According to research from Cerulli Associates, U.S. insurance companies, which have more than $4 trillion in mostly investment-grade bonds in their portfolios and more than $6.2 trillion in total invested assets, view the late stage of the credit cycle as “very concerning” as compared to other investment concerns, such as the low-interest-rate environment, market volatility and market liquidity.
“A prolonged period of historically low long-term rates has proven extremely challenging for insurers from a business perspective, both making it difficult to reach annual book yield goals and raising the present value of longer-term liabilities,” Cerulli says.
The firm’s surveys show nearly two-thirds (64%) of respondents plan to increase their allocations to private debt and half expect to add to structured or securitized debt during the next 12 months. Among alternatives investments, which are limited in insurers’ general account investment portfolios due to regulatory capital constraints, a majority of insurers plan to add to infrastructure investments (75%), alternative fixed-income strategies (63%), and private equity (55%).
Why does this matter to retirement plan fiduciaries? Because the performance of capital preservation investment options, such as stable value funds and guaranteed investment contracts (GICs), depends on how insurers’ general accounts—and possibly other accounts—perform.
How Insurers Protect Portfolios
John Simone, managing director and head of Voya’s Insurance Investment Solutions business in Chicago, says the challenges of insurer’s general account investors is akin to the task of offsetting future liabilities for defined benefit (DB) plans.
“Rates staying low for long is an issue, as well as tightening of spreads with regard to the credit market. Longer-term investments are maturing, and new vehicles have lower rates,” Simone says. “Insurers need to generate rates of return to meet obligations, but they can’t dial up risk because that may cause their credit rating to go down. There are only certain things they can do to secure yields, like buying long-duration securities.”
However, he says insurance companies are well-suited to address these challenges because of the breadth of their access in capital markets. “At Voya, we favor private assets over public in many areas where an investor can get greater diversification and better yield and better protections. When an investor buys a public bond, it doesn’t have a say if the company starts violating covenants; it can only sell. But, with private assets, investors have some say,” Simone says.
Insurers are also using high-quality, low-volatility assets, such as federal home loan bank borrowing or floating rate borrowing to invest in floating rate securities, according to Simone. In business and finance, a floating rate loan (or a variable or adjustable rate loan) refers to a loan with a floating interest rate. The total rate paid by the customer varies, or “floats,” in relation to some base rate, to which a spread or margin is added (or more rarely, subtracted).
They are also buying securitized assets with terms not necessarily tied to corporate balance sheets. Simone says if firms securitize assets, the terms are tied to U.S. consumer asset-backed securities like credit cards, high quality student loan debt and mortgages. Securitization is the financial practice of pooling various types of contractual debt, such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs).
Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).
When investing in alternatives, Voya prefers primarily private equity or private mezzanine funds that provide attractive yields in areas it feels have asymmetric risk. According to Simone, “We feel comfortable in mezzanine renewable energy funds, currently generating around 11%. People need power, and there has been a shift globally from fossil fuels to renewable energy.” He says infrastructure is a theme with alternative investing.
Russ Ivinjack, senior partner at Aon Hewitt Investment Consulting in Chicago, says insurers do position portfolios to meet their current needs or, if they are planning for a market pull back, they may move into the highest quality securities. A pullback can also be seen as a buying opportunity. “Generally, what we’re seeing is insurance companies continue to diversify portfolios with Treasuries trending downward. Asset-backed securities and real estate debt are among the investing opportunities to boost yield,” he says. Ivinjack adds that it’s not just in their general accounts that insurers are moving to different investments.
Still, he says that because of the lower yield environment, the performance of stable value funds and GICs will trend downward.
Monitoring Insurer’s General Accounts
So, should retirement plan fiduciaries monitor insurer’s general accounts like they do other investments?
“Fortunately, insurance companies are rated by groups that make sure they are solvent,” Simone says. “And, there is protection in terms of the amount of capital they have to hold based on total assets they hold and risk.”
Larry Steinberg, an investment adviser with Claraphi Advisory Network LLC, an SEC-registered investment adviser, and CIO of Financial Architects, based in Pasadena, California, says retirement plan fiduciaries are looking at the credit rating of the insurance company backing the investments in general accounts. And, as far as monitoring the investments backing annuities in qualified plans, he says that has not come up as an issue. “We are still seeing how annuities in qualified plans are going to work. Insurance companies are inventing products right now, and we’ll see what gains acceptance in the market,” Steinberg says.
However, Ivinjack says there are two things retirement plan fiduciaries should do. First, understand what capital preservation funds are investing in, asking whether assets are commingled with an insurance company’s general account or are kept in a separate account. Second, if they are exposed to an insurance company’s general account, look at the underlying credit quality of the insurance company.
He explains that, if the assets are separated, that fund is segmented for the sole purpose of paying investors in that fund and is not linked to the credit quality of the insurer. If plan fiduciaries are looking at a strategy where yields look much higher than peers, they should be concerned that could be too good to be true. “If yields are much higher, [plan fiduciaries] need to understand why,” Ivinjack says.
If yields are competitive for different capital preservation funds, retirement plan fiduciaries should compare what else is in the market, he adds.
“Most folks can bear a decent amount of volatility in equities, but in fixed income—the safety investment—everyone is concerned,” Ivinjack says.