US fixed-income market, according to a recent report.
The gap in interest rates has also resulted in higher foreign exchange (FX) hedging costs for US dollar-denominated assets, finds the report by asset manager DWS, which is majority owned by Deutsche Bank. This is especially true, it finds, for Japanese insurers for whom the demand for US dollar-denominated fixed-income investments has dropped significantly on the back of significantly higher FX hedging costs.
Search for yield
For new investments, rising interest rates have improved the attractiveness of most liquid asset classes amid the significant re-pricing that took place in 2022. During the low interest rate environment of the past several years, insurance companies had to significantly increase their investment risk in order to get a decent yield; they can now again get an attractive return from high-quality core fixed-income instruments, the report argues.
In their search for yield, insurance companies not only took on more credit risk in fixed-income investments but also significantly increased their allocation to alternative assets, such as real estate, infrastructure or direct lending. While the report sees insurers now focusing again on high-quality fixed-income instruments, such as government bonds and investment-grade corporate bonds, it does not yet see significantly less interest in alternative assets.
The reason for this might be that alternative assets can still provide other advantages than just an illiquidity or complexity premium over comparable liquid assets. To name a few, alternative assets can typically also provide diversification benefits, better structural protection, some degree of inflation hedging as well as a high capital efficiency under most risk-based capital regimes that have been introduced (or are currently in the process of being introduced) in many jurisdictions across Asia-Pacific.
One alternative asset class that has almost immediately responded to rising interest rates is private debt, given that most loans are floating rate and higher rates are directly (or with a short time lag) passed on to investors. The report forecasts continued demand in this alternative asset class, which is also driven by other structural advantages, such as typically lower expected credit losses than for comparable investments in bonds.
However, at the same time, some insurers are also worried that rising rates could have a negative impact on the borrowers’ capacity to service their debt payments. Therefore, the current market environment may serve as a “first stress test” for private debt investments of insurers as this asset class has basically emerged as a new one for them since the financial crisis of 2007-08.
Traditional insurance policies
While the marketing of investment-linked policies (ILPs) is typically challenging in volatile markets, and rising rates may have improved the attractiveness of traditional guaranteed life insurance products, the report currently does not see the long-term trend toward ILPs to reverse. It does, however, see some changing demand to the types of funds in which these policies are linked due to the rising rate environment.
While equity funds were especially in high demand over the past several years, the report sees more interest in multi-asset products that also have an allocation to fixed-income investments. This also includes solutions with capital protection features such as products based on the constant proportion portfolio insurance mechanism that dynamically shifts between a risky portfolio of assets (usually consisting of equities) and a less risky portfolio of assets (usually consisting of cash or high-quality bonds) to achieve a certain degree of capital protection. The construction of these products had been challenged during the low interest rate environment.
Overall, rising interest rates had a positive impact on most insurance companies. Despite significant (unrealized) losses on existing investments, the overall solvency position of most insurers has remained stable or has even improved given the value of their liabilities has come down. Insurance companies that had been starving for yield on traditional fixed-income investments for more than a decade now have the opportunity to again lock-in attractive yields on high-quality core fixed-income instruments.
However, at the same time, the report does not see higher interest rates resulting in the reversion of some long-term trends observed in the insurance industry, such as higher allocations to alternative assets and the shift from traditional life insurance policies to investment-linked policies, as these structural trends have also been driven by other factors, such as the introduction of risk-based capital regimes in most Asian countries.