Insurance general accounts are starting to see that ETFs can be valuable, inexpensive tools to diversify their portfolio, manage volatility, or lower transaction costs when compared to individual securities and other investment products. Over the last year, investments in ETFs by general accounts grew 20% from prior year and enjoyed an 18% compound annual growth rate (CAGR) over the five years through year-end 20161. Part of the recent growth of ETF usage in this channel stems from a change in how fixed-income ETFs are treated within the general account. Another change is on the horizon, which may enable general accounts to better manage volatility through fixed-income ETFs.
INSURANCE COMPANIES LIKELY TO SNAP UP MORE ETF ASSETS
According to a recent report from S&P Global, the use of ETFs by insurers is growing quickly. In 2016, a total of 571 insurance firms used ETFs in their general account, up from 399 in 2010 – a 43% increase. And the number of ETFs used by insurers grew from 292 in 2010 to 424 in 2016 – a 45% increase. Looking forward, S&P Global predicts ETF usage by insurance companies could increase as much as 86% over the next five years.
This growth has mainly favored equity ETF managers, as ETF allocation across general accounts is approximately 75% equity, compared to 24% in fixed income ETFs. However, the more recent growth of fixed-income ETFs has resulted in a five year CAGR of 32%, outpacing equities’ 16%. Within these asset classes, S&P data suggests insurance companies have greater concentration in core-equity ETFs, though growth and value strategies may have opportunities with large insurance firms. Fixed income usage appears to be more diverse, with insurers showing appetite for corporate bond, broad market, and treasury ETFs.
There are good reasons to believe this growth trend will continue. While ETFs offer general accounts a diversified basket of securities similar to other comingled products, the reduced trading costs, liquidity, and lower expense ratios typical of ETFs offer benefits over mutual funds and individual securities. Additionally, recent changes to how insurance companies can account for their ETF positions may continue to drive greater use of this product.
NAIC CHANGES INCREASE INSURERS’ INTEREST IN ETFS
The first change, which came in 2013, thanks to the National Association of Insurance Commissioners (NAIC), is that insurers can now record a fixed-income ETF as a fixed-income security rather than as a common stock holding. To gain this treatment, ETF managers have registered their fixed-income products with the Securities Valuation Office (SVO) at the NAIC. This office reviews the ETF and assigns designations for fixed-income ETFs (and preferred-stock ETFs) that correspond to the fund’s credit risk. This designation also assigns a specific risk based capital charge (RBC) the insurer will incur by holding the ETF, as they would for any other investment. For example, a general account for a property and casualty firm would have incurred a 15% RBC on a long-term corporate bond ETF under the prior treatment as a common stock. Today, the same corporate-bond ETF would incur an RBC of 1%.1 By receiving the designation, general accounts can better identify ETFs that meet their risk appetite and manage their capital requirements. This change has helped propel the recent growth in fixed-income ETF usage.
The second significant switch was made to the accounting guidelines by the NAIC which will allow insurers to calculate the value of a bond ETF by the cash flow of the fund’s underlying holdings, a process known as systematic value. This type of valuation is similar to how general accounts value their individual bond holdings. By accounting for fixed-income ETFs similar to individual bonds, general accounts may have more low-cost, liquid investment options to help manage interest rate volatility and capital requirements.
Insurance companies already using ETFs had until the end of 2017 to designate which ETFs in their general accounts will be treated using the new accounting methodology. The new valuations took effect in 2018.
CAPTURING THE INSURANCE GENERAL ACCOUNTS MARKET
ETF managers and those assessing the market should consider how to best target the general accounts channel.
For equity managers, understanding how smart-beta products can manage down-side risk of the general account is a key part of the product narrative for this channel. Ultimately, the general account needs to help manage insurer liabilities and ETF managers need to orient their product positioning strategy around how their ETFs can help manage risk.
Fixed-income ETFs should seek an NAIC designation issued from the SVO of the NAIC. This designation allows fixed-income ETFs held in the general account to be reported as bond positions, which requires lower amounts of capital from the insurer to back their investment than for common stock.
Given the potential growth that insurance general accounts present, asset managers may find opportunities within this channel. For managers who are affiliated with insurance organizations, understanding the general account’s view on ETFs, especially within fixed income asset classes, may present a captive distribution channel, provide valuable input in your product roadmap, and offer an opportunity to secure seed capital for new ETFs.
Brown Brothers Harriman has proven expertise in assisting asset managers with developing their ETF business cases and launching and supporting their ETF platforms. We’d be pleased to provide insight and help guide your firm through the NAIC designation process. Please contact Ryan Sullivan if you’d like to discuss your options further.
Stay tuned for the second piece in our series: ETFs and Variable Annuities.
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