Allianz Australia has been on a diversification journey over the past three years. In this interview, we speak with CIO Anthony Michael about the challenges an insurance company faces in achieving better diversification.
When Anthony Michael joined Allianz Australia as Chief Investment Officer more than three years ago, he was handed a portfolio that was built for the apocalypse. It consisted predominantly of very liquid, sovereign bond holdings; safe but not particularly punchy.
The brief was to create an investment strategy that was a little less one dimensional, but still provided enough stability to support the insurance business.
“Literally, when I first showed up, the chairman at the time, John Curtis, said: ‘We need to look for more diversification in our investment strategy,’ Michael says in an interview with [i3] Insights.
“The key message from the board, investment committee and also from the head office in Germany was that we’ve got a higher interest rate regime [in Australia] than Europe, but you’ve got an extremely conservative investment portfolio and you need to look for more ways to diversify your portfolio.
“We were basically told to work our investment portfolio more actively to generate returns and we couldn’t just enjoy the relatively higher interest rate environment that we’ve had. And so that was exciting; that was the challenge.”
We were basically told to work our investment portfolio more actively to generate returns and we couldn’t just enjoy the relatively higher interest rate environment that we’ve had. And so that was exciting; that was the challenge
But not only did Michael need to diversify the portfolio, he had to do this in the context of various regulatory regimes.
“I walked into an insurance company that not only is global, not only operates on European accounting and solvency, which is focused on historical book values, but also locally in Australia, where we’ve got mark-to-market standards, which provides more volatility. And you also have got the regulatory framework under LAGIC (Life and General Insurance Capital Standards) and then our own internal capital model,” he says.
“It is a far more constrained environment than a superannuation fund.
“But the easiest thing to do in that situation is to look for the low-hanging fruit. There are two things you can do: look at what you are doing and see if you can do it better. And the second thing is: can you do anything completely different that is going to improve your risk/returns?”
Starting with the first part of the approach of what they might be able to do better, Michael tackled the abundance of liquidity in the fixed income portfolio.
“We had far too much liquidity across our portfolio. Too many government bonds, too many liquid, vanilla, money market securities. We basically had too much of this same-day, next-day, one-week liquidity in the portfolios,” he says.
“And we just really didn’t need that much in our portfolios, so we could immediately allocate more money into relatively less liquid investments to achieve our diversification objectives.”
In the narrow context of fixed income, the most obvious choice was credit.
“We broadened the mandates to allow for more credit, more lower-rated credit, and we widened the duration bands for our mandates. We also simplified our performance benchmarks because we had very convoluted/custom benchmarks. So our goal was to generate more outperformance in our existing mandates,” Michael says.
New Asset Classes
Looking at what they could do differently, Michael cast the net wider to see what new asset classes they could introduce into the portfolio.
Listed equities can be inefficient investments for insurance companies because the regulator requires them to hold significantly higher levels of capital against these assets than it does for fixed income. Michael decided that given the asset valuation levels at the time it was better to look for diversification in alternative assets.
“That meant for us the whole gamut: private equity, infrastructure, property, alternative debt and all the gazillion different opportunities in the private debt space,” he says.
“Australia’s public credit markets aren’t particularly large, liquid or diversified. They’re concentrated in financials, they are dominated by offshore issuers and they’re mainly A or AA rated. There’s very little liquidity in the BBB sector and no meaningful high-yield public bond market in Australia.
“How can you achieve sensible diversification in the credit allocation of your portfolios in a reasonable amount of time, particularly when you can take advantage of all the liquidity we had in the books? And so the pretty straightforward answer for us was to also consider the alternative debt markets, the private debt markets.”
How can you achieve sensible diversification in the credit allocation of your portfolios in a reasonable amount of time, particularly when you can take advantage of all the liquidity we had in the books? And so the pretty straightforward answer for us was to also consider the alternative debt markets
Historically, Allianz Australia relied heavily on asset manager PIMCO, which is majority owned by Allianz. But while PIMCO is very strong globally and in the public investment-grade fixed income space in Australia, it did not have a private debt capability locally and so Allianz started canvassing which managers were best in class.
“Remember that with Allianz globally you’ve got a fairly large in-house asset management capability that covers most asset classes. So if you’re going to go out of that group and go to third-party non-Allianz investors, then you have to have a very good reason to do it,” Michael says.
But the investment committee appreciated the logic of the decision and approved the team to engage external managers for these allocations.
“We started funding those strategies about two years ago with very small amounts because we wanted to make sure it made sense from a regulatory, reporting, systems, risk and accounting perspective,” Michael says.
“The approach we took was to start off with alternative senior debt, senior secured lending in diversified funds.”
Exploring the asset class landscape, researching managers and building relationships takes time and the team had only just started to hand out its first mandates to new managers when they suddenly found themselves in the midst of a global pandemic.
“It wasn’t a fabulous time to embark upon this massive diversification strategy to effectively go and sell government bonds and buy higher-risk investments,” Michael says.
“We realised that we wanted to save our gunpowder for times where we could be more opportunistic, but we needed to set up the plumbing to allow us to be opportunistic.”
He recalls his past experience, in particular as a principal consultant at Frontier Advisors, for always thinking about whether asset classes can have a role in the portfolio, even if they seem too expensive or cumbersome at the time.
“It always pays to think about whether an asset class can have a role in your portfolio in the next three to five years under certain circumstances. And so what we had to do is line up a range of products that we knew we were going to invest in over the next couple of years and basically put some starting capital into these and start building some relationships with managers,” he says.
It wasn't a fabulous time to embark upon this massive diversification strategy to effectively go and sell government bonds and buy higher-risk investments
Michael and his team did allocate some money opportunistically during the sell-off in March and April last year, but only marginally so.
“There were definitely opportunities if you look at some areas like Carnival [Cruise Line] and Viking Cruises, and some of the heavily distressed sections of the high-yield market, especially the publicly traded high-yield debt market in the US,” he says.
“There were some absolutely fantastic opportunities that have experienced a complete turnaround over the last six to nine months. The question is: Did we get enough capital out the door to take advantage of all of them? Absolutely not.”
But Michael thinks there will be plenty of opportunities to come in the distressed and opportunistic space over the next couple of years as many companies are still quite leveraged.
“We think that there is going to be a form of normalisation of interest rates and that there is going to be more and more distressed borrowers over the next three to five years. We’re going to be seeing increasing debt servicing costs, we’ve got stretched balance sheets and there’ll be plenty of opportunities in the opportunistic and distressed space,” he says.
The allocation to alternative credit can be regarded as an equity replacement strategy. It is still a relatively small allocation, although Michael doesn’t want to give out any details about the size of the allocation.
[i3] Insights understands the current overall allocation to alternatives sits at around 10 per cent of the portfolio and is likely to increase to 12 to 15 per cent.
“I don’t want to give any percentages, but as long as you can manage your costs in terms of capital charges and liquidity budgets, we think this is going to be the place to be in for the next three to five years,” Michael says.
Setting an investment strategy for an insurance company is fraught with many difficulties, but sticking to it is equally challenging.
The investment portfolio is usually of secondary concern. Insurance executives are focused on capital from an underwriting perspective, while investment returns take a back seat.
This dynamic becomes painfully clear in times of financial stress and the coronavirus pandemic was no exception.
As COVID-19 started to cast a shadow over financial markets globally, insurance companies scrambled to strengthen their capital positions and there were some instances where investment teams were required to sell listed equities just as markets started to sour.
“My experience going back to 2000 and to the dotcom bubble working with insurance companies is that they’re often pro-cyclical. They tend to chase bull markets and they’re forced sellers in bear markets because of their capital position,” Michael says.
Unlike many other insurance companies, Allianz Australia didn’t hold any equities, so it didn’t have to sell into the downturn. But Michael says it was still a sobering experience.
“The key learning from COVID is that you’ve got to do contingency planning and scenario analysis,” he says.
“Last year, during a conference, we all sat around and specifically had a conversation around what we would do if there was a 30 per cent sell-off in equities. We actually had that conversation in February last year.
“Within a couple of months, the theoretical conversation of a 30 per cent drop turned into a reality.”
Many investment professionals from insurance companies that did hold equities initially thought they could stick to their long-term investment strategy, only to find that this proved difficult as the pandemic unfolded.
“They didn’t have any choice. The investment teams were told that they had to get out of public equities in order to manage the capital position,” Michael says.
“For us, we could use our cash reserves, our government bonds, which were still extremely liquid, to free up cash and to push ahead with some of the strategies that we wanted to get into.”
Battling the fallout of the coronavirus pandemic took up much of the time and effort of institutional investors, but it hasn’t reduced their focus on climate change. In fact, for many investors climate change has only become a more pertinent issue, partly because pandemics are inextricably linked with climate change.
The increased temperatures have already made conditions more favourable for the spread of infectious diseases as they influence when and where pathogens appear.
To help limit the risk of infectious diseases, scientists argue that we need to limit global warming to 1.5 degrees.
Allianz has recently set interim targets for reducing carbon emissions in its investment portfolios and aims for a reduction of 25 per cent in emissions by 2025 in its corporate bond portfolio.
“We’re putting in concrete steps to build a pathway to reducing our carbon by 25 per cent using a base date of 2019 so you can’t fiddle with [the target],” Michael says.
This means Allianz will invest in assets that will contribute to achieving this goal.
“We’re going to invest more in green bonds when the opportunities arise. We also really like the infrastructure equity side of things and what some of the managers are doing in renewables,” Michael says.
“So we’re also looking at more sustainable investing, particularly the infrastructure equity space, which is where we think we can make a big difference.”
He says he has seen the mindset of investors and fund managers on climate change issues shift dramatically in recent years. One of its infrastructure managers had almost no allocation to renewables a few years ago, but now has almost one-third of its portfolio allocated to sustainable infrastructure.
“It has come a long way and there are some really interesting projects for us to co-invest in, including greenfield projects,” Michael says.
Allianz Australia CIO Anthony Michael spoke about diversification at the [i3] Insurance Investment Forum, held on 16 June 2021 at the Intercontinental Double Bay.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.