Given that reinsurers exist to take on insurance risks, it is not surprising that they are more exposed to underwriting, reserving, and catastrophe risks than to investment risks. However, their investment risk has never been negligible, and a decade of low interest rates and tough underwriting conditions forced reinsurers to increase their appetite for investment risk.

To generate additional return, reinsurers invested, cautiously, in riskier and more illiquid assets. The gradual shift in strategy has been successful--reinsurers' capital adequacy has remained high, on average. Had their asset allocations remained unchanged, their investment returns would have shown an even more material decline.

The economic impact of the pandemic has somewhat eroded reinsurers' capital adequacy, but their caution has largely paid off. Despite unfavorable movements in the financial markets and in the economy, the stress test S&P Global Ratings performed on reinsurers' balance sheets as of the end of 2019 does not indicate change to our assessment of the sector's overall capital adequacy.

Our stress test examines asset allocation at the Top 20 global reinsurers, as a proxy for the sector. We also looked back over the past five-to-10 years and forward for the next two-to-three years, given current and expected market conditions and reinsurers' strategies and risk tolerances.

Risk Tolerance Varies Between Reinsurers And Primary Insurers

For primary players, average exposure to asset risk typically exceeds 50% of total risk-based capital, as we calculate it. By contrast, it was about 35% for the Top 20 reinsurers at year-end 2019. This is unsurprising, given that reinsurers exist to take on insurance risks that primary insurers cannot keep on their own balance sheet and reinsurance cover is typically renewed annually.

Meanwhile, many primary players operate significant general account savings business. These often constitute the most important part of their balance sheet and generate material investment risks. Asset allocation at primary players is set up to match this kind of long-term liability. Therefore, a more material proportion of their investments take the form of equities or real estate.

Reinsurers' Asset Allocation Evolved As Interest Rates Dropped

As returns on reinsurers' traditional investments have declined over the past decade, the relative weight of risky assets in the investment portfolios has increased. Here, we define risky assets as listed and private equities, real estate, and alternative investments. The gradual shift toward these riskier and more illiquid assets has helped reinsurers to generate additional return and slowed the decline in their investment returns.

Although no significant change can be observed from one year to the next, the trend has been steady. Risky assets accounted for just over 5% of reinsurers' investment portfolios in 2011. The proportion doubled over 2011-2017 and represented 13% at the end of 2019. Nevertheless, we consider this level manageable, given reinsurers' capital adequacy. On average, we view capital adequacy at the Top 20 global reinsurers as robust.

The most common risky assets in reinsurers' portfolios are listed and private equities, which account for 9% of total investments. We recognize that overall positive market movements have supported the inflationary trend for the past decade. That said, other asset classes have seen similar market movements. Valuation of fixed-income instruments has materially increased due to low interest rates and the general tightening of credit spreads. Real estate investments have also generally experienced material positive revaluation since the global financial crisis of 2008-2009.

Chart 1

Because of the lower-for-longer interest rate environment, large reinsurers have modified their investment guidelines over the past decade. They deliberately chose to invest more in riskier assets, most likely to offset the gradual dilution of their investment yield caused by years of lower interest rates. The whole insurance industry experienced a dilution in yields, but the reinsurance sector was hit faster because their business is shorter-tail in nature. Many primary players are very active in the long-term savings business; by contrast, reinsurers have limited exposure to this line of business.

Chart 2

When we drill into exposure within the Top 20 sample, we see that certain types of players are more exposed to risky assets than others. Despite large global reinsurers' (Group 1) increased exposure, it remains below average, especially for equities, which accounted for just 8% of total invested assets at the end of 2019. By contrast, up to 15% of portfolios at midsize global reinsurers (Group 2) and other reinsurers (Group 3) were invested in equities. We consider that these riskier investment policies were clearly adopted to reduce dilution of the investment yield on fixed-income investments. In addition, it was a more significant move for less-diversified players as they are more involved in short-tail reinsurance, such as natural catastrophe business.

Reinsurers Also Moved Into Illiquid Assets

Illiquid assets (defined as real estate, hedge funds, private equity, and loans) have become a slightly more significant part of the investment portfolios of the Top 20 reinsurers over the past five years. We consider the current level of just over 7% of total invested assets to be manageable; the year-end 2015 figure was less than 6%.

Most of the increase has come from greater investment in private equity and real estate assets. Investment in hedge fund vehicles and loans remained low and stable and was less than 2% of total investments at the end of 2019.

Chart 3

Although large global reinsurers were cautious in their overall asset allocation, they have been more willing to increase the share of their investments that comprised illiquid assets (9% at end-2019). Typically, these reinsurers are more sophisticated investors and their liabilities are of longer duration, giving them more leeway to tolerate lower liquidity on the asset side of their balance sheet.

Midsized global reinsurers and other reinsurers, by contrast, have historically been more reluctant to allow their liquidity profile to deteriorate. Even now, they do not invest more than 3%-6% of the total in illiquid assets, on average. Many of these players are relatively involved in short-tail lines of business. For example, property catastrophe claims must be paid promptly once an event has occurred. As such, they cannot afford to invest in illiquid assets that they could be forced to sell at short notice.

Credit Risk Is On The Up

The average rating in the fixed-income portfolios held by the Top 20 reinsurers has not changed over the past decade--it is still in the 'AA' category. That said, in 2011, more than 40% of the bonds held were rated 'AAA'; by year-end 2019, this share has dropped to 31%. We attribute the shift to a number of downgrades, notably of sovereign issuers, that occurred during the period, combined with the gradual shift in the portfolios toward corporate bonds. Over the same period, the share of bonds rated in the 'BBB' category has spiked to 16% from 6%. Excluding these movements, bonds rated in the 'A' or 'AA' category have remained broadly unchanged.

Chart 4

Overall, reinsurers still aim to invest almost all their cash flows in fixed-income securities rated investment-grade. However, they have become increasingly willing to invest in speculative-grade bonds. Indeed, the share of speculative-grade and unrated bonds has doubled over the past decade and now represents 8% of the average bond portfolio. That said, reinsurers have shown prudence; most of the speculative-grade bonds they invest in are rated in the 'BB' category, the highest level within the speculative-grade space. They have not deployed more-risky strategies, such as buying instruments issued by ailing companies and hoping for recovery or favorable liquidation.

Once again, risk appetites for investing in speculative-grade bonds demonstrate material differences across the Top 20 reinsurers. Group 1 players invested less, at just 6% of total fixed income portfolio at end-2019, while reinsurers in Groups 2 and 3 have been more aggressive. Some have invested as much as 18% of their bond portfolios in speculative-grade instruments, albeit mostly in the 'BB' category.

These trends clearly illustrate that the sector has had to adapt to the persistently low interest rates and the challenge of controlling tariffs amid intense competition and frequent natural catastrophe claims. Both investment and underwriting have suffered, and reinsurers have sought additional profitability elsewhere. They found it in revising their investment guidelines and increasing their tolerance for credit risk. That said, the shift has been fairly gradual and was managed in a controlled way.

An Adapted Investment Mix Protected Reinsurers Against Larger Yield Dilution

Investment yields achieved a soft landing, but probably won't take off again for some time. Over the past decade, average yield in reinsurers' investment portfolio has fallen to an estimated 2.4% average in 2020 from 3% or more before 2010. This dilution is in line with the general fall in interest rates affecting every major currency that reinsurers invest in.

Oddly, performance in recent years has shown that yield dilution has become less significant. We consider that this stems from the relatively short duration of the reinsurers' bond portfolios. The old instruments that generated higher yields were mostly repaid during the first part of the decade. They have therefore contributed little to portfolio yields since 2015.

If reinsurers had not changed the credit quality of their fixed-income portfolios, the downward trend could have continued. The actions they took in shifting toward riskier assets instead helped to sustain investment returns. In our view, the change in policy formed the basis of the broadly stable trend we have observed over the past three-to-five years.

Chart 5

Investment Expertise Can Be Exploited

Large global reinsurers typically generate somewhat higher investment returns than smaller market participants because their investment horizon is slightly longer. In addition, most of them have taken advantage of their size to establish their own asset management company. Such specialized firms typically generate better return for a given risk appetite. They can also build on their expertise to offer third-party asset management activities, which help to amortize cost across a larger asset base.

Reinsurers with asset management companies can also develop valuable specialist knowledge, for example, of insurance-linked securities (ILS). This not only leads to a better investment performance, but also offers potential business synergies with their non-life underwriting and risk management functions.

Given the generally conservative nature of the investment mix, realized capital gains have historically contributed little to reinsurers' investment yields. Although investment mixes are now slightly less conservative, their contribution has not altered significantly. Constructing material unrealized gain capital buffers takes time and equity markets have also been somewhat volatile over the past three years.

That said, the impact of realized capital gains is likely to increase materially as current investment yields are further diluted by persistently negative interest rates. Reinsurers have historically dedicated a material portion of their cash flow to short-to-medium term maturities, which have been most affected by yield dilution. In our view, the gradual increase in investment in riskier assets is mostly intended to provide financial flexibility to realize capital gains, as opposed to supporting annual investment yields. That said, the availability of such buffers is by nature uncertain, given the inherent volatility of financial markets. Therefore, we continue to appreciate investment returns over the medium term, rather than quarterly.

Stress Test Aims To Replicate The Economic Effect Of The Pandemic

We expect reinsurers' investment portfolios could be hard hit by the economic fallout from the pandemic. To measure the potential impact, we set up a range of stressed assumptions covering the main asset classes to which they are exposed: equities, bonds, real estate, and loans. We compared the outcome of our stress tests with the year-end 2019 total adjusted capital available to determine how well the various players will weather the crisis. This gives us an indication of which ratings could be at risk.

Since COVID-19 started to spread, we have been measuring the sensitivity of insurers' capital to volatility in the financial market using a consistent set of assumptions regarding the stresses applicable to certain asset classes (see "Down But Not Out: Insurers' Capital Buffers Are Proving Resilient In The Face Of COVID-19," published on Sept. 22, 2020). We consider the reinsurance sector to be more resilient than the global insurance sector, by these measures. These stresses combined, account for 54% of the reinsurance sector's starting capital buffer, compared with 85% for the global industry.

Our stress test suggests that, based on their investment portfolios, the Top 20 reinsurers are in a good position to navigate the crisis. Taken as a whole, we anticipate that capital adequacy will be reduced by a manageable amount that will still enable most reinsurers to meet their respective targets.

The Top 20 reinsurers had total aggregated adjusted capital of around US$263 billion at year-end 2019. The aggregated buffer above the target level that justifies their respective assessments was then slightly above US$20 billion. However, as we apply the various stresses in our stress test, the aggregated excess melts away, falling by over half to US$9.3 billion. Nevertheless, we still anticipate that capital adequacy would remain in line with our current assessments for the group as a whole and, on an individual basis, for 16 of the 20 players.

Chart 6

Our stress testing exercise suggests that reinsurers' capital adequacy would be most affected by the simulated equity shock, and by the assumed credit migration of their bond portfolio, which would reduce their capital buffer by about US$4.8 billion and US$2.6 billion, respectively. By contrast, the stress we applied to the bond portfolios to replicate a potential spike in credit defaults had a lesser impact of about US$1.7 billion. This is because only a limited portion of the portfolios is invested in rating categories for which we assume a high default rate. A hypothetical drop in real estate asset values would reduce the capital buffer by a moderate US$1.6 billion. Lastly, defaults on loans and bank deposits would lower capital adequacy by a minimal amount--just US$200 million.

Smaller And Less Diversified Players Are Most Likely To Buckle

Although the aggregate figures show a somewhat healthy picture, this conceals the variation across the groups and at an individual level. Large global reinsurers included in the Top 20 are in a good position. We anticipate that they would be able to maintain their capital adequacy above their current target level. The same is generally true for other reinsurers that we classify as having excellent capital adequacy, according to our criteria. Half of the Top 20 reinsurers have excellent capital adequacy, in our view, and we forecast that nine of them would still have a positive buffer after our stress test.

The players whose capital buffer could be exhausted under our stress test are typically smaller or less diversified regional reinsurers that have lower capital adequacy assessment. For some of these, the pressure on their credit quality could even trigger a rating action. That said, we take rating actions after considering a wide range of metrics. Investment-related risk is important, but far from the only factor we would consider.

Related Research

• Down But Not Out: Insurers' Capital Buffers Are Proving Resilient In The Face Of COVID-19, Sept. 22, 2020
• Black Swan Or Not, COVID-19 Is Disrupting Global Reinsurers' Profitability, Sept. 8, 2020
• Global Reinsurers Face Threat If COVID-19 Losses Are Followed By A Major Catastrophe, Sept. 8, 2020