GLOBAL INSURANCE INDUSTRY

OUTLOOK

2014: THE YEAR AHEAD

2014

The opinions expressed are those of David Lomas as of January 2014, and may change as subsequent conditions vary.

2014

As we turn the page on the calendar once again, it is time for us to look both forward and back. One year ago, we presented our inaugural Insurance Industry Outlook, which detailed the most important trends that we felt would shape the industry in 2013. The response from our clients was overwhelmingly positive, so we have prepared a fresh outlook that captures our highest-conviction thinking for the year ahead.

But before we jump into 2014’s trends, we felt that it was appropriate for us to take a look back at last year’s predictions, in order to see what we got right, where we were off-base, and what we learned in the process.

Overall, we are pleased with the results of last year’s efforts. We were right on track with several of our predictions, many others began to play out and just one proved largely off-base. For a complete look at how we fared, see the scorecard that precedes this year’s predictions.

With regard to the year ahead, we expect that an environment in which rates are likely to remain low for longer will drive insurers to take a more flexible approach in their search for income. At the same time, pressure to enhance shareholder value will compel insurers to deploy their capital more efficiently in order to maximize profitability, and global regulations will continue to evolve and force insurers to refine their business strategies.

As financial markets and monetary policy continue the slow march to normalization in the post-crisis world, many unique challenges await insurers. But, as always, the well-prepared can find opportunity in those challenges.

In order to help you prepare for the road ahead, we offer seven predictions, which lay out our view of how the world of insurance investing is likely to unfold this year.

I look forward to discussing these ideas with you in the months ahead, and to hearing your feedback, as we work together to help you achieve your goals for 2014 and beyond.

Sincerely,

David Lomas, ACII

Head of BlackRock’s Global Financial Institutions Group within the Institutional Client Business david.lomas@blackrock.com

The Year Ahead

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While some insurers have embraced the concept of risk-factor investing as a better approach to overall portfolio risk management, implementation has proceeded slowly because of the opaque nature of position-level data in many alternatives, the lack of robust analytical tools and the fact that regulatory capital charges are still based on investment vehicle, not investment style.

Given the potential of a risk-factor approach to deliver superior risk-adjusted returns, we expect that insurers will seek to improve their analytical capabilities and will work with asset managers to gain greater transparency from alternatives providers in order to access the level of detail that the approach requires.

As highlighted in a Greenwich Associates report, insurers are broadening their use of ETFs. Nearly 50% of insurers indicated their intention to increase use of ETFs by the end of 2013 while 42% said they plan to maintain their current usage. Firms are utilizing ETFs in a variety of ways, from gaining exposure to less-liquid sectors to tactical allocation and cash equitization.

In 2013, municipal, high yield and corporate bond ETFs all experienced significant growth. We expect that growth to continue, and we also believe that the recently introduced Term ETFs—which carry a maturity date—will prove particularly useful for insurers, further cementing ETFs’ place in their portfolios.

Insurers pursued a variety of innovative approaches to help manage annuity risk. Tactics included de-risking GLBs by reducing benefit rates, suspending 1035 exchanges, cutting wholesaler commissions, managing sales through repricing, offering contract buy backs, developing and marketing investment-only variable annuity (IOVA) products and pursuing focused investment options into risk-appropriate solutions.

Going forward, we believe that more VA providers will dedicate resources to building out new IOVA platforms and will seek new ways to improve the risk-adjusted performance of their installed VA funds.

Insurers introduced a great number of managed-volatility funds in 2013. One large insurer cut ten mutual funds from its VA lineup in a move geared at reducing costs and enabling the insurer to manage risk more easily. Eight of the funds it dropped were actively managed and three of the six funds that replaced them were index-based.

Other firms added managed-volatility strategies as underlying funds in their risk- targeted fund-of-funds models in an effort to control volatility risk and increase risk-adjusted returns. We believe that efficiently managed passive funds, including ETFs, will continue to gain market share within advice-wrapped funds, and that managed-volatility strategies will become a cornerstone of the VA landscape.

The process of deleveraging continued to play out, and a number of insurers demonstrated their willingness to embrace illiquid assets. Commercial real estate debt (senior and mezzanine), infrastructure debt and mortgage servicing rights all saw notable asset flows within the less-liquid space.

While financial institutions did shed some significant assets, deleveraging has much further to go—with several trillion dollars in assets likely to come to market over the next few years. We expect to see a continued flow of mortgage servicing rights from US institutions, and in Europe there is a significant volume of legacy loans—both performing and non-performing—that should eventually come to market.

WHAT WE SAID As insurers reappraise their hedge fund allocations, they will increasingly focus on risk factors and manager selection rather than investment style.

WHAT WE SAID The variable annuity market will experience innovation and evolution in 2013.

WHAT WE SAID Passive management will begin to supplant active in guaranteed funds, including variable annuities, with managed volatility strategies dominating the list of new funds coming to the market.

WHAT WE SAID Deleveraging in the financial sector will create income opportunities for insurers, particularly in the illiquid space.

WHAT WE SAID Insurers will increase their use of ETFs to gain immediate access to credit markets.

2013 Predictions Scorecard

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[ 3 ]B L A C K R O C K

One year ago, we presented our inaugural Insurance Industry Outlook, which detailed the most important trends that we felt would shape the industry in 2013. Here’s a scorecard to show you how our predictions panned out.

WHAT WE SAID There will be a large shift of core assets into hold-to-maturity portfolios.

We have not seen such a move into hold-to-maturity. Our thesis was predicated on insurers’ likely reaction to rising interest rates. While interest rates did start to move higher, the rise in 2013 was relatively modest and forward guidance from the leading central banks was largely dovish.

Looking ahead, we may see some insurers switch core portfolios to hold-to-maturity status, although perhaps not at the level that we had initially envisioned.

We have seen both acquisitions and dispositions, sometimes as two sides of a single transaction. Significant deals saw insurers expand their operations through acquisitions in countries including Turkey, Thailand, Malaysia and Mexico. On the other hand, insurers also sold businesses in Russia, Ukraine, Belarus, Kazakhstan and South Korea.

In terms of investment returns, these markets generally lagged developed market equities and fixed income in 2013. Going forward, insurers will primarily focus on their core markets as a source of growth, but given the higher return on equity that many companies in the developing world display, insurers will continue to make strategic acquisitions and long-term investments in emerging markets.

This is a trend that will take years to unfold but there are many signs that a shift is under way. For example, a number of firms have been designated Global Systemically Important Insurers (GSIIs), resulting in uncertainty around capital and risk management requirements and precipitating a review of the asset exposures on their balance sheets. Dodd-Frank is impacting the way in which US insurance companies use derivatives. Many insurers are rethinking their enterprise risk management (ERM) and asset liability management (ALM) systems in light of potential future regulatory reporting and risk management requirements, especially with Solvency II and ORSA on track.

As regulatory rules continue to evolve, insurers will adjust their asset allocations and risk management accordingly, and data quality and reporting will take on even greater importance.

On October 21, 2013, the implementation date for Solvency II was formally delayed until January 2016. The European Insurance and Occupational Pensions Authority’s (EIOPA) Long Term Guarantee Assessment did not find universal support, particularly in the areas of the Matching Adjustment and Volatility Balancer. However, significant progress towards a compromise was subsequently made with the result that the trilogue of November 13, 2013, reached agreement on the key elements of Solvency II. A path has been cleared for a vote in the European Parliament in early 2014, with implementation by 2016. It appears that Solvency II is now on its way to implementation.

As a whole, insurers continue to outsource—particularly in the alternatives space, where many of them lack the capabilities to manage assets in-house. In 2013 we saw many insurers look to outside companies to help customize investments, while others forged strategic agreements with asset managers.

While consolidation still appears to be at an early stage, we expect that insurers will continue to concentrate assets with a smaller number of investment managers, and will demand more from their asset-management partners.

WHAT WE SAID Changes in regulatory capital rules and enhancements in risk management will impact asset allocation decisions and drive more robust reporting.

WHAT WE SAID Rumors of Solvency II’s demise are greatly exaggerated—it is on track and insurers should prepare for it.

WHAT WE SAID Insurers will broadly reduce the number of outsourced managers that they use and will engage in non-core M&A activity in order to reduce costs and increase income.

WHAT WE SAID Emerging markets will drive business growth, M&A activity, and investment returns for insurers.

C O R R E C T PA R T I A L IN C O R R E C T

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2014 will present insurers with a host of challenges, both old and new. Interest rates in much of the world will remain significantly below long-term averages, and the intense pressure to maximize value for shareholders will continue. At the same time, the implementation dates of sweeping new regulations covering US and European insurers are rapidly approaching.

To help confront these challenges head on, we’ve tried to identify the investment themes that are likely to take shape this year, and we have some concrete advice on how to harness these themes to maximize income, increase profitability and keep up with the shifting regulatory landscape.

The table to the right summarizes the broad themes (and attempts to answer the timeless question “So what do I do with my money?”) while the pages that follow delve more deeply into seven predictions that we believe will unfold in 2014.

Read on to find out more of what we see in store for the year ahead.

At a Glance

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A “low for longer” fixed income environment will drive insurers to reevaluate and ultimately relax certain investment guidelines.

Insurers will realign their investment portfolios in order to earn adequate income, provide principal protection, and deliver diversified sources of return while managing correlation risk.

Take a more flexible approach to fixed income. Consider an allocation to high yield, bank loans, mezzanine debt, infrastructure, collateralized loan obligations (CLOs) and other less-liquid, non-core assets in order to minimize risk, enhance yield and reduce duration.

Reevaluate your allocation to alternatives, and consider a holistic, multi-asset solution. Take risk factors into account when constructing an alternatives portfolio.

Take advantage of disintermediation in the lending markets to gain access to issuances that do not come to public markets and that may earn attractive risk-adjusted returns and reduce correlations.

Adjust your allocation to equities. Minimum volatility strategies, factor-based allocations, and dividend-paying funds can help provide growth, income, and downside protection.

INCOMEI N V E ST M E N T T H E M E W H AT D O I D O W I T H M Y M O N E Y ?

PROFITABILITY

Pressure to enhance shareholder value will compel insurers to become more efficient with their capital deployment.

In response to this pressure, insurers will need to adjust their product lines, operational processes, capital allocations and investment portfolios in order to improve efficiency and maximize profitability.

Focus on optimizing risk-adjusted yield/return on capital charges.

Take a critical look at your entire business structure and processes and find areas to innovate.

Consider making bold changes like exiting overly competitive lines of business and redeploying capital in new markets. Build investment processes and structures that support these new businesses.

Blend alpha and beta strategies to improve efficiency, flexibility and cost-effectiveness.

Focus on embedding diversification within portfolios and consider marginal regulatory capital charges rather than the standalone regulatory capital charges when making allocation decisions to new asset classes.

Work with your asset manager to understand the drivers of risk and return in new asset classes so that they become eligible investments to drive an increase in diversification and expected returns.

REGULATION

Changes in global regulatory regimes will force insurers to refine their business and investment strategies.

Capital deployment, asset allocation and risk management are all likely to be impacted.

I N V E ST M E N T T H E M E

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INCOMEWith interest rates likely to remain low for longer, insurers will relax some of their investment guidelines and demonstrate increasing flexibility in their fixed income allocations.

While central bank policy in the US is set to become less accommodative, and interest rates appear likely to continue their gradual ascent from historic lows, we don’t expect core rates to move dramatically higher in 2014. Managing investment risk in this environment will prove complicated, and insurers will need to both refine and complement their core fixed income exposures.

As insurers globally adjust to the reality of a challenging fixed income environment, they will continue to review their investment guidelines. Many are likely to initiate policy changes that will provide them with greater flexibility to adopt a defensive stance in their portfolios and to protect unrealized gains. The current trend of shortening index duration and reducing extension risk in sectors with embedded options will also likely persist. Some insurers will consider implementing simple derivatives strategies as part of their overall risk management efforts.

Many insurers will look to increase asset class flexibility within their core portfolios through simple steps such as the addition of floating-rate and BBB securities and the widening of gain/loss and turnover budgets. Beyond their core holdings, insurers will be particularly drawn to assets that offer higher yields, protection from rising rates and duration reduction. A combination of emerging market debt, high yield bonds and bank loans may prove attractive.

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B L A C K R O C K [ 7 ]

The search for uncorrelated returns will drive interest in non-core assets. This will lead insurers to review and redefine liquidity within their portfolios and to seek exposure to risk factors other than rates.

In pursuit of uncorrelated returns in diversifying assets, such as infrastructure, mezzanine debt, and CLOs, insurers will take a more holistic approach to portfolio construction. As part of this new approach, they will reexamine their assumptions around liquidity and will redefine what is liquid and illiquid. By utilizing liability profiling and advanced cash-flow modeling, insurers can gain a better grasp of their cash-flow requirements and construct liquidity ladders that allow them to take advantage of a variety of longer-term, less-liquid assets.

Given the challenges inherent in building a cohesive set of alternative exposures, multi-asset alternatives portfolios that dynamically allocate across strategies are likely to prove increasingly attractive to insurers. These portfolios will be structured cost-effectively, will be optimized for regulatory capital, and will target a broadly diversified, opportunistic set of liquid and less-liquid alternative investments.

Managers will follow an “informed investing” process wherein insurers and their managers nurture a continuous feedback loop that addresses evolving client requirements, exposures and limitations. For more esoteric instruments, risk analytics that allow insurers to discuss capital, transparency and liquidity with their regulators will be essential.

2Disintermediation and the shifting landscape in lending markets will provide insurers with new opportunities to earn attractive risk-adjusted returns.

Newer participants, such as peer-to-peer lenders, have reshaped the lending markets by bypassing the traditional intermediaries and have transformed the dynamics between borrowers and lenders, resulting in increased access to capital for the former and more attractive rates for the latter.

By partnering with direct lenders that are providing funding to consumers, small businesses and middle-market institutions, insurers will be able to take advantage of this evolution in credit and will gain access to a higher-yielding set of assets.

As the lending market continues to mature, there will be increasing opportunities for insurers to invest in loans that were originated outside of the traditional banking model, and that offer attractive risk-adjusted returns and low correla-tions to many core fixed income holdings. But accessing opportunities in these new and esoteric markets will prove challenging and will demand a nuanced approach to asset selection and risk management.

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PROFITABILITY

As part of an overall move to improve the risk-adjusted returns of their investment portfolios, insurers will review and adjust the equity allocations within their general and sub-advised accounts.

Minimum-volatility strategies are likely to become a core holding within equity portfolios as insurers look to reduce downside risk while still participating in the majority of long-term equity market appreciation. Factor-based allocations, which strive to capture equity risk factors in an efficient and cost-effective manner, will also find a home with insurers seeking a strategic approach to maximizing long-term risk-adjusted returns.

In addition, we expect that insurers will continue to find value in dividend-paying strategies, as both a reliable stream of income and a defensive allocation to equity markets. And finally, in order to increase diversification and reduce correlation within their equity portfolios, we may see insurers shed some of their home-country bias and more fully embrace a global equity opportunity set.

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5The availability of alternative capital will put pressure on reinsurance pricing. Much of the new capital will prove to be permanent and will not flee even after a major catastrophic loss.

There has been a huge influx of alternative capital into the reinsurance market, owing to the increased appeal of insurance-linked securities, sidecars, and catastrophe bonds. Investor demand is expected to be high for these uncorre-lated, high-return assets, signaling that supply will continue to increase.

The entrance of this alternative capital allows property and casualty insurers to cede catastrophe risk off their balance sheets. Although the market is currently concentrated in select lines of catastrophe risk, we can expect pricing pressure to filter through to the larger P&C reinsurance market as the boost to capital increases primary insurers’ underwriting capacity. We expect to see this take place during contract renegotiations throughout 2014, beginning with the first round of negotiations in January.

As a long-term result of the competition that new providers have brought to the reinsurance market, many traditional reinsurers will reevaluate their operations and consider shifting capital into alternative lines of business in order to remain competitive. As they deploy capital into new areas, insurers will need to design and implement investment strategies that support these new business structures.

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Insurers will expand their use of ETFs, embracing both new products and new strategies.

Innovation has long been a hallmark of the ETF market, and the recently intro-duced term maturity ETFs—which carry a maturity date, like traditional bonds—are the latest evidence of this. Because term maturity ETFs can offer compelling yield, predictable cash flows and decreasing duration over time, we believe that insurers, specifically those in the US, will be among the early adopters.

We also expect that insurers will maintain their high current utilization rates of traditional credit ETFs and will utilize their efficient structure to accomplish a range of investment objectives from tactical asset allocation to duration man-agement. ETFs that provide exposure to less liquid, more nuanced markets, such as municipals and international debt, are likely to see increased interest as complements to core fixed income assets. For smaller accounts we expect to see many insurers utilizing ETFs as core holdings, as they can provide an operationally efficient means to build a well-diversified portfolio.

Finally, insurers will find new strategies for harnessing the technological power of ETFs. The most liquid fixed income ETFs allow buyers and sellers to transact without having to access the underlying bond market, thus facilitating executions that can fall within the bid/ask spread of the underlying bonds. And in less liquid fixed income sectors, investors can utilize ETFs’ unique creation/redemption process to quickly and efficiently gain a desired bond exposure or to exit an illiquid bond position.

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“ ...insurers will find new strategies for harnessing the technological power of ETFs.”

B L A C K R O C K [11]

Capital-efficient and regulatory-optimized investing will become increasingly prevalent and will drive activity across asset classes and geographies.

For US-domiciled insurers, the 2015 compliance requirement of Own Risk and Solvency Assessment (ORSA) is likely to drive large- and medium-sized insurers to reevaluate and, in many cases, upgrade their enterprise risk management processes and systems. Adequately quantifying investment risk under stressed scenarios will be challenging for much of the industry.

In addition to preparing for the implementation of Solvency II and ORSA, the largest insurers will also be grappling with Global-Systemically-Important-Insurer (G-SII) and Systemically-Important-Financial-Institution (SIFI) designations and the enhanced regulatory reporting and capital requirements that accompany them.

In Europe, increased certainty around the implementation of Solvency II will lead insurers to start adjusting their asset allocations in order to align them with the upcoming regulatory framework.

In contrast to the US and Europe, where insurers will be grappling with a new set of regulations, there seems to be a tide of deregulation throughout much of Asia. Loosening restrictions on foreign investment will continue to drive Asian insurers with adequate capital further afield from their home markets in the search for yield and diversification. As a result, we are likely to see increased demand for higher-yielding non-domestic assets.

7 REGULATION

This material is for distribution to Professional Clients (as defined by the FCA Rules) and should not be relied upon by any other persons. Circulation must be restricted accordingly.

The opinions expressed are as of January 2014 and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information in this material is at the sole discretion of the reader. Past performance is no guarantee of future results.

In the EU issued by BlackRock Investment Management (UK) Limited (authorized and regulated by the Financial Conduct Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. In Hong Kong, the information provided is issued by BlackRock (Hong Kong) Limited and is only for distribution to “professional investors” (as defined in the Securities and Futures Ordinances (Cap. 571 of the laws of Hong Kong)) and should not be relied upon by any other persons. In Singapore, this is issued by BlackRock (Singapore) Limited (company registration number: 200010143N) for institutional investors only. For distribution in Korea for Professional Investors only (or “professional clients”, as such term may apply in local jurisdictions). For distribution in EMEA and Korea, for Professional Investors only (or “professional clients”, as such term may apply in relevant jurisdictions). This material has not been approved for distribution in Taiwan. In Japan, not for use with individual investors. In Canada, this material is intended for accredited investors only. This material is being distributed/issued in Australia and New Zealand by BlackRock Financial Management, Inc. (“BFM”), which is a United States domiciled entity and is exempted under

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