Corporate bond defaults are one of the major risks insurers face in time of stress.
As such, the £350bn emergency package announced on Tuesday evening will be welcomed by insurers as Covid-19 disrupts the economy. In times of stress, sub-investment grade bonds are more likely to slide into default; in addition, investment grade bonds dropping into the sub-IG category also consumes capital. Insurers that have the capital strength to hold bonds to maturity are in a better position to absorb the volatility of the bond portfolio.
Insurers are particularly sensitive to changes in corporate default expectations and the coordinated approach in the UK (£350bn emergency support package announced on Tuesday) and US to support both SME and large corporates will be welcomed by the UK insurance industry, whose investments are the most exposed to the UK & US bond markets.
Corporate bonds account for 50% of the UK investment portfolios across our coverage universe, having increased in the past few years as insurers moved to pick up yield in a low interest rate environment. Sub-investment grade bonds account for 2% of the fixed income portfolio or 6% of NAV. According to credit research, we estimate that c.4% of Sub-IG debt defaults after one year; in 2009 Sub-IG debt defaults reached c.10%. Economic stress can therefore materially accelerate defaults in the short term, particularly for the lowly rated categories.
We believe that whilst the volatility of the bond portfolio will materially increase (as bond valuations are impacted by: a) a decline in risk free rates; and b) spread widening), the ultimate risk for insurers is not being able to meet claims due to a loss of principal as a result of a default. The second risk is credit migration. As rating agencies downgrade debt by one notch this triggers an increase in insurer’s capital requirements under SII. As such, many insurers will be combing through their corporate bond portfolios and considering whether it makes sense to crystalize losses on sub-IG debt (BB and below), which could be potentially offset by gains on investment grade assets (AAA-A). Meanwhile, government intervention should help slow down, or significantly mitigate, the path towards bond defaults.
Sub-investment grade debt exposures
As COVID-19 starts to impact economic growth, insurers are exposed to defaultrisk via their corporate bond exposures within the investment portfolio. We have broken down the investment portfolio of the main UK insurers and focused on the fixed income portfolio, which on average accounts for 80% of total investments.
In a low interest rate environment, insurers have been gradually increasing their exposures to corporate bonds and reducing their sovereign risk. Corporate bonds account for c50% of the fixed income portfolio across our universe. Sovereign bonds account for 18% of fixed income investments, with UK insurers predominantly exposed to UK and US government debt.
Whilst changes in interest rates and spread widening can create significant NAV volatility (under IFRS accounting; less so under Solvency II), the key risk for insurers is the probability of default. We have looked at insurers exposures to below investment grade debt as this is the most likely to default.
According to S&P, sub investment grade (or speculative grade) bonds/issuers accounted for around 50% of total rated companies across the globe in 2018, with new issues in 2018 predominantly (c80%) sub investment grade. Default rates of sub-investment debt are on average 4% albeit taking 2009 (the financial crisis), the default rate was c10%. Over a longer period, say three years, the default rates on sub-investment grade debt increase materially; for example ‘B’ rated corporates at origination see default rates increased to c19% in year three.
In times of stress, sub-investment grade is likely to accelerate into default. Also, as rating agencies downgrade their credit views, rate migration is as much of a risk for insurers as actual defaults, as lower rated exposures require higher levels of regulatory capital.
All insurers are required to hold capital against a material stress of the bond portfolio, hence capital buffers are already in place to absorb this well identified asset risk. However, there is likely to be pressure on solvency ratios should agencies such as Moody’s, S&P and Fitch materially lower credit ratings on corporate bonds; this credit migration risk may trigger higher capital requirements across the insurance industry in the event of a prolonged recession.
