By Todd Rosenbluth, CFRA
Insurers held just $19 billion in ETF assets at the end of 2016 — a minuscule portion of the $6 trillion in insurance general account assets. Moreover, some 75% of these assets were in equity ETFs, despite insurers’ asset allocation strategies that tilt heavily toward fixed income investments. Yet, growth in the use of ETFs in general has been healthy: ETF assets held by insurers rose 20% in 2016 amid gains for both equity and fixed income ETFs. CFRA believes the industry may be at an important inflection point, though, following a significant regulatory change.
The National Association of Insurance Commissioners (NAIC) – the insurance industry’s chief regulatory body- recently changed the way fixed income ETFs are designated from a capital requirement perspective. Previously, all ETFs (fixed income and equity) were designated as equities by the NAIC. Now, fixed income ETFs are designated like bonds.
“By giving fixed income ETFs regulatory capital parity with bonds, the NAIC’s move has greatly enhanced the already attractive value proposition for ETFs,” noted Cathy Seifert, CFRA equity insurance analyst.
This change is set to be implemented in early 2018 and should significantly increase insurers’ demand for fixed income ETFs, CFRA believes, as the industry has gained comfort with the ETF wrapper. According to a recent report from Raghu Ramachandran, head of the insurance asset channel at S&P Dow Jones Indices, 571 insurance companies (approximately 30% of all insurance companies) had invested in 424 different ETFs, up from 260 firms and 126 ETFs a decade ago.
CFRA further believes demand will accelerate across the insurance spectrum, with insurers of varying sizes and business mixes increasing their utilization of ETFs to provide diversification, liquidation, and/or to lower investment costs.
From an equity asset allocation perspective, life insurers were heavier users of large-cap ETFs, while P&C companies had relatively higher exposure to mid- and small-cap ETFs according to S&P Dow Jones Indices. While Ramachandran did not highlight specific tickers, CFRA believes SPDR S&P 500 Index (SPY), Vanguard 500 Index (VOO) and iShares Russell 1000 (IWB) are among the popular large-cap ETFs used by institutional investors, while iShares Core S&P Mid-Cap ETF (IJH) and iShares Russell 2000 (IWM) are widely held mid- and small-cap ETFs.
Meanwhile, in 2016, fixed income ETF assets owned by insurers climbed 82% in 2016, relative to the 8% growth for equity ETFs. Fixed income ETFs comprised 39% of life insurance company ETF assets at the end of 2016, higher than the 13% for P&C companies.
“The liquidity of the ETF gives life insurers efficient access to beta and, importantly, yield,” according to Josh Penzner, head of iShares Fixed Income & Insurance distribution at BlackRock. “This enables portfolio managers to focus on research and sourcing of individual bonds while still meeting duration and spread targets.”
For example, insurance companies gain exposure to intermediate-term investment-grade corporate bonds using iShares iBoxx $ Investment Grade Corporate Bond (LQD) in a diversified and low cost manner. Managers seeking to shorten duration of their portfolio could consider Vanguard Short-Term Bond Index (BSV 80 Overweight), as the ETF’s average duration of 2.8 years is lower than the 8.2 years for LQD.
While LQD, BSV and other ETFs cited above regularly trade with a penny bid/ask spread, CFRA thinks greater adoption by a range of investors helped ensure that all that want to gain access to these ETFs can do so with limited costs. Typically, as volume increases and assets swell, bid/ask spreads and expense ratios tighten.