JEDDAH – Gulf Cooperation Council (GCC) insurers continue to face investment risk given the dominance of high-risk assets in their investment mix, Moody's Investors Service said in a new report. The report, "Gulf Cooperation Council Insurers: Investment Risks Remain a Credit Negative in the Medium-Term", noted "equity and real estate account for a material portion of GCC insurers' total invested assets." Mohammed Ali Londe, a Moody's analyst, said "because of low interest rates in the GCC region, traditional investment options offer low returns compared with those of equity and real estate, weakening the appeal of traditional investments." Equities remain the key asset class for GCC insurers, accounting for over 40 percent of total investments in 2013. Middle Eastern equities have historically provided volatile returns given the market's relatively small size and the recent turbulence in the global financial markets. Furthermore, the Middle East lacks extensive use of risk mitigation strategies such as hedging, and a significant rise in the use of such techniques is unlikely in the medium term. Real estate is also a key investment class, accounting for over 20 percent of total invested assets in 2013. The main risks of real-estate assets stem from their valuation and liquidity. Specifically, real estate assets are often recorded in insurers' financial statements at market value, exposing the balance sheet to volatility. In addition, liquidity of real estate is frequently low, with a surplus of completed properties further limiting the ability to liquidate real-estate assets quickly at balance-sheet values. "The current regulatory framework for GCC insurers does not fully reflect the risk posed by material investments in high-risk assets," added Harshani Kotuwegedara. "However, regulatory frameworks are gradually evolving in many countries, including limitations on investment in high-risk assets." Moody's expects that, over time, GCC insurers' investment strategies will shift towards higher allocations to lower-risk assets. The region's investment mix continues to be dominated by equity and real estate, accounting for roughly 65 percent of the total invested assets in 2013, as opposed to 13 percent in Western Europe. As previously noted, the region still has limited traditional investment options, restricting investment avenues for insurers. The local corporate fixed-income market remains relatively undeveloped compared with Europe and the US markets. Meanwhile, the issuance of debt by the region's governments is low because of the high hydrocarbon wealth of GCC countries. Additionally, due to low interest rates prevailing in the region, traditional investment options, when available, offer low returns compared to equity and real estate, thereby rendering traditional investments rather unattractive. More recently, there has been an increase in safer investment options, albeit these asset classes are still relatively marginal. For example, there has been growth in Shariah-compliant sukuk issuances, assets typically used by Shariah-compliant entities. The drivers of this growth include: (1) increasing demand for Islamic financial assets and services; (2) global investors' increasing familiarity and comfort with sukuk instruments; (3) increased support from governments of Muslim countries; and (4) increasing standardization of unsecured sukuk structures. Moreover, Moody's report noted that Middle Eastern stock markets have proven to be significantly volatile because of the markets relatively smaller size and the recent turbulence in the global financial markets. This has lead to volatility in reported net income and shareholders' equity, which is a credit negative. Meanwhile, the region lacks extensive use of sophisticated risk mitigation strategies such as hedging, widely used in developed markets. Moody's forecast the use of such techniques in the Middle Eastern insurance industry to remain limited in the medium-term. There is potential for increased use of hedging protection as the regulation of insurers and their use of risk management techniques mature, although we do not expect any sizeable developments in the next few years. More negatively, though, the report further said, some GCC insurers have considerable amounts of related party equity investments. Some insurance companies are owned by high net worth individuals or families who already have other significant business interests in a wide array of businesses (banking, construction, infrastructure, oil, etc), and insurers often have equity investments in the same group. In such scenarios, we note that the liquidity of these investments during a time of crisis may be somewhat restricted Significant spending on real estate by GCC governments (for example in advance of the upcoming Expo 2020 in the UAE and FIFA 2022 in Qatar) have resulted in wider and more attractive real estate investment options for insurers. Moreover, for takaful insurers in the region, “permitted” real estate holdings are a significant asset class given their inability to hold conventional fixed-income securities. As such, real estate investments accounted for roughly 21 percent of Moody's rated GCC insurers' investment portfolios. “Our major concerns for real estate portfolios largely reflect the valuation of these assets and their liquidity. With respect to valuation, real estate assets are often recorded in insurers' financial statements at market value – thus exposing the balance sheet to volatility – even though market values in the Middle East still typically exceed the book value/historical cost of these assets for insurers,” the report said. In addition, property valuations are highly contingent on occupancy rates, which have recently been volatile, and additional financing needs that may be required for construction projects. As in other regions, the liquidity of real estate is often low, which exacerbates these concerns, while a surplus of completed properties is a further limiting factor on the ability to liquidate real-estate assets quickly at balance-sheet values. “Overall, we regard material investments in real estate as a credit negative for insurers,” Moody's pointed out. Further, the report said sukuk are somewhat exposed to the property market, therefore may indirectly expose the companies to property market volatilities, albeit at a lower level. Moody's noted that fixed income securities are reasonably diversified in sectors such as air lines, banking, energy and chemicals, however, still small in absolute size. As many insurers in the region have poor underwriting performance, they tend to rely on investment income to improve overall profitability and as conventional bonds and sukuk offer low returns, these investment classes may not be the prime choice for most insurers. “Therefore, although we would usually regard higher investment in bonds as credit positive, we expect that as economic conditions in the region improve, insurers will continue to prefer real estate and equities over sukuk and conventional bonds,” the report added. — SG
