Persistently low fixed-income rates will force changes in the insurance industry this year as large companies exit the bond market to search for higher yields in exchange-traded funds (ETFs), emerging markets and illiquid assets such as infrastructure projects, says a BlackRock report released Thursday.

Insurers are likely to move their asset allocations as low rates challenge business models and profitability, according to BlackRock’s global insurance industry outlook, 2013: The Year Ahead. Putting the blame on central banks’ easy monetary policy around the world, the report says interest rate risk is increasing significantly and putting pressure on insurance companies’ asset portfolios.

“This is a crucial time for insurers as persistently low interest rates will challenge their income prospects and stress their business models,” said David Lomas, head of the Financial Institutions Group within BlackRock’s Institutional business, in a statement. “We expect them to embrace new ways of achieving profitability to meet the increasingly complex challenges of the global investment environment and the post-crisis regulatory regime.”

Insurers’ Dilemma

Faced with the dilemma of needing predictable cash flows to pay client claims and policy guarantees, insurers will become more selective and opportunistic with their fixed-income allocations, according to the report, which predicts that insurers will engage in non-core mergers and acquisitions to dispose of capital-intensive businesses and gain new revenue streams.

Further, The Year Ahead analyzes the key drivers that are likely to shape the insurance industry, including current market volatility, regulatory changes and post-2008 capital increases that are forcing banks to deleverage by exiting businesses, selling assets and transferring risks. BlackRock predicts that larger insurers will help fill the void as they seek higher yields, inflation protection and better risk-adjusted returns.

“We expect that some insurance companies will take advantage of the situation and increase their exposure to illiquid assets, particularly those assets with predictable cash flow, such as infrastructure project finance,” Lomas said. “Not only is profitability being squeezed, but the investment returns insurers generate from traditional fixed-income assets to match their underwriting liabilities are now harder to access at attractive risk-to-reward levels.”

Infrastructure, Emerging Markets, ETFs Seen as FI Replacement

As the world’s largest asset management company, BlackRock itself will contribute to these industry trends. It recently established a European infrastructure debt investment team to meet demand from insurers seeking long-dated and predictable income, and it expects increased inflows into areas such as opportunistic credit, real estate debt, social housing, high-yielding bank loans and equity dividend strategies.

“Insurers may look to growth and higher investment returns in emerging markets in order to increase and diversify revenue,” Lomas said. In addition to emerging market sovereign hard currency debt, BlackRock expects demand to increase for emerging-market corporate debt and local currency denominated debt.

Further, ETFs should help round out insurers’ investment strategies. For example, Lomas believes that insurers in the developed world will invest in flexible, credit-oriented ETFs.

“ETFs provide an efficient and effective manner for insurers to deploy cash or tactically allocate assets,” Lomas said. “The inventory of emerging market fixed income is limited, which may reduce the effectiveness of investing through traditional means. ETFs can make this process more efficient.”

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