Here’s one more example of how central banks’ global coordinated monetary stimulus in the wake of the financial crisis has increased systemic risk in the US: According to an analysis conducted by BlackRock, insurers are more vulnerable to a market downturn now than they were ten years ago.
The reason? Ultralow interest rates have forced insurers to venture into markets with higher yielding assets, forcing them to stomach more risk along the way. Whereas insurers once tended to adhere to only the safest types of fixed-income products – typically highly rated government and corporate debt – they’re increasingly buying exposure to risky high yield and EM products, along with illiquid private equity funds, to try and boost their earnings back to pre-crisis levels.
These products carry a potentially higher reward for insurers, but heightened risks are also omnipresent. In a downturn similar to the 2008 crisis, BlackRock estimates that US insurers' holdings would drop by 11% - even more than they did during the crisis. Such a drop would be tantamount to $500 billion in losses.
“The world’s largest money manager mined regulatory filings of more than 500 insurance companies and modeled their portfolios in a similar downturn. Their stockpiles - underpinning obligations to policyholders across the nation - would drop by 11 percent on average, according to its calculations. That’s significantly steeper, BlackRock estimates, than the group’s “mark-to-market” losses during the depths of the crisis.
The reason is simple. Insurers needed to make up shortfalls after the crisis. But in a decade of low interest rates they had to venture beyond their traditional holdings of vanilla bonds. They now own vast amounts of stocks, high-yield debt and a variety of alternative assets - a bucket that can include hard-to-sell stakes in private equity investments, hedge funds and real estate.”
Even as interest rates rise, Zach Buchwald, head of BlackRock’s financial-institutions group for North America, said that the insurers’ appetite for riskier assets will remain because “many of the allocations are hard to reverse.”
‘There is more risk being put into these portfolios every year,’ Zach Buchwald, the head of BlackRock’s financial-institutions group for North America, said in an interview. And such shifts may become permanent, especially because many of the allocations are hard to reverse, he said.”
Which is a problem because, even though insurers claim they’re offsetting risk by “diversifying” into different types of risky assets, big losses can accrue if all of these assets were to drop at the same time – as one might expect during a “risk off” flight to quality.
“The new diversity should provide a huge benefit, according to Buchwald. After all, it was concentrations of investments in mortgage-backed securities and certain equities that proved the biggest pitfalls during the crisis, a study by the Organization for Economic Co-operation and Development found.
But even piles of investments that appear diverse can suffer big losses if care isn’t taken to ensure the assets won’t drop at the same time.”
The BlackRock study was an attempt to market its new “Aladdin” analytics software.
“BlackRock examined the insurers’ holdings as it pitches a service called Aladdin. It’s trying to sell the companies analytics and advice, helping them test how complex portfolios may perform under various conditions, so they can design them to withstand catastrophe.”
According to Bloomberg, the study has been published at an “interesting time” for markets.
“The assessment comes at an interesting time. With U.S. stocks trading near record highs and the Federal Reserve starting to unwind years of extreme measures, there’s a raging debate on Wall Street over whether a big correction is looming - and if so, whether unforeseen faults in financial markets might crack open, as they did a decade ago.”
Mohamed El-Erian, chief economic adviser at German insurance conglomerate Allianz, warned that “non-banks” are increasingly reaching for high-yield bonds without regarding the risks.
“The strong ‘quest for yield’ remains visible in non-banks,” Allianz SE Chief Economic Adviser Mohamed El-Erian said in a Bloomberg View column this month. The group, which typically includes insurers, has pushed into asset classes “including what most deem to be a stretched market for high-yield bonds.”
Some insurers, like Athene Holding, have bragged about the outsized returns from their riskiest investments.
“Athene Holding Ltd., an insurer that leans on Apollo Global Management to oversee investments, is wagering on complex, hard-to-sell debt. Its alternatives portfolio, representing about 5 percent of total holdings, posted a 12.3 percent return on an annualized basis in the second quarter.
It’s among a handful of insurers backed by private equity firms betting they can earn better returns than peers focusing on traditional investments. But even MetLife Inc. and Prudential Financial Inc., two of the oldest and largest life insurers in the U.S., have said they’re pushing into commercial property bets and private market debt in search for yield.”
When insurers invest in illiquid products like a private equity fund, they need to hold more capital on their books to offset the risk – money, that, as Bloomberg points out, “isn’t free.” After adjusting for the reverse capital, BlackRock found that the high-flying PE returns weren’t as spectacular as some insurers believed.
“BlackRock’s study showed that the industry’s forays into alternative investments haven’t always delivered yields on par with what the underlying money managers project. Insurers have to hold large amounts of capital against the investments they make -- money that isn’t free. When adjusting for those charges, private equity returns are generally less than 4 percent, whereas they would have been above 6 percent.
That, according to BlackRock, indicates insurers would probably earn more on investments in mezzanine real estate debt and high-risk equity investments in global real estate and other real-asset financing.”
Since the crisis, insurers have increased PE investments by 50%, despite the lower risk-adjusted returns highlighted by BlackRock. Maybe some of them SHOULD consider buying the asset-manager's new software…
“After experimentation with different assets, some insurers have shifted wagers. By the end of last year, the industry’s funds held in private equity had soared 56 percent to $56 billion from 2008. That trend is leveling off, Buchwald said.
Real estate investments, meanwhile, hit a seven-year high in 2015, then dropped by $7 billion the next year to $42 billion. Hedge fund holdings spiked to $24 billion in 2015, only to drop to $18 billion the next year. MetLife and American International Group Inc. were among those that began changing strategies.
The key is to find “other, more predictable income generators,” Buchwald said, ‘things like infrastructure and real estate.’”
Whatever their risk tolerance, a growing number of market strategists believe that the next sharp downturn in markets could begin as soon as this year. This would mark the first real test of insurers’ capital cushions since the crisis. And, particularly if it triggers a wave of defaults in the high-yield sector (or even among European sovereigns), a market rout could wipe out trillions of dollars worth of insurance company holdings.
Let’s hope that – for their sake - when the other shoe drops, insurers are ready. With Republicans controlling the White House and both chambers of Congress, failing insurers likely won’t receive the same type of bailout that AIG did during the crisis.