Low yields are a persistent concern for the insurance sector. As firms attempt to overcome this by investing further down the credit scale, thorough credit risk management is increasingly necessary to avoid an altogether more imminent and sharper shock as a result of credit defaults and downgrades. Our latest report examines the increased importance of thorough risk management practices.
Over recent years, the protracted low interest rate environment has started to cause difficulties for insurers looking to re-invest their maturing asset portfolios and secure sufficient yields to match liabilities. Recent European Central Bank (ECB) data shows that 72% of all insurance company and pension fund bond holdings are yielding <1%. Firms usually have three options to increase returns – adjust duration, decrease liquidity, or decrease credit quality of assets.
Firms are already utilising these options, with 64% of net bond transactions in H1 2019 rated BBB or lower. More fundamentally, asset allocation strategies are shifting, with illiquid assets increasingly used as a source of high yielding, long duration and capital efficient investments. EU-wide, across the past 18 months levels of investment grew by almost 10% in absolute terms, to a total value of over £610B.
Thorough credit risk management of both liquid and illiquid assets is a fundamental business priority. As firms adjust asset allocation strategy to improve returns, they must also upgrade risk management practices to optimise the risk-adjusted performance. In our work across the industry, we identified four focus areas: The governance and organisational structures in place, an overreliance on asset managers, the tools used for internal credit assessments, and the systems underpinning credit risk management as a whole.
There has also been a fresh wave of regulatory scrutiny, with concerns of a ‘race to the bottom’ in asset origination, particularly focused on illiquid assets. Scrutiny has been followed by intervention, with regulatory challenges observed across the whole risk management framework – from board level credit risk understanding, through to Commercial Real Estate rating methodologies and the risk identification process.
An overarching concern for both market analysts and regulators is the state of industry preparedness for any potential significant deterioration in credit quality. As we enter the later stages of a credit cycle in which debt has built to levels higher than in 2008, there are particular concerns around the monitoring of existing exposures and the appropriateness of workout procedures in place.
Thorough risk management is therefore essential to reduce business risk and regulatory exposure. Leading firms are going one step further, through the development of technology solutions for credit risk management such as credit analytics, rating and monitoring tools. This results in a competitive advantage, by improving decision making and increasing efficiency by removing duplication of effort with other activities.