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The search for yield: low interest rates are forcing life insurers and their asset managers to find alternatives to investment-grade bonds.

On Sept. 30, 1981, the 10-Year Treasury Constant Maturity Rate was 15.84%, and mostly it has been dropping ever since, according to Federal Reserve Economic Data. As of early August this year, it was down to about 1.5%.

"Obviously, that's a big issue for insurers," said Steve Doire, global head of Insurance Advisory Services for Deutsche Bank's Insurance Asset Management. "The bonds they bought at higher yields are rolling off, and they have to reinvest."

In short, that is the reason behind a new search among insurers for yield. The search means they have to move out of their comfort zone of investment-grade fixed income.

And insurers, with the help of asset advisers and managers, have cautiously been moving outside of traditional investments into a variety of investments that provide higher yields along with higher risk.

The dilemma for insurers is that if they buy a long-duration bond, it will decline in value if prevailing rates rise. "Of course, insurers could then hold the bonds and avoid realizing losses, but then they'd be forgoing potentially higher investment yields," Doire said. "What it comes down to is whether they want to try to time the market." At the end of last year, Deutsche Insurance Asset Management had $207 billion in insurance general assets under management among 110 clients.

According to several asset managers/advisers, insurers have turned to high-yield bonds, bank loans with floating rates, mezzanine debt, mortgage trading securities and global infrastructure securities. Stocks with high dividends are increasingly in demand among property/casualty insurers, but not life insurers.

Other assets in the conversation are exchange-traded funds and emerging market debt. (Mezzanine debt is subordinated, meaning that if assets are distributed in a legal proceeding in the event of a default, its owners would usually be last in line among bondholders, but ahead of stockholders.)

Both life insurers and property/ casualty insurers are feeling the urgency to find higher yields and/ or better total returns. Stewart Foley, head of U.S. Insurance Advisory for P-Solve, said his company found in a survey early this year that 60% of insurers added an asset class in response to low interest rates. His clients are mostly diversifying into high-yield bonds, bank loans, emerging market debt and high-dividend equities. P-Solve manages more than $13 billion for 175 clients in the United States and United Kingdom, 27 of which are insurers (many are Lloyd's syndicates), and also advises $37 billion of client assets.

In Demand: High-Yield Bonds

High-yield bonds have been in demand, including by insurers. A big reason is that those rated B or BB are averaging 6.5% to 7% yields, and credit quality is very strong. "In 2008 and 2009, many issuers recognized the need to pare their expenses and turn out their debt," said Joseph Syage, managing director and portfolio manager, Insurance Asset Management, for Brookfield Investment Management, which manages $16 billion in assets. "As a result, we're seeing very low default rates and more upgrades than downgrades. And balance sheets are in the best position they've been in quite a number of years.... So we think the incremental yield is more than compensating for the perceived risk."

Brookfield also expects that high-yield bonds will hold their value very well in a rising interest rate environment because of the wide spreads over Treasuries and because the average duration of high-yield bonds is only about five years, Syage said.

Risk-based capital charges--as assessed by the National Association of Insurance Commissioners' Securities Valuation Office--also favor high-yields. According to Doire, RBC charges for high-yield bonds are in the single digits for life insurers, but can be 30% or more for equities.

"So high-yield bonds, particularly at the BB to B level, are probably the least capital-intensive way to get a little more yield" he said.

On the down side, high-yield prices have become "frothy" Doire said. "So it's probably not the ideal time to get in, but we do think it's a good place to put money, and you've got to find the right issuers and to be patient to build a good portfolio." Insurers have traditionally allocated 5% to 10% of their bond portfolios to this class, Doire said.

Floating Rate Bank Loans

Peter Noris, president and chief investment officer of Safe Harbor Re, said that the bank loan market, mezzanine debt and mortgage-backed securities are currently very attractive alternative investments. Safe Harbor Re is in the business of reinsuring the business of fixed and equity-indexed annuities, and the legacy products in those lines can have 3% or 4% floor guarantees. The bank loans--made mostly to corporations--can be a few hundred basis points above the London Interbank Offered Rate. "Our view is that interest rates are going to go higher, so having some floating rate asset in your mix is attractive" he said.


Doire said that a good feature with bank loans is that they tend to have better debt covenants than a typical publicly issued bond, which results in good recoveries when there are defaults. "And generally, they experience low defaults;' he added.

However, Syage said Brookfield is not concerned about Libor moving higher anytime soon. "We've all heard the Fed say it will not raise rates for two or three years," he said. "Bank loans are similar to high-yield bonds, except high-yield bonds have fixed rates and therefore slightly more interest-rate risk." Syage said high-yield bonds provide 200 basis points more in yield than many bank loans.

Mortgage-Backed Securities

Meanwhile, the prices for mortgage-backed securities have come down a great deal post 2008, and they've been re-rated higher as NAIC 1 and 2 securities. "So for reserving purposes, they work very well," said Noris. "But again, that's not always a yield play. That's more of a back-ended return, so you need to have a long-term time horizon to get the returns out of that asset class."

New mortgage-backed securities on the residential side are all backed by the agencies, Fannie Mac and Freddie Mac, publicly traded companies implicitly backed by the U.S. government. Unfortunately, the companies got involved in subprime and other "rocket-fuel-type mortgages" that lost a great deal of money, and the federal government had to pump some $200 billion into them to keep them afloat, Syage said. "But we are still investing in these high-quality mortgages, although we are concerned about faster prepayments due to government refinancing programs;' he said.

'Mezzanine' Debt

Mezzanine is a generic term to describe both private and public issuances of debt. Syage said that getting access to privately issued debt usually requires a larger capital commitment, but publicly traded debt can be purchased in smaller sizes. The downside to deeply subordinated debt, Syage said, is that the buyer would be in the lowest capital structure recovery among bondholders, "so the key is that you want to stay with very solid companies. But with good credit work, we think it pays to go a little lower in the capital structure."

While P/C insurers have more interest in high-dividend stocks, many of which have higher yields than 10-year Treasury bonds, life insurers still have just 1% of their assets in this category, Doire said. One reason is the high RBC charge, but Doire also said that for statutory accounting purposes, equity values are marked to market straight through surplus. "If you buy an investment grade bond, it's carried at amortized cost," he said. "A market move doesn't affect your reported capital"

But holding equities provides an economic diversification benefit that gets some recognition in RBC capital charges via the covariance calculation, and "our studies indicate that life insurers can modestly increase equity allocation with modest increases in required capital,' he said.

Other Asset Classes

Doire said his team likes global infrastructure securities, which can include debt from the purchase of airports, bridges, toll roads and water departments. He expects that debt-laden governments are going to have to monetize some of their assets by selling to private investors, who in turn will rebuild and maintain crumbling infrastructure. "These types of investment tend to be high quality because they're not like a start-up business,' he said. "Something already exists. People have to drive on a toll road, and it has a revenue stream. There's not a whole lot of risk here."

The assets also tend to be of different durations, but mostly long, which matches up well for life insurance liabilities, Doire said.

Exchange-traded funds in July received a boost as an asset class when 27 of State Street's Global Advisors' fixed income SPDR ETFs received RBC designations from the Securities Valuation Office. The addition brought the number of ETFs rated by the NAIC to 63 funds.

Key Points

* The News: Seeking higher yields, life insurers increasingly are exploring alternatives to traditional investments.

* The Situation: These involve greater risk, but companies are retaining the bulk of core fixed-income portfolios.

* What It Means: Asset managers and other outsourcers will play a larger role in selecting and providing insurer assets.
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Author:Panko, Ron
Publication:Best's Review
Date:Sep 1, 2012
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