FUND BOUTIQUES & PRIVATE LABEL FUNDS: Insurance-Linked Securities – insurance subordinations, expertise, opportunities & “boredom” (Interview – Rötger Franz, Plenum Investments AG)

“Ability of calm consideration – beginning of all wisdom, source of all goodness!” (Marie von Ebner-Eschenbach). Due to the low-interest rate phase, many investors are looking for investment alternatives, in a wide variety of “niches”, keywords: Insurance-Linked Securities, CAT Bonds, Subordinated Bonds. Markus Hill spoke for FUNDBOUTIQUES.COM with Rötger Franz, Plenum Investments AG, about the special challenges and opportunities that currently arise for portfolio managers in the segment of subordinated bonds of insurance companies. Topics such as the size of the market, diversification, and the depth of expertise in analyzing individual stocks are addressed, as well as regulation, timing, and the boredom factor.

Hill: Why should investors be interested in subordinated insurance bonds? What makes the sector so attractive?

Franz: We live in times of permanently low-interest rates. Even optimistic estimates expect only moderate interest rate increases. Subordinated insurance bonds still offer permanently higher yields than other sectors in this environment. BBB-rated insurance bonds offers up to 100bp higher yields. To this end, the insurance sector has had the lowest default rates of any sector over the past 40 years. Going forward, this is likely to decrease even further as regulation has been significantly improved once again following the introduction of the Solvency II supervisory regime in 2016 and other countries have followed or will follow suit.
Furthermore, we expect steady growth in the restricted Tier 1 (rT1) segment. Although rT1 issuance volumes will be nowhere near T2, the new issue by Allianz has shown that there is interest in this new bond class even among the best-capitalized market leaders.

Rötger Franz, Plenum Investments AG
Rötger Franz, Plenum Investments AG

Hill: Why do you think subordinated insurance bonds trade at a discount relative to other sectors?

Franz: There are several reasons. For one, the sector is relatively complex, and traditional and generalist approaches of credit analysis often not fully applicable to insurers. This means that investors have to build up and maintain specialized knowledge. However, subordinated insurance bonds are only a relatively small niche of the overall market, so in the past, only very large asset managers or niche players had specialized knowledge here. On the other hand, the cost pressure of recent years has led to the large and medium-sized asset managers in particular, and also investment banks, withdrawing from such niches. Most investors also rely too much on ratings, even though in the vast majority of insurers are rated much lower than their solvency ratios would suggest. This loss of knowledge encourages risk-averse behavior on the part of investors and thus leads to spreads widening.

Hill: Aren’t investments in subordinated insurance bonds also covered by other, more broadly diversified funds?

Franz: Certainly many broadly diversified funds also invest in subordinated insurance bonds. While these can realize a general “sector discount,” they cannot identify mispricing and realize the significant alpha potential on a single name basis. Either these track the index or underweight more complex sectors like insurance.

Hill: Is now a good time to buy subordinated bonds from insurers?

Franz: We think so. While spreads are very tight right now, we still see clear potential for further compression. In addition, some mispricings have emerged again in recent weeks. It should also not be forgotten that insurers – unlike other sectors – will tend to benefit fundamentally from rising interest rates.

Hill: There is a lot of talk at the moment about grandfathered perpetuals and the end of grandfathering in 2026. Are there still many good investment opportunities here?

Franz: “Grandfathering” and its end in 2026 is an old topic that is largely priced in. In addition, there is an extremely high call discipline for institutional bonds issued by insurers. Blindly buying bonds issued before 2015, therefore, makes no sense in our view. However, there are still some opportunities in retail bonds. Here, however, the question is not whether these will be called in 2026, but before. But such an assessment requires a deep analysis of the issuer’s capitalization and capital management strategy.

Hill: Doesn’t an allocation to rT1 mean too much risk?

Franz: An increased risk resulting from possible coupon defaults and conversion into shares or write-downs is indisputable. But it is nowhere near as high as the spreads suggest. It is important to know that insurers on average hold almost twice the required solvency capital. Many insurers have also defined clear triggers for how they react to falling solvency ratios and with what countermeasures. These triggers are usually far above a regulatory capital shortfall. It should also be noted that in many lines of business, such as reinsurance or industrial lines, a financial strength rating of at least A- is a prerequisite. This provides an additional incentive for insurers to maintain a good capitalization. If you compare this to the additional spread of an rT1 bond, you come to the clear conclusion that the higher risk of an rT1 bond is not only well manageable but also well rewarded.

Hill: You’ve been involved with the insurance sector for many years. Don’t you ever get bored with it?

Franz: No, we’ve had deregulation in Europe, US Workers Comp crisis, Dotcom Bubble, 9/11, KRW, Great Financial Crisis, Nat Cat 2011, Sovereign Risk Crisis, steadily falling interest rates, 20 years of Solvency II development and implementation, 25 years of IFRS 17 development and now Covid-19. There’s always been a lot going on and there will be in the future too.

Hill: Thank you very much for talking to us.

Rötger Franz has more than 20 years of international experience in the coverage of the insurance sector. Mr. Franz was sell side credit analyst at Société Générale and 10 times in a row he was ranked as the best insurance analyst in the Euromoney Fixed Income Research Survey. Previously, he was as lead analyst responsible for the coverage of the leading primary insurers and reinsurers at the rating agency A.M. Best and has experience in M&A, Equities and Accounting. He holds a master-equivalent degree from the University of Cologne (Dipl.-Kfm.) with a focus on insurance science. He joined Plenum Investments AG in April 2020 and is responsible for insurance bonds.


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