The growing use of gilt-based investment strategies by UK life insurers has been examined by UBS, highlighting the reasons behind the shift, the mechanics of leverage within such structures, and the associated risks and rewards.
Legal & General Group PLC (LSE:LGEN), Phoenix Group Holdings PLC (LSE:PHNX) and Aviva PLC (LSE:AV.) have all increased their gilt allocations, analysts at the Swiss bank noted.
The appeal, UBS says, lies in a mix of tighter credit spreads and greater competition in the pension risk transfer (PRT) market, prompting insurers to turn to gilts as an alternative to traditional credit assets.
Wider gilt-swap spreads have also made the relative value of gilts more attractive compared with corporate bonds.
In practical terms, the bank estimates that gilt-based strategies can now deliver similar absolute returns to a typical credit-heavy portfolio from two years ago, though with roughly 20 basis points lower risk-adjusted returns.
The trade-off is a slightly higher “new business strain” (a measure of upfront capital intensity) at around 4% for gilt-based allocations versus 2.5% for more conventional portfolios.
Some insurers are going a step further by using leverage to improve returns, notably through so-called “forward gilt trades” or “par-par” asset swaps.
UBS argues that these levered strategies could bring risk-adjusted returns back in line with historical levels while reducing capital strain.
Still, leverage introduces its own challenges. The bank points out that while the Forward Gilt Trade can enhance spreads, it adds credit, counterparty and liquidity risks.
Although these trades are collateralised, insurers could face liquidity pressures during market volatility, particularly if the yield curve steepens and collateral calls rise.
UBS concludes that gilt-based approaches help insurers reduce day-one capital needs when writing bulk annuity business, but at the cost of thinner spreads.
Legal & General’s recent results, which showed lower margins under its gilt strategy, illustrate the trade-off.
Regulators, for their part, already require firms to stress test liquidity positions rigorously, even if no explicit liquidity capital charge exists.
In essence, UBS says the move toward gilt-based and levered gilt strategies reflects a balancing act: lower capital intensity and improved flexibility on one side, offset by thinner margins and heightened liquidity management on the other.