Euro Funds from Life Insurance Companies

Summary:

– Insurance companies’ euro funds offer an optimal combination of security and return, particularly for retirement savings, making them one of the French people’s favorite investments.

– In order to guarantee the level of return distributed by Euro Funds, insurers invest the vast majority (around 60-70%) of their assets in bonds (private and/or sovereign).

– The Greek default shows that the risk of capital loss is not zero, which reinforces the need for risk monitoring and transparency on the part of companies.

– The current low level of interest rates, the numerous downgrades by rating agencies, and the planned implementation of the Solvency II regulatory framework suggest that returns on Euro Funds will continue to decline.

Life insurance, and in particular insurers’ Euro Funds (also known as General Assets), provide a supplementary pension for policyholders when they cease their professional activity. In 2011, assets under management in life insurance amounted to €1.3 trillion, invested in various asset classes (equities, bonds, cash, etc.) on both the domestic and international markets.

Euro funds: what investment policy?

Euro funds from a life insurance company are distinct from unit-linked funds (UL), with the former providing a regular return accompanied by a capital guarantee, while unit-linked funds, which are more exposed to financial market risks, offer a volatile return with investment security limited to certain funds. As can be seen in the graph, the return on Euro Funds has remained constant, albeit declining (4.1% in 2007 compared to 2.8% in 2012), while the performance of UCs is much more erratic (-22.3% in 2008 and +12.5% in 2012). Given that policyholders build up private savings with the aim of supplementing the pensions they receive after retirement while benefiting from tax-free savings (in the case of an investment horizon of more than 8 years), they seek to secure their investments by taking out life insurance policies invested in the Euro Fund. As a result, in 2011, French citizens’ financial assets consisted of €2.5 trillion in long-term savings, 55% of which, or €1.375 trillion, was held in life insurance policies, making them the preferred investment of French citizens.

The average maturity of insurers’ liabilities, i.e., the duration of policyholders’ contracts, must coincide with the maturity of the assets held. Thus, since the savings collected by insurers are long-term savings, insurance companies must invest in long-term securities that appear to present the most moderate risk. Institutional investors are therefore the main subscribers of bonds with maturities of 10-30 years, favoring the long end of the yield curve [1].

Furthermore, as part of their investment policy, insurers are limited by external regulatory constraints (Solvency II) and, in some cases, internal constraints (some insurers adopt an internal line-by-line exposure limit based on the rating of the security held). The aim of these two measures is to ensure that companies have a certain level of capitalization so that, in the event of default on one of the securities held, they do not go bankrupt themselves. Equity capital is therefore mobilized, fictitiously, according to the risk taken, i.e., the quality of the financial security held. The role of rating agencies is therefore crucial for insurers in assessing the credit quality of the securities held [2]. The investment strategy of life insurance groups and pension funds will depend on this technical expertise. Similarly, in order to hold listed securities, insurers must mobilize sufficient amounts of capital (greater than for bond investments, as the risk is higher) to cope with any market downturn without jeopardizing the company’s solvency.

What exposure to different asset classes?

Given the current context of tensions surrounding the quality of assets held by insurance companies in France and Europe, it is crucial that these companies communicate about the composition of their euro funds, with the dual objective of ensuring the security of the insured’s financial investment and offering them a sufficient return so that they do not turn away from the contract. In fact, the vast majority of insurers’ portfolios are composed of both corporate and government bonds, representing between 70% and 85% of total invested assets. As stated above, management constraints require insurance companies to hold mostly government and/or corporate bonds that are highly rated by rating agencies. This is why the average rating of the bond portfolio is high (AA or A).

However, while insurers prioritize security in their asset management, they also seek to build up a portfolio of so-called « risky » assets in order to boost the overall return on the portfolio. As a result, the vast majority of insurers turn to the equity market to diversify this pocket, which represents between 3% and 10% of total invested assets. It is thanks to this risky envelope that some insurers were able to generate attractive portfolio returns in 2012, given the context of falling rates on the bond market.

Finally, companies must hold a certain level of cash in order to meet potential contract redemptions by their customers. This cash is invested in well-rated bond assets at the very short end of the yield curve (maximum maturity of three months), which are certainly not very profitable but are liquid and secure. These assets must be as liquid as possible, i.e., easy to sell on the markets, so that insurers can reimburse their customers quickly and without facing sudden market pressure that could lead to a sale at a loss. Indeed, particularly in times of economic and financial crisis, policyholders may doubt the quality of the assets held in the portfolio and therefore ultimately the solvency of their insurance companies, which may lead them to withdraw their investments. This phenomenon, which caused a withdrawal of funds, particularly affected the life insurance sector between September 2011 and September 2012, with the crisis in the eurozone weighing on the quality of the assets held by companies. Thus, in a context of tension on the financial markets, cash levels are increasing structurally, not only to cope with potential contract redemptions but also to hedge against a sudden market reversal. Hence the need for transparency on the composition of the asset portfolio, which is still lacking among many companies.

Source: Premiums and investments of the 12 leading life insurers at the end of December 2012,ACP

How to balance return and security?

Insurers follow a carry investment strategy, which means that they hold the bond until maturity and are remunerated by the annual coupon paid by the issuer. In theory, this means they are not subject to daily fluctuations in bond prices on the secondary market, where players (funds, banks, institutional investors, etc.) trade debt securities. However, there is still counterparty risk, i.e., the probability, which is not zero depending on the rating, that the issuer will default on its debt. Thus, insurers, the main holders of Greek debt until 2012, had to face a « haircut  » or forced discount of 60% of the face value of the Greek sovereign bonds they held. In fact, in the event of a fall in the value of a security and in view of a potential discount, insurers will seek to smooth out the effects of the loss over time by increasing provisions for permanent impairment (which impacts the income statement but not the portfolio’s return).

In addition, during good times, when the economic cycle favors rising financial markets, insurance companies will build up a « return cushion » by adding to their Capitalization Reserve in order to smooth out the performance distributed to policyholders in the event of a downturn in the cycle. The Insurance Code stipulates that companies are required to pay out a minimum of 85% of the financial income generated, with the remainder being placed in the Capitalization Reserve. Thus, during the stock market crisis of 2008-2009 and again in 2011, insurers continued to pay positive and stable returns to their customers, not only thanks to the coupons paid out as part of bond management, but also by drawing on these reserves accumulated in previous financial years.

What are the prospects in the current financial climate?

The recent downgrades of the sovereign ratings of Eurozone countries are reducing the investment universe for insurers. Thus, despite the attractive returns on Italian and Spanish securities (between 4% and 6% over 10 years) for insurers seeking returns for their clients, their off-limit ratings (too high a risk of default) prevent managers from buying these securities. With the risk of default particularly high for sovereign bonds from peripheral countries (Portugal, Italy, Ireland, Greece, Spain), insurers are divesting from these issuers. Thus, while the total exposure of the twelve leading life insurers to peripheral sovereign bonds amounted to €64.6 billion at the end of 2011, this figure fell to €53 billion a year later.

Companies must therefore turn to oversubscribed securities such as government bonds that are popular with investors (sovereign ratings above AA, such as France, Germany, Finland, etc.), which are now very expensive. Since bond yields move inversely to their prices, these expensive securities offer very low interest rates or coupons, such as 2.46% per annum for 10 years in the case of France (10-year OAT rate as of June 26, 2013). Companies are therefore actively involved in financing the French government, as they hold nearly 50% of the French government’s resident debt stock, or €194 billion (ACP data).

Furthermore, the accommodative monetary policies of central banks do not guarantee a rapid return to normal interest rates. As a result, the returns offered by euro funds will remain low (barely above the inflation rate), putting the contracts offered by life insurance companies in direct competition with the investment products offered by banks, foremost among which is the Livret A savings account, which offers a return of 1.75% per year and a capital guarantee (for deposits of less than €100,000) and no tax constraints (unlike life insurance, which requires customers to invest for at least eight years before benefiting from tax allowances).

Thus, if the rates offered by companies continue to converge with the Livret A savings account rate, the incentives to save through life insurance will be reduced.

In addition, under the Solvency II directive, companies must meet increased capital requirements based on the risk of the assets they hold. As the risk weighting on sovereign bonds is zero, insurers will automatically increase their exposure to this asset class.

Conclusion

Faced with a shrinking investment universe due to numerous rating downgrades and the planned implementation of the Solvency II regulatory framework, insurers must modify their portfolio management in order to maintain an optimal risk/return ratio. Certain securities, considered safe, are therefore oversubscribed by institutional investors, particularly highly rated sovereign bonds (AAA or AA+).

In fact, this structural shift in demand towards these securities has contributed to a significant decline in interest rates for countries such as France and Germany, which are benefiting from historically low borrowing costs, to the detriment of non-financial companies (particularly SMEs), which are facing a slowdown in financing flows.

Bibliography:

– Fundraising and investments of the 12 leading life insurers at the end of December 2012,ACP

– French Federation of Insurance Companies website