“Search for yield” behaviour
In a low yield environment insurers may be tempted to engage in more risky activities or follow a more aggressive investment strategy by shifting a considerable part of their investment portfolio to more risky assets. This conduct is usually known as “search for yield” behaviour. There is a need, however, to differentiate between usual behaviours to optimize yields by re-allocation of portfolios from undesired behaviours resulting in an inappropriate increase of risk exposure. The term “search for yield” usually refers to the latter.
A “search for yield” is considered to be undesirable if the undertaking’s risk appetite exceeds its risk bearing capacities and risk management capabilities. In this context risk bearing capacities have to be evaluated from various perspectives: determination of own funds as well as quantification of risks based on economic valuation but also taking into consideration accounting and regulatory requirements and restrictions.
In relation to insurance “search for yield” behaviour may take place, for example, by significantly increasing the investments in riskier financial assets without appropriate management of increased risks (e.g. bonds below investment grade, hedge funds, equities or certain classes of real estate investment); engaging in liquidity swap and other instruments above a certain threshold considered to be normal for efficient cash-flow management; entering into new businesses (e.g. credit guarantee or credit insurance business) without the expertise to do so; or providing direct credit to the economy in the form of mortgage loans.
The strong flow of new capital into insurance-linked securities (ILS) raises some concerns. The significant change in the market has been driven by subdued economic growth and a low yield environment increasing demand from investors who are searching for safe investments uncorrelated with other assets. It is expected that over the next years funding will increasingly come from alternative sources, such as “sidecars” – specialist vehicles set up by insurers that non-insurers can invest in. Some concerns are that inflows of new capital into ILS, such as catastrophe bonds originate mostly from fixed-income investors, such as pension funds who are searching for yield, but not necessarily having the modelling capabilities and experience to fully analyse the underlying risks and complexity of the insurance market. Without adequate supervision, such developments could cause systemic risk.