Expect Central Bank Divergence and Volatility
Inflation generally declined closer to central bank targets across most regions over the first six months of the year, and moderate economic growth is expected across developed markets. In response, several central banks have started to cut policy rates, including the Swiss National Bank and the European Central Bank. The Bank of England has signaled its intent to follow suit in the near future, and we now expect the Federal Reserve to make its first move in September rather than December.
On the geopolitical front, 2024’s election calendar is one of the more active in recent memory, with no shortage of meaningful contests on tap. The UK and France are recent examples of nations that have seen power shifts at the ballot box, and the US is in the run-up to its own high-profile election campaign. Geopolitical issues still loom as potential tail risks for insurance investors—most notably conflicts in the Middle East and Ukraine.
Taking these elements together, we expect the next few months to see further volatility as markets grapple with potential divergence in central bank actions and the changeable geopolitical environment. However, insurance investors must weigh these potential twists and turns against a backdrop of moderate global economic growth and yields that remain quite attractive globally.
Corporate fundamentals are still solid, though we expect them to weaken marginally as the impact of higher financing costs plays out. Refinancing challenges will be somewhat eased by the prospect of rate cuts. Credit spreads range from near average to marginally tight in European investment grade, so it’s important for investors to pick their spots thoughtfully—and to actively avoid weaker credits.
Regulators Continue Fine-Tuning the Rule Book
Adjustments to Solvency II in the European Union are in progress, including an effort to make the long-term-equities category more accessible. Solvency UK efforts are introducing changes focused on bulk-purchase annuity players, with incremental changes to rules on the matching adjustment. Both initiatives intend to reduce the cost of capital for the risk margin, which should boost solvency positions.
By this point, insurers have largely adapted to the accounting standards of International Financial Reporting Standard (IFRS) 17 and IFRS 9. From here, we think the effects on insurers will largely be more business as usual—though we saw some allocation changes stemming from IFRS 9, particularly in reducing equity exposure to help manage profit-and-loss volatility.
In our view, these regulatory changes will alter insurers’ investment strategies, but largely at the margins. Regulatory changes in the banking sphere, interestingly enough, may have a bigger impact on insurers. That’s because as banks retreat from consumer lending, it presents an opportunity for insurance investors to channel capital to the alternative lending strategies helping fill the void.
Keep ALM in Line, Make Credit More Solvency Efficient
The evolving interest-rate environment and current outlook, as we see it, reinforce the importance of testing balance sheets to gain comfort with their resilience under a variety of scenarios.
From a rate perspective, we think it remains wise to keep asset duration well-matched to liabilities. From a credit perspective, focusing on quality, active issuer selection and diversification seems sensible, given where we are in the cycle. This approach points to a number of allocation options for insurers to consider when addressing different objectives and market opportunities.
With public credit, increasing quality and focusing on shorter duration could help improve portfolio solvency efficiency—measured as portfolio yield and/or spread over the solvency capital requirement for spread risk. Put another way, this shift could reduce the solvency consumption of the public credit portfolio without sacrificing much return, freeing up solvency budget to allocate elsewhere. This is possible because the solvency-capital curve is steeper than the spread curve for BBB and A assets right now. Shorter-duration credit is also more solvency efficient than longer-duration credit.
An example helps illustrate the implications of shifting from a broad-market corporate-investment-grade allocation to one focused on shorter duration and higher quality. We can start with a base portfolio allocation (Display 2) that includes a market-weight allocation to corporate credit, some sovereign bonds and private assets. It’s then possible to assess the changes under three scenarios to portfolio duration, yield and spread as well as the solvency capital ratio (SCR) for spread risk under the Solvency II standard formula.
