23 May 2012

BaFin: Insurance undertakings - Real estate financing and real economy investments are becoming more attractive

Incentives for financing real estate

It is increasingly more attractive for insurance undertakings to become more active than they have been as lenders in the field of commercial real estate financing. In past years, investment in this area remained very stable at a low level. Despite individual large-volume loans, no significant increase could be seen in the investment statistics.

However, insurance undertakings will use available market potential more intensively in the future. For instance, under the new European Solvency II insurance supervision regime as it stands today, the standard approach in particular contains incentives not to take real estate risks primarily through direct real estate investments, but rather through providing debt financing in commercial real estate transactions. The main reason for this is the considerably lower capital requirement. This difference in the capital requirement is likely to have a less serious effect on larger insurance undertakings which use internal models.

The real estate market benefits

In the current environment, insurance undertakings' increasing activity as lenders comes as a blessing for the real estate markets, which continue to suffer severely from the consequences of the financial crisis. Banks, the traditional providers of debt financing, are increasingly withdrawing from this area, anxious to reduce balance sheet risk. The reason for this is primarily the significantly stricter capital adequacy requirements which credit institutions will soon have to fulfil under the Basel III international regulatory standards and which strengthen the deleveraging process they have begun.

Against this background, it is becoming increasingly difficult for real estate investors to obtain follow-up financing. From their point of view, insurance undertakings are discovering lending at the right time because the gaps left by the banks can be at least partially filled in this way, and it somewhat lessens the danger of serious turmoil on the real estate market.

Alternative investments' risks and opportunities

As interest rates have remained extremely low for several years, insurance undertakings currently have an investment dilemma. The existing widespread focus on fixed rate bonds will make it increasingly difficult for life insurers in particular to generate the guaranteed returns on long-term liabilities to their customers. They therefore have an incentive to switch to alternative assets which promise higher yields.

Investments in infrastructure

Infrastructure investments are attractive for insurance undertakings because their lifespans are a good fit for long-term liabilities and they normally generate stable cash flows. Low-risk, long-term forms of investment have become rare since the sovereign debt crisis has shown that even bonds from highly developed economies can no longer per se be seen as virtually risk-free.

Diversification with commodities

Insurance undertakings invest in commodities primarily in order to round out and diversify their portfolios. For many years, insurance undertakings were interested in commodities due to their ability to create a balanced risk-return relationship for the entire investment portfolio, because their correlation with other asset classes was low. In the financial crisis, however, commodities performed similarly weakly compared to other types of assets. The correlation has increased substantially, such that their risk mitigating effects for the portfolio have become less strong.

As with real estate financing, BaFin will keep an eye on the developments of insurance undertakings' investment patterns in other real economy assets in order to identify risks early. In this context, the separate reporting requirement for commodity investments which was introduced as at 31 December 2011 will create greater transparency in this area.

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