The warning comes as the $17.7 trillion insurance industry in the developed world – representing 9.5% of global financial assets – battles the trade off between risk and reward in a changing global financial and regulatory environment.
“In the short-term, regulatory changes may cause insurance firms to reduce their allocations to emerging markets in favour of more safe investments and government treasuries,” said David Laster, one of the report's authors.
The report entitled “Insurance Investment in a Challenging Global Environment” says regulatory changes – including revised accounting standards, increased regulatory and accounting requirements, and higher capital charges on some investments – may encourage insurers to increase investments in developed government securities at the expense emerging markets.
These developments come “at a time when yields are extremely low and sovereign bonds are no longer fail-safe investments,” said Laster, citing the surge in public indebtedness in the West. Institutional investors are increasingly attracted to emerging markets, seduced by lucrative returns, lower perceptions of risk and the typically lower correlation of developing market assets compared with the West, said Laster.
But new regulations are complicating insurers’ bids to diversify their investments – which in aggregate are six times larger than sovereign wealth fund assets – into emerging market equity and bond markets.
Europe’s Solvency II framework for the insurance industry – set to take affect at the end of 2012 – could see a 20% increase in new capital requirements, which will hamper investment performance and asset diversification. In addition, new fair value accounting rules –which judges asset values by prevailing market prices – will have a disproportionately negative impact on emerging market equities, due to the volatility of the asset class, said Laster.
Insurance funds could increase their emerging market stock investments because they would be starting from a relatively low base, said Laster. But tighter financial regulations in Europe suggest that emerging equities may not form a large, strategic portion of the portfolio of Western insurance funds, even as emerging market stock markets expand in the coming years, he said.
In addition, the diversification benefits of emerging market investments are increasingly in question. In the 2008 crash, stocks, bonds and currencies in the emerging world drastically underperformed their developed world counterparts.
From their peaks in October 2007 until the March 2009 rally, mature equity markets fell by 59%, or $19 trillion, as measured by the MSCI World Index. Emerging equity markets lost more in percentage terms at 64% or $4.3 trillion in market value. Hard currency emerging market bond spreads widened from 240 basis points (bp) before the 2008 collapse of Lehman Brothers to 700bp. By contrast, spreads for European and US government paper fell dramatically due to their status as safe havens.
Nevertheless, during periods of benign financial market conditions, diversifying into emerging markets generates market-beating returns while regional equity market returns are less correlated with each other than during periods of financial market distress, according to Swiss Re research.
INSURANCE MAP
The report also maps out the global insurance industry’s assets. China is the only emerging market among the world’s ten largest insurance market with $340 billion of assets. Taiwan holds $320 billion, South Korea $318 billion and India $148 billion. While Latin America and Africa – led by South Africa with $170 billion – represent just 3% of world insurance assets.
The report also calculates that if new US requirements – that forces insurance company companies to allocate half of assets to Treasury bills and half to Treasury bonds – were applied to the global insurance industry’s $23 trillion, it would cost insurers over $1 trillion within three years. The net result will be higher premiums for insurance products and lower returns for investors, the report concluded.