Elie Saikaly, Principal Consultant, Frontier

Elie Saikaly, Principal Consultant, Frontier

Liability-matching Increasingly Difficult

Frontier Urges Insurers to Diversify

Insurers are facing increasing difficulties in running liability-matched investment strategies, according to Frontier. In the current low-yield environment, insurers are better off looking for further diversification, including in unlisted assets.

Insurance companies will find it increasingly difficult to run liability-matched investment strategies at the current low bond yields and with inflation likely to rise in the near future. Holding on to such a strategy runs the risk of generating a return that doesn’t keep up with inflation, according to asset consultant Frontier.

Insurers are better off diversifying their holdings into unlisted and other risk asset classes, Elie Saikaly, Principal Consultant at Frontier, says in an interview with [i3] Insights.

“Gone are the days that you would invest in government bonds to match your liabilities. Based on Frontier’s assumptions, a portfolio of matched assets is likely to underperform inflation over the foreseeable future,” Saikaly says.

Insurers should start with revisiting their risk appetite statement and reset their investment objectives, taking into account the potential of rising inflation. Frontier has done extensive research into the various inflation scenarios and has concluded a good starting point for investment objectives for general insurers is the Consumer Price Index (CPI) plus 1 per cent.

“The modeling we have undertaken recently suggests that you would be fortunate if a portfolio matching liabilities is going to produce [a return similar to] CPI. In fact, we anticipate an insurer’s liabilities would grow at a faster rate than CPI. You then need a growth element to your portfolio that targets something like CPI plus 3 per cent to achieve [an overall] CPI plus 1 per cent,” Saikaly says.

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The modeling we have undertaken recently suggests that you would be fortunate if a portfolio matching liabilities is going to produce [a return similar to] CPI. In fact, we anticipate an insurer’s liabilities would grow at a faster rate than CPI

Private assets are one asset class insurers should consider, since many of these assets offer good protection against inflation. Infrastructure and property assets are also more capital efficient from a regulatory perspective. Expected returns are similar to equities, but the capital charge under the Life and General Insurance Capital (LAGIC) Standards tends to be lower.

But unlisted assets form a popular asset class at the moment, as many institutional investors are looking for stable income-producing assets. Asked whether this was the right time to invest in unlisted assets, Saikaly says there are interesting opportunities in certain niche sectors.

“The lead time is at least nine months if not 12, so that is a problem. So I’m not going to suggest that you can get set in these asset classes tomorrow,” he says.

“However, there are a number of niche strategies which insurers should be looking at, including needs-based property. So think of education, built-to-rent, healthcare and logistics whose assets tend have a greater level of inflation hedging built in.”

Diversification

Insurers should also consider how to get the most out of their fixed income allocation, Saikaly says. Low-hanging fruit here includes more active investment management, but also active duration management, he says.

“General insurance companies typically have a liability duration much lower than the Australian composite bond index, which has a duration of around six years. So start with your view of three-year bonds and then we work out from there what levers can add value,” he says.

Insurers should also consider equities to provide more growth in the portfolio, he says. To mitigate some of the worst effects of the higher volatility and capital risk charge, they could consider an allocation in combination with an overlay or a protection strategy.

“Equities are always going to be the kicker in terms of return, but they are also going to be the kicker in terms of asset risk charge,” Saikaly says.

“Some insurers might say that they don’t want to buy equities because they’re too risky, but you can get some capital relief by buying put options, or you could think about buying call options instead. They’re relatively capital efficient.

“What we’re saying is insurers need to diversify if they haven’t already started to diversify. They need to because we’re starting to move into an environment that we haven’t experienced for some time.

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What we're saying is insurers need to diversify if they haven't already started to diversify. They need to because we're starting to move into an environment that we haven't experienced for some time

“Inflation has to rise at some point and then you will underperform. How does that impact your capital position? Many people think about risk as volatility or in terms of standard deviations, but to me risk is about insolvency. It is the risk of falling below your prudential capital requirement.

“It is the risk that you don’t keep up with your liability cash flows. That is the real risk, because you can solve some of the volatility of asset classes through diversification, through active management and through some downside strategies in the portfolio.”

It is also important to set a strict governance policy around any equity allocations, as in previous periods of stress insurance companies have tended to behave pro-cyclically, selling their equities in the midst of a crisis.

Last year’s pandemic-driven sell-off was no exception.

“We have seen a number of general insurers not buying back into equities still a year and a half since the bottom of the market. They have obviously missed out on significant returns. How do you reduce the possibility that you are a forced seller? Well, we’ve got to think about overlays,” Saikaly says.

“What if you had a put strategy, for example, and you can monetise that by paying a little bit away for some protection, or potentially looking at buying calls if you don’t have any physical equity exposure.”

Alternatives also have a role to play in insurance portfolios, but Frontier is still conducting research on how some of these strategies are treated under LAGIC. Many alternative strategies hold derivatives and other synthetic vehicles and treating these strategies on a look-through basis could result in capital efficiencies.

But this is still a work in progress, Saikaly says. “It is one of our next projects because there’s a risk that it all gets treated as equities, for example. You don’t want to have an equity asset risk charge applied to an alternatives portfolio,” he says.

Model Portfolios

Frontier has been expanding its insurance practice in recent years and it now has nine liability-driven investor clients on retainers, while undertaking projects for others.

As part of this growth, the firm has developed two model portfolios, one for Australian Prudential Regulation Authority (APRA)-regulated clients, which has a short duration focus, and one for government insurers, which is more of a long-term investment strategy.

“If we look at the APRA-regulated or general insurers specifically, what we did is build an asset risk charge modelling capability within our asset allocation modeling tool, Portfolio Analytics,” Saikaly says.

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If we look at the APRA-regulated or general insurers specifically, what we did is build an asset risk charge modelling capability within our asset allocation modeling tool, Portfolio Analytics. It helps us work out which strategic asset allocation is the most capital efficient

“It helps us work out which strategic asset allocation is the most capital efficient. We built that technology over the last six to nine months. It is available to clients, but we use it internally to customise an insurance portfolio and build our own model portfolios as a starting point for client discussion.

“This doesn’t mean that every client is going to get the model portfolio, but it is a starting point for what asset classes and what risk-return profile insurers should start with.”

Currently, the model portfolio for APRA-regulated insurers is aimed at general insurers, but Frontier is planning to extend the research to life and health insurers too.

“I don’t mean to say that we’re going to be able to address every challenge, or that we’re going to have the one solution to everyone’s problem, but it is looking for greater customisation,” Saikaly says.

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[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.