18 March 2013

Risk.net: Insurers explore exchange-traded funds (ETF) to boost yield

As insurers look for new opportunities to increase the yield on their investment portfolios, ETF could provide an efficient way to diversify and gain exposure to areas such as emerging markets and commodities. ETF providers are expanding their range of products, but insurers are cautious.

Insurers need to venture further afield in the hunt for yield. With the developed world locked in a depressed interest rate environment, investment teams are increasingly turning to emerging markets to secure a decent income. However, tapping into the wealth generated in these regions in a safe and sustainable way is challenging. Emerging market debt is highly illiquid and equities unnervingly volatile.

Insurers are also looking to put their cash balances to work, even if these are only being held for a few months in between long-term fixed-income investments. When prospects for stable yield enhancement are few and far between, every little helps, and the opportunity cost of holding cash is becoming increasingly intolerable.

This is where exchange-traded funds (ETFs) could prove useful. ETFs, one of the most popular sub-sets of exchange-traded products (ETPs), are investment vehicles that are traded on stock exchanges and hold assets such as  stocks, commodities or bonds. They will typically track a stock or bond index.

An investor benefits from the diversification that comes with exposure to an index, but can also sell short, buy on margin and exploit all the other strategies available to equity players. For investors who want access to fixed-income markets in the developing world, or to accrue beta returns on an index in the short term, an ETF offers a simple, liquid and low cost means to do so.

Liquidity is crucial for using ETFs for short-term yield pick-up. Insurers want to be able to use an ETF for a period of months as they reorder their fixed-income portfolios to meet updated portfolio objectives, and get their money out when the right opportunity arises. Jeremie Ouaki, Paris-based head of fixed-income index trading at Société Générale Corporate and Investment Banking, says: “The liquidity on an ETF, even in normal conditions, is higher than the underlying bond. Let’s say, for example, that a basket of investment-grade corporate bonds in Europe is trading at 40 basis points. A fixed-income ETF tracking these bonds will be quoting 10–15bp. This means it is easy to buy and sell, even for the big players.”

One big obstacle standing in the way of ETFs becoming more than just a fringe investment for European insurers is Solvency II.  In the technical specifications for the long-term guarantees impact assessment (LTGA), the European Insurance and Occupational Pensions Authority (EIOPA) specifies that for collective investment schemes (such as ETFs) insurers should use the look-through approach for calculating the Solvency Capital Requirement (SCR) under the standard formula. The charges applied to an ETF would therefore depend on the constituents of the fund.

However, it also specifies that where look-through is not possible the capital charge relating to ‘other equities’ of 49 per cent would apply to investing firms. It remains uncertain whether so-called synthetic ETFs (which use derivatives to track an index rather than a representative sample of the underlying assets) would be liable for this ‘other equities’ charge or not. This may rule out this type of ETF from insurers’ portfolios, even if a synthetic product tracks an investment-grade fixed-income index.

In an industry fixated on increasing its investment income, operating in a world where safe opportunities for yield generation are becoming rarer, perhaps the time of the ETF has come. 

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