11 March 2014 Insurance

Solvency II will force insurers to dump corporate bonds

Driven by Solvency II requirements that favour diversification in investment portfolios, insurers could be forced to dramatically cut the amount of corporate bonds they hold, driving up companies’ borrowing costs in the process.

A report by Cazalet Consulting suggests that UK insurers will cut their holdings of sterling corporate bonds by £50 billion before 2020. It is estimated that insurers hold around half of the £343bn of sterling-denominated corporate debt in issuance.

Solvency II will likely categorise long duration corporate bonds as risker than they have traditionally been perceived. This means insurers will have to hold more capital against them, in turn incentivising them to rebalance their portfolios towards other non-traditional investments such as infrastructure deals, commercial real estate and secured loans.

Although the Cazalet report is UK-centric, a similar dynamic could be replicated in other parts of Europe.

A number of the big European insurers and reinsurers have already started moving in this direction. Two years ago, Swiss Re said it would invest $500 million in businesses and assets related to long-term infrastructure deals, for example, as it sought greater diversification.

“Solvency II looks to provide a challenging new landscape for insurers who hold long dated corporate debt, even as many fixed income investors and commentators still find the credit term premium attractive,” said Harris Gorre, head of new financial products at Investec, an asset management specialist.

But Gorre added that there are alternatives available for insurers looking to maintain liquidity but worried about interest rates rising. One option is to work with a third party such as Investec to structure a swap that can hedge this interest rate risk.

“We’ve developed a unique solution that ensures they can hold long dated corporate bonds whilst removing their interest rate risk,” Gorre said. “However, those less worried about liquidity should ensure that the illiquidity premium they receive compensates for the additional risk assumed. Unfortunately the more investors looking for these assets the harder this is to achieve.”

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