Although it is increasingly complex for insurance companies to match their liabilities, we shouldn’t give up on asset/liability matching just yet, McKinsey says.
In the current environment of low, and in certain cases negative, interest rates, insurance companies sometimes struggle to find the right assets to match their liabilities. This is especially true for life insurers, which tend to have longer time horizons than their property and casualty counterparts.
For example, life insurers have historically been large buyers of government bonds. But at the moment, the yield on a 10-year US Treasury bond stands at a mere 1.58 per cent per annum, which means it doesn’t even come close to covering inflation in the country, which surged to 6.2 per cent in October.
It begs the question whether insurance companies should aim to match liabilities at all or simply shift to an absolute return model, where they just optimise returns at a modest level of risk.
Bernhard Kotanko, Senior Partner, Hong Kong, for McKinsey & Company, is an adviser to insurance companies in the Asia-Pacific region. Kotanko says we shouldn’t give up on asset-liability matching just yet.
I think asset-liability management (ALM) continues to be absolutely critical and the reason for this is that when we look at an economic risk capital profile for a life insurer, still about 70 per cent of the market risk comes from asset-liability mismatches
“I think asset-liability management (ALM) continues to be absolutely critical and the reason for this is that when we look at an economic risk capital profile for a life insurer, still about 70 per cent of the market risk comes from asset-liability mismatches,” he says.
“Therefore, understanding what you do on the asset side, even if you decide to run a bigger or smaller mismatch, [is very important].”
But there is also a deeper philosophical reason not to abandon liability matching, which goes to the heart of the insurance industry, he says.
“When you look at the underlying reason for this industry to exist, it is about holding promises and keeping promises, and those promises are accounted for on the liability side of the balance sheet,” he says.
“So if somebody says we shouldn’t do asset-liability matching anymore, then I think that would be an approach that puts the basic principle of keeping promises at risk.”
A study by the Actuaries Institute on failures in the insurance industry shows that apart from outright fraud or catastrophic events, such as wars and depressions, asset-liability mismatches are a key factor in bankruptcies.
Many insurance failures since World War II have been related to companies offering long-term guarantees, based on short-term conditions, or because of investment issues.
For example, between 1988 and 1994, 42 life insurers collapsed in the United States. Many of these insurers had sold five-year term products with a guaranteed rate of return, while on the asset side they were heavily exposed to real estate and junk bonds.
When the mortgage market and junk bond prices began to fall in the late 1980s, insurers struggled to meet their liabilities.
Looking at Asia, insurance companies in South Korea had grown rapidly up to the currency and financial crisis of 1997/98, partly by adopting bank practices that saw them issue loans and sell short-term savings products.
But when the cost of these products started to rise dramatically, customers simply abandoned them as these products often had low or non-existent surrender charges, causing funding gaps for insurers and they could no longer meet their liabilities.
“We have seen this at the end of the 1990s/early 2000s in Europe too when some insurers treated the liability side more as a funding for their investments,” Kotanko says.
“The whole Swiss life insurance sector almost went bankrupt because when interest rates changed they weren’t able to sustain their liabilities.”
Liability Aware
Although Kotanko makes the case for asset-liability matching, he also points out few insurance companies fully match all liabilities at all times. In order to optimise investment returns, insurance companies tend to have periods where they either are closer or more removed from a perfect match, depending on the economic environment and their claim experience.
“Asset-liability management doesn’t necessarily mean you need to find an equilibrium. It just means that you have the transparency and take management decisions based on a deep understanding of your liability side,” Kotanko says.
Nobody is fully matched because this would not allow for superior returns. I think it is more about smart management, where you say: ‘This is my liability profile in all its detail and these are the sensitivities to the liability profile'.
“In fact, nobody is fully matched because this would not allow for superior returns. I think it is more about smart management, where you say: ‘This is my liability profile in all its detail and these are the sensitivities to the liability profile.’
“Then if I was to fully replicate [these liabilities], then what would it look like in theory? In reality, that is when the availability and liquidity of financial instruments kicks in.
“You also have investor expectations and policyholder expectations, so you need to deviate from this theoretical replicating portfolio and begin to make conscious decisions where to deviate and where to allow mismatches.”
Alternatives
Yet, insurers still face the problem of record low bond yields and some companies have responded to this situation by allocating more to alternative assets, including private equity and certain hedge fund strategies.
Kotanko says this trend is not in conflict with proper ALM practices.
“From an asset-liability perspective, going into alternative assets is perfectly in line with professional ALM because alternative assets give you long duration and so you can harvest some of that illiquidity premium,” he says.
“It also gives you well-diversified returns, depending on the structure, so it is clearly an asset class where insurers go more into.”
Alternative assets also make more sense as a first point of diversification compared to equities as they tend to be treated at par or with more flexibility from a regulatory perspective, depending on the solvency regime insurers are subject to.
Depending on the solvency regime, [alternative assets] allow you to play the liquidity premium and the duration of some alternative assets better. They actually have a longer duration, whereas equities, for example, under Solvency II have a duration of zero
“Depending on the solvency regime, [alternative assets] allow you to play the liquidity premium and the duration of some alternative assets better. They actually have a longer duration, whereas equities, for example, under Solvency II have a duration of zero,” he says.
“So from an overall perspective, it is not unattractive to absorb the relatively high capital charges [of alternative assets] assuming the long-term returns come back.”
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