Raghu Ramachandran: How Insurers Are Affecting ETF Flows

A new report from S&P Dow Jones Indices this week estimates that insurance companies added $1.5 billion in ETF assets last year, bringing the total invested in these products to more than $45.4 billion. 

Recently, VettaFi contributor Dan Mika spoke with Raghu Ramachandran, head of S&PDJI’s insurance asset channel, about why the insurance industry has been so slow to embrace ETFs, and what recent regulatory changes could lead to greater adoption industry-wide.

Dan Mika, contributor, VettaFi: Let’s start off with some of the figures from the report. In 2021, insurance companies invested $1.5 billion of new net assets. But we also saw a big rotation out of equity ETFs and into fixed income. Why?

ramachandran-raghuRaghu Ramachandran, head of insurance asset channel, S&P Dow Jones Indices: What we’ve heard from clients is that it goes [back] to the liquidity of ETFs. Another trend that has been going on in the insurance industry is the allocation to alternative investments, and those alternative investments have a higher capital charge. As those values have increased, the capital charges for insurance companies have gone up, and the best way to reduce capital charges is to sell things that are liquid. From what we’ve heard clients saying, they were selling equities to reduce the capital charge in the balance sheet. It’s the liquid alternative, and ETFs are very liquid.

Mika: Last fall, the New York Department of Financial Services started allowing firms domiciled in that state to substitute individual bonds with bond ETFs. How much is the insurance industry using ETFs for risk management purposes or for strategies outside of generating returns?

Ramachandran: The NYDFS regulation is unique to New York, but insurance companies outside New York have been using ETFs long before [that regulation came to pass]. 

The first case for which most insurance companies use ETFs is cash utilization or cash equitization. Let’s say an insurance company gets $5 million in excess premiums, and then they have to invest it, according to their allocation. But because the cash markets were tight, and the supply of bonds wasn’t readily available, it was easier to buy an ETF and essentially get the yield, duration, credit, and the risk exposure that matches their allocation. [Then,] as bonds become available, you can sell out of the ETFs. That gets their cash out of the cash bucket and into the allocation bucket, [which is where] insurers need it to be. 

Similarly, if you have, say, a high yield portfolio, and you want to adjust that, ETFs are an easy way to make a change, as opposed to having to sell or buy bonds. You can adjust your tactical allocation very quickly, because the liquidity in the ETFs and the underlying indices allows it to be easily transacted.

Mika: The implied compound growth rate for insurance company assets in ETFs is growing 100% every four to five years. But as of the end of 2021, the total owned by insurers amounts to just $45 billion of the $7.8 trillion in assets held in ETFs by all parties. Why do you think the adoption from insurers has been slower than in the retail space or in large-scale institutional investors?

Ramachandran: Historically, that’s had to do with regulatory constraints. Previously, any commingled vehicle, like mutual funds or ETFs, carried a capital charge of 30%, regardless of what was owned in it. So when you were buying an equity ETF versus [individual] equities, there was no cost difference, and insurance companies started buying equity ETFs [but not fixed income ETFs.]

Then about six years ago, the National Association of Insurance Commissioners put out some new rules that allowed for look-through into fixed income ETFs. Investment-grade bonds have a capital charge of 3% versus 30% for [individual] equities. [Author’s note: In this context, “look-through” means that for the purpose of risk management, insurance companies can treat ETFs based on their underlying assets, rather than treating ETFs solely as equities. Before the look-through was implemented, a fund like the iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD) would carry capital charges similar to holding a stock. After the rule was enacted, insurers could treat shares of LQD and other bond ETFs as if they were bonds.]

So it didn’t make sense to buy a fixed income ETF and get a 30% capital charge, when you could buy the bonds and get a charge of 3%. Now that insurers have the look-through to the underlying, companies can start investing in fixed income ETFs and get that lower capital charge.

Now the NDRC is not a regulatory agency, so each individual state had to adopt those regulations [to allow insurers to treat ETFs based on their underlying assets for the purpose of risk hedging]. It varies by state how fast they adopted it, but most states have adopted it. New York had not until very recently allowed the look-through, so for New York companies, they still had to hold fixed income ETFs at an equity capital charge price. As those regulations changed, they understood the underlying liquidity and efficiency of an index-based product.

A big part of the conversations we have had with insurance companies revolves around educating them on what an ETF is, how it’s structured, the index is public and it’s not a black box. It’s just a matter of getting them comfortable with that.

Mika: In the report, you found that ETF trading volume was pretty much flat from 2020 to 2021, while trade turnover declined by 24%. What does that mean? Is that a sign these assets are going to be relatively sticky?

Ramachandran: You have to bifurcate ETF usage into two cases. One is, are they using it as a positional strategy, and the second is, are you looking at it as a transactional strategy. 

If you look at the transactional stuff, you see the fixed income has a higher trade ratio. There’s a big part of ETF usage where insurers buy an ETF, then rotate into [directly holding underlying securities], as securities become available. Then there are other securities that they hold longer, and insurance companies tend to hold assets longer because their liabilities are long-term. So when they take that position, it tends to be sticky.

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