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David Lomas |
As we move into the new year and closer to full implementation of a post-crisis regulatory regime, global de-leveraging of the financial sector is taking firm hold.
Regulatory reforms, including the Dodd-Frank Act, the Volcker Rule and Basel III, are putting pressure on banks to be smaller and more risk-averse. As a result, banks around the world are adjusting their business models to meet higher capital requirements while streamlining or closing their proprietary hedge funds and other alternative investment strategies.
This means efficient access to long-term capital is increasingly scarce ― making it harder for small and mid-sized businesses to fund their growth and hire new talent.
Yet, as banks exit these proprietary trading businesses, sell assets and transfer risk off their balance sheets, enormous opportunities are being created for non-bank finance companies, particularly insurers, to invest in alternative assets and help fill part of the capital void.
Insurers’ long-dated investment portfolios are valued at trillions of dollars ― and there has always been a place for alternatives and fewer liquid assets on their balance sheets. However, the competitive advantage in analyzing, sourcing and holding alternative assets has not always been in their favor. That is no longer the case. The recent decline in capacity of banks and other financial institutions will swing the advantage toward insurers, especially those that hire the appropriate investment talent internally or partner with external managers.
Another, less obvious factor with the potential to drive insurers to alternative assets is Solvency II. As a direct result of Europe’s new regulatory capital and risk standards for the insurance industry, insurers could receive improved regulatory treatment of illiquid assets when held against specific liabilities.
But perhaps most urgently, another year of persistently low interest rates and a dwindling supply of quality fixed-income assets will stress insurers’ income prospects and force them to embrace new methods for achieving their investment return targets.
Just consider, the Federal Reserve is on pace to take more than $1 trillion of “safer” fixed-income assets out of the market this year ― absorbing virtually all fixed-income net supply. At the same time, life, property and casualty insurers in the U.S. will need to replace $600 billion of maturing fixed income. As they put that money back to work in a highly competitive marketplace, insurers will need to rethink how that capital is invested.
While investors have piled into interest rate and credit risk over the last five years, illiquidity risk has been left on the table. That, too, will change. Insurers will increase their exposure to the illiquidity risk premium by setting illiquidity budgets and dedicating part of their portfolios to those investments, particularly those with predictable cash flows.
Insurance capital will be redeployed to higher yielding areas such as opportunistic credit, real estate debt (senior and mezzanine), social housing and high-yielding bank loans. Insurers will look beyond high-yield bonds and find attractive opportunities in leveraged loans and collateralized loan obligations.
Infrastructure project financing is another area deserving a much closer look by insurers. These assets provide the long-dated horizons that insurers, particularly life insurers, have traditionally looked to government bonds for when matching their liabilities. Today, a long-dated infrastructure debt investment offers approximately two to three percentage points more in yield than a comparable U.S. Treasury.
And there is an even greater social benefit to infrastructure investment than just high returns: Infrastructure is precisely the long-term capital investment essential to upgrading aging American and European roads, railways and other public services ― and helping governments bolster sluggish economies around the world.
The OECD estimates that $3 trillion is needed for global infrastructure projects by 2018, and upgrading America’s infrastructure alone is estimated at a staggering $2 trillion. With banks shifting away from long-term, job-creating investments like infrastructure, insurers and other non-bank institutions can step in to extend that sorely needed source of capital.
We are in great need of the kind of patient capital required to fund these long-dated development projects ― to build bridges, schools or hospitals, and provide much-needed jobs. To date, the U.S. municipal bond market has been one provider of infrastructure capital, but it’s not enough to make the meaningful difference we need. Fiscal austerity around the globe will constrain government spending and sponsorship of infrastructure investments, furthering the need for private capital.
Insurers are in a unique position to take advantage of the rapidly changing environment to enhance their investment return prospects ― but they need to step outside their comfort zone of traditional fixed-income assets to do so. Equally as important, by making long-term, job-creating investments, insurers have the opportunity to make an even more meaningful societal contribution to the communities and countries in which they operate.
By David Lomas
The writer is head of BlackRock’s Global Financial Institutions Group. The opinions reflected in the article are his own. ― Ed.
