Could insurer investment risks cause a drag on buyout volumes?

The outbreak of COVID-19 has taken a significant toll on financial markets, businesses and governments around the world.

Whilst governments have offered an unprecedented level of support to corporates during this time, including staff furlough schemes and in the UK, amendments to insolvency legislation, many companies have been unable to weather the storm. This is evidenced by the recent material uptick in global corporate defaults and downgrades (defaults and downgrades reached 180 and 1,033 respectively as of 30 Sep’20 – source: S&P Global Ratings) and the road to recovery is unlikely to be a smooth one.

What does this mean for insurers?
The pandemic has triggered a record pace of credit rating actions / downgrades as economic disruptions push many corporates to become ‘fallen angels’ i.e. shifting them from investment grade to “junk” territory. This heightened risk of corporate defaults, particularly as government support measures come to an end, could impact insurers by way of permanent capital losses over the next 18 to 24 months. This deterioration in credit conditions is compounded by the low-interest rate environment and pressure on property prices, most notably commercial property prices which have declined c7% during the first half of 2020. Whilst the magnitude of such losses has not yet been quantified, the end result could strain insurers’ capital positions. This may even force some of them to hit the pause button on quoting activity for new business.

Which insurers will be hit the hardest?
This depends on an insurer’s investment strategy. While insurers are incentivised to hold a predominantly investment grade strategy, some providers more actively seek to stretch the current boundaries of the Solvency II framework to meet target returns on capital. Those holding sizable ‘BBB’ rated bonds, i.e. one notch away from “junk”, could for example see the biggest strain to their capital positions.

Insurers have so far managed to absorb the capital strain well through a combination of raising new capital, seeking additional reinsurance and improved risk processes. These actions have come at the expense of increased leverage and reduced flexibility for Management to deploy similar risk mitigating actions in future, should the situation continue to worsen.

So, what can Trustees do to make sure they choose the “right” provider in these uncertain times?
Understanding counterparty risk should be at the fore of a Trustee Board’s agenda before entering into exclusivity with an insurer. Trustees should be taking a long-term view in their due diligence of shortlisted insurers rather than focusing on short-term market volatilities. Rather than a box ticking exercise, insurer selection should involve stress testing insurers’ balance sheets to understand the resilience of their capital position and what mitigating actions could be taken in a downside scenario – this will go a long way to help Trustees to secure the “best” deal for their transaction.

Nillani Jeyapalan, Associate

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