The Insurer Investment Management Insights Issue 2 This marketing document is exclusively for use by Professional Clients in Continental Europe (as defined in the important information), Qualified Investors in Switzerland and Professional Clients in Dubai, Jersey, Guernsey, Ireland, Isle of Man and the UK. This document is not for consumer use, please do not redistribute. Contents Executive summary 1. Macro outlook update 02 Last quarter was dominated by two main events with long term 2. Regulatory strategic news 04 implications for the insurance industry: first, on the economic side, the FED confirmed its dovish stance consolidating the 3. Insurance asset allocation 06 persistence of the low yield environment and second, on the benchmarks market updates regulatory side, EIOPA issued its opinion on the Solvency II review 4. About Invesco Insurance 09 indicating the lines of the review of the framework. Investments 5. References 10 In our second insurance management insights letter, we detail the implications of those two events on the insurance industry. We also analyse the various asset classes in the context of existing portfolio allocations. During this period of uncertainty, mitigating against downside risk through capital protections and diversification will be critical, considering the divergence in growth in different economies. We believe that continued diversification in alternative investments can help with risk mitigation in the current environment. In our view, senior secured loans and investment grade continue to exhibit interesting profiles in terms of capital adjusted return in the context of the average allocation of the insurance industry in EMEA. “ During this period of Authors uncertainty, mitigating against downside risk through capital protections and diversification will be critical” Alexandre Mincier Charles Moussier Global Head of Insurance Solutions Head of EMEA Insurance [email protected] Investment Solutions [email protected] Elizabeth Gillam Kristina Hooper Head of EU Government Relations and Chief Global Market Strategist Public Policy 1. Macro outlook update 1. Disruption – both monetary and geopolitical Continuous decrease of the risk free yields in Eurozone leading to very negative yields (-60 bps) for the 10Y benchmark Monetary policy disruption sovereign bonds. The Fed has taken an abrupt turn towards a more dovish stance for 2019, and we expect that to continue in 2020 as the Fed has indicated the bar is very high for any rate hikes. This abrupt change in policy raises the longer term risk that the Fed will not Figure 1 EUR SWP have enough ‘dry powder’ available for the next crisis. However, Risk free historical yields EUR SOV this creates a very supportive environment for risk assets in the 10Y Risk free yields (%) coming year. Oct Dec Feb Apr Jun Aug Geopolitical disruption 18 18 19 19 19 19 We have seen significant geopolitical disruption in recent months, and that is leading to structural fragmentation. Of 1.0 course, the greatest geopolitical risk is the potential for full- blown trade wars, which remains a distinct possibility at this 0.8 juncture, and which can place downward pressure on economic growth in a variety of ways. 0.6 Technological disruption 0.4 We expect innovation and the so-called Fourth Industrial Revolution or IR 4.0, as we like to call it, to maintain its trend- 0.2 setting role across global and major national economies, with major implications for the distribution of global growth and 0.0 the balance of power in the world. The potential for highly innovative firms to use technology to disrupt established -0.2 businesses and business models is likely to continue – even if tech stocks come under further pressure as markets normalize -0.4 and the regulation of private data and the political role of social media platform firms come under greater regulatory oversight -0.6 and political scrutiny. IR 4.0 also feeds back into geopolitical disruption and international competition. US-China trade tensions are only partly about trade; the underlying issues are Source: Bloomberg Barclays US Corp, Euro Corp, UK Corp, about investment and global economic and political influence – US HY, Euro HY, UK HY, EMD Agg; Bloomberg; Invesco attaining and maintaining the technological frontier as reflected Analysis, 30 September 2019. Please refer to 2, 3, 4. in US concerns about national security and the protection of intellectual property. Figure 2 EUR SWP 2. Debt overhang Risk free curves EUR SOV In % by maturity The world is becoming increasingly indebted. As monetary policy normalization continues and accelerates in coming years, this 0 5 10 15 20 25 pressure is likely to increase. In addition to the short-term effects of debt pressure, there is a long-term effect as well: more money spent on servicing debt means less money able to be used for investment 0.4 purposes, and that will impact longer-term economic growth. 3. Implications 0.2 In this environment, we believe exposure to risk assets is 0.0 important for meeting long-term goals – especially given that an upward bias for stocks continues to exist, although it is weaker. Mitigating against downside risk will be critical, and that includes -0.2 -0.2 being well-diversified within equities and fixed income; that is also important given the divergence in growth in different economies. -0.4 And, perhaps most important during this period of uncertainty, we believe that exposure to alternative investments can help with diversification and risk mitigation. That may include strategies -0.6 -0.6 such as market neutral portfolios and other lower-correlating asset classes, especially including those with income-producing -0.8 potential such as real estate. Source: Bloomberg Barclays US Corp, Euro Corp, UK Corp, US HY, Euro HY, UK HY, EMD Agg; Bloomberg; Invesco Analysis, 30 September 2019. Please refer to 2, 3, 4. 02 The Insurer Investment Management Insights Issue 2 Hedging costs increased during the last quarter (-22 bps) for During the summer of 2019 corporate bond yields fell to very long duration hedges. low levels by the end of September 2019. In this environment, the significant yield pick-ups on long term USD hedged bonds are very attractive to EUR based investors. Figure 3 USD vs EUR Figure 5 EUR local Historical foreign exchange hedging costs Credit historical yields USD hedged to EUR Currency hedging cost for 10Y USD hedges (bps) 10Y Corporate bonds yields (%) GBP hedged to EUR Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug 18 18 19 19 19 19 18 18 19 19 19 19 0 3.0 -5 2.5 -10 2.0 -15 1.5 -20 1.0 -25 Benchmark curves and currency basis curves are sourced from Source: Bloomberg Barclays US Corp, Euro Corp, UK Corp, Bloomberg. All the hedging is based upon swap curves and basis US HY, Euro HY, UK HY, EMD Agg; Bloomberg; Invesco curves from Bloomberg, 30 September 2019. Please refer to 2, 3, 4. Analysis, 30 September 2019. Please refer to 2, 3, 4. Figure 4 USD to EUR Figure 6 EUR local Foreign exchange hedging costs Credit curves USD hedged to EUR Currency hedging cost (bps) by maturity 10Y Benchmark corporate GBP hedged to EUR yield curves (%) by maturity 0 5 10 15 20 25 0 4 8 12 16 0 2.5 -5 2.0 -10 1.5 -15 1.0 -20 0.5 -25 0.0 -0.5 -30 -35 Source: IG yield curves are built upon constituents in Bloomberg Barclays US Corp, Euro Corp, UK Corp and are all sourced from Bloomberg; Benchmark curves and currency basis curves are Currency basis curves are sourced from Bloomberg. All the sourced from Bloomberg. All the hedging is based upon swap hedging is based upon swap curves and basis curves from curves and basis curves from Bloomberg, 30 September 2019. Bloomberg, 30 September 2019. Please refer to 2, 3, 4. Please refer to 2, 3, 4. 03 The Insurer Investment Management Insights Issue 2 2. Regulatory strategic news The Solvency II review kicks off in earnest Sustainable finance and climate risk is still a hot topic The biggest development in the second half of 2019 was the Embedding sustainability considerations across the financial European Insurance and Occupational Pensions Authority system continues to be a focus of regulators around the globe. (EIOPA) publication detailing its opinion on the Solvency II In Europe, the European Commission published its Green Deal Review in October. This broad-ranging review covers everything Strategy in December 2019, which sets out how the EU plans to from measure relating to long-term guarantees to the standard achieve climate-neutrality by 2050. The plan includes dozens of formula, reporting and disclosure, group supervision, freedom of initiatives to send a clear price signal to markets regarding climate services and macroprudential oversight. risk. Regarding financial services and the insurance sector more specifically, the strategy includes proposals to define a European Attention is likely to focus on the EIOPA’s findings in relation to green label for financial products and a commitment to review the package of measures relating to long-term guarantees and capital requirements to incentivise green investments. measures on equity risk, particularly given the political focus on deepening European capital markets to provide long-term In preparation for this work, EIOPA has followed up on its earlier financing within the real economy. advice on sustainability risks under Pillar 2 with an opinion on the integration of sustainability and climate risk under Pillar 1. However, EIOPA has instead suggested a tightening of the regime. In its report, EIOPA expresses concerns that the current While the Commission request hinted at possible regulatory rules are leading to the underestimation of technical provisions, incentives that could be introduced to promote investments in leading to misaligned risk management incentives and possible sustainable assets, the industry is likely to be disappointed with negative impacts for financial stability.