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Magazine Issues » July-August 2019

Insurance AM: Absolute returns versus government bonds

Old_turntableAbsolute return strategies can boost government bond-heavy insurance portfolios – but the business profile of the insurer is a vital consideration, writes Fiona Rintoul.

Talk of the low-yield environment has been happening for a very long time. Although it may be wearisome, there’s little sign that the DJ will be spinning a new record on the turntable any time soon. With the Federal Reserve abandoning its programme of interest rate hikes and the European Central Bank possibly not raising rates until mid-2020, many people in asset management, including Prashant Sharma, head of international fixed income insurance at JP Morgan Asset Management (JPMAM), describe the environment as being “lower for longer”. 

For insurers, who are traditionally heavy investors in government bonds, this creates a problem, particularly in the eurozone with its rock-bottom and sometimes even negative rates. To fix it, some insurance companies have tried to move from government bonds into absolute return portfolios. However, such a shift brings its own challenges and must be carefully managed.

The European Insurance and Occupational Pensions Authority (EIOPA) highlights the dichotomy that insurers face. In its June 2019 ‘Financial Stability Report’, covering the European Economic Area’s (re)insurance and occupational pensions sectors, it notes that on the one hand, the low-yield environment remains the key risk for these sectors, putting pressure on profitability and solvency positions and triggering a further search for yield. On the other hand, that search for yield behaviour can lead them into choppy waters.

“We continue to observe high valuations in certain equity, real estate and bond markets and a sudden reassessment of risk premia could potentially lead to significant losses in the investment portfolios of insurers, which could be exacerbated during a period of economic slowdown,” says Gabriel Bernardino, chairman of EIOPA.

There are other issues too. Important among them is Solvency II capital charges for balance sheet investments. Government bonds may have a low-return profile, but they do not incur these charges.

“Insurance companies tend not to be big investors in absolute return for their own balance sheet,” says Ed Collinge, global head of insurance strategy at Robeco. “If an absolute return bond fund were to invest in high yield, for example, that is around a 20%-25% capital charge.”

It’s a different matter for unit-linked investments, where the policyholder is taking the investment risk. But for investments affecting insurers’ own balance sheets, capital charges can be a make-or-break consideration.

“The Solvency II capital charge has become an important aspect in portfolio construction and asset allocation for insurance companies, next to the traditional trade-off between risk and return,” noted David van Bragt, senior consultant for investment solutions at Aegon Asset Management and Rémi Lamaud, head of regulation and asset-liability management at La Banque Postale Asset Management. The pair were joint authors of a recent report on the symmetric adjustment of the equity capital charge under Solvency II.

This is especially true of equity investments where the amount of capital that an investor needs to set aside can vary significantly from one year to the next – by almost 70% in some cases, according to the authors.

Revealingly, 54% of UK insurers surveyed by the Institute and Faculty of Actuaries said they wanted to see alternative regulation to Solvency II or Solvency II with modifications following the UK’s exit from the EU. Fully 71% agreed with the proposition that “the UK should explore alternative methods to replace the risk margin calculation post-Brexit”.

At the same, there are signs that regulation along the lines of Solvency II is becoming the global norm – just as the Ucits regulation became a global standard. “If you look at the Asia-Pacific region, a lot of companies are moving to Solvency II-style regimes,” says Collinge. “The US has a different insurance regulatory regime, but these things do tend to transfer between markets.”

The UK survey was conducted before a March 8, 2019 amendment from the EU Commission, which seeks to loosen restrictions. In broad terms, according to commentary from Jean-Renaud Viala and Sylvie Nonnon, experts in insurance solutions engineering at Amundi Asset Management, the amendment reduces the constraints on attributing a capital charge of 22% to long-term equity investments. There are caveats, but collective investment schemes stand to benefit.

“The ownership of equities through mutual funds could also benefit from the 22% treatment,” Viala and Nonnon say. “In this case, the average holding period superior to five years can be calculated at the fund level (and not at the underlying assets held in the fund level).”

Dual role of assets
However, Solvency II capital charges are only one of many challenges that insurers face when choosing how to invest their assets in the low-yield environment. Part of the challenge for insurers is that the assets play a dual role: they support the insurer’s claims-paying ability, but also add to their corporate profitability.

“The world of insurance these days is very competitive on the underwriting side and so they need the assets to support the profitability of their business,” says Erinn King, managing principal at Payden & Rygel. “For most insurance companies, if you look at profitability, the asset returns have played a material-to-large role.”

There’s an irony here, because insurance companies see underwriting as the primary driver of their business. But that irony creates a strong incentive to get the asset management right. It is a goal that insurers have been pursuing in various guises for the past decade. Depending on the insurer, that can involve increasing exposure to government bonds, looking at lower-rated corporate credit within corporate bond exposures, branching out into emerging markets corporate credit, or looking beyond fixed income, perhaps to illiquid assets. JPMAM’s Sharma says there has been a broad shift to take on more risk, which includes increased exposure to the illiquidity premium.

When it comes to absolute return strategies, the dual purpose of insurers’ investment portfolio can make these attractive. “Insurance companies don’t want the assets to have a material negative effect on their earnings or cloud what they’d done on the underwriting side,” says Payden’s King. “That’s where absolute return strategies that limit downside risk can be quite attractive.”

However, absolute return strategies can also pose issues for insurers that go beyond capital charges. Sharma cites the example of the securitisation sector in the US, which often features in unconstrained, absolute return strategies.
“There are some challenges around making sure that absolute return strategies are eligible investments from an insurance company perspective,” he says. “For example, there have been some challenges around US securitisation issues being eligible under securitisation rules for Solvency II.”

In some ways, it’s a question of definitions. Absolute return strategies have two roles: seeking a positive outright return and managing downside volatility. This can muddy the waters.

“Absolute return means different things to different people,” says King, and so insurers and asset managers need to be very careful in articulating the specific profile of their absolute return strategy.

Different types of insurance company also have different needs. For a property and casualty insurer, King says they’d want something with lower volatility, a consistent return profile, some element of predictability and “certainly liquidity in order to meet those claims”. An absolute return strategy might be the asset that directly supports those liabilities.

By contrast, a life insurer has very long-duration assets and needs to match that duration. That is often done with government bonds or high-quality investment-grade credit instruments.

Geography is another factor that can affect insurance companies’ choices. Moving away from a home-market bias can be one way of diversifying exposure to improve returns, but what King describes as “the local risk-free rate” also determines strategy. Italian bonds have better yields than, say, Dutch bonds, which puts Italian and Dutch insurers in different positions.

“Italian insurance companies may be comfortable with a higher percentage allocation to Italian government bonds than, for example, a Dutch company,” says Sharma. “Similarly, many investors are more comfortable with commercial real estate in their home market versus other markets.”

Non-economic considerations
Whatever investment strategy insurance companies pursue, in a continuing low-yield environment with an increasingly heavy regulatory burden, the choices are only going to get more, not less, complex. As a result, some large insurers are beefing up their in-house investment teams, but many will turn to asset managers, which are also expanding their capabilities.

This will hopefully enable them to provide the bespoke solutions that insurance companies typically require – and to take account of insurance companies’ specialist needs.

“It’s important to recognise that no two insurance companies are alike,” says King. “Off-the-shelf products don’t work well. You need to understand that there is a layer of non-economic considerations.”

The DJ may be spinning the ‘lower-for-longer’ record for some time to come, in which case asset managers need to make sure they are dancing to the same tune as their insurance clients.

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