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Insurers Need to Cast Net Wider

14 October 2020
Greg Wilkinson, Head of Insurance Strategy

Organisations and individuals across the globe are struggling to adapt to the myriad challenges posed by the COVID-19 pandemic. Insurers, with such a critical role to play in dealing with and helping others recover from crises, sit at the eye of the storm.

A range of factors intersecting with the effects of the pandemic are negatively impacting the environment for insurers and are bringing into sharper focus the importance of adopting optimal investment strategies to maximise returns within acceptable risk frameworks.

However, it is an inescapable fact that, in this new and lower interest rate world, traditional investment strategies which have been successful for so long are unlikely to continue to deliver the returns of the past.

COVID-19 hit certain fixed interest portfolios particularly hard early this year, causing some insurers to question whether their portfolios were really as defensive as they thought. With yields now even lower, there is a further question over whether traditional bonds can provide the degree of protection they have traditionally provided in risk-off market environments.

Where insurers’ capital buffers have been reduced due to market impact, a natural desire to hold more defensive investments with lower capital risk charges to lessen regulatory capital requirements also becomes a reality. The effect of having increasingly defensive portfolios would be lower anticipated investment returns over the long term.

Challenging Environment

The insurance environment is currently extremely challenging. Life insurers are facing potential increases in claims, including significant increases in mental health claims exacerbated by the effects of COVID-19. More sophisticated products and features being offered at a time when the pricing of such products is being driven down, places further downwards pressure on profitability.

General insurers are facing potential increases in business interruption claims caused by the pandemic, and private health insurers are experiencing well-publicised declines in younger member numbers, and providing deferrals of premium increases and premium concessions.

These factors, along with untold others, mean it is now more important than ever for insurers to consider how to utilise the reserves backing their regulatory capital requirements and any surplus capital to best support their businesses.

The difficulty is that assets such as cash and bonds typically make up significant proportions of insurers’ investment portfolios due to their traditionally defensive characteristics and beneficial treatment in regulatory capital frameworks.

Bond portfolio returns have benefited significantly from falls in yields over the past few years. This is unlikely to be repeated and certainly cannot be counted upon given the US and Australia’s aversion to entertaining negative interest rates.

Cash rates and bond yields are at, or near, all-time lows and central banks, notably including the Reserve Bank of Australia, are committed to retaining low rates for longer and expanding their quantitative easing programs further. Accordingly, forward-looking return potential from these asset classes has also been significantly reduced.

It is, therefore, tempting for insurers to consider moving up the risk spectrum, either within their existing defensive portfolios, or by expanding to other more growth-focused assets such as equities in the search for investment returns.

However, apart from the additional typical risks such as increased volatility, the pandemic and its uncertain effect on company earnings has heightened the risks lurking within such growth assets. These include the risk of defaults in credit markets and missteps on earnings estimates which could lead to downward re-ratings of share prices.

Growth assets are also considered to be expensive by many – certainly by historical valuation metrics – due to the inflationary effect on asset prices of central bank and government stimulus and the demand from investors for yield-generating assets, including record volumes of retail investors trading in listed equities.

Add to this the fact that more volatile growth assets typically incur increased regulatory capital requirements and it is clear that increasing allocations to such assets is unlikely to be the panacea.

Innovation

While there is no single silver bullet for the most appropriate way forward from an investment perspective, a key first step is for insurers to acknowledge traditional strategies are unlikely to deliver the returns of the past and to manage internal stakeholder expectations accordingly.

Each insurer will have its own objectives and requirements, not least of which will be its regulatory capital position, which should be a key determinant of strategy, along with its ownership structure, anticipated revenue, claims experience, expenses and ultimately profitability. Insurers with greater surplus capital buffers will have greater freedom for exploring different investment strategies, but for all, appropriate asset allocation will be vital.

Insurers should consider whether existing defensive portfolios are as well structured as possible to ensure the most efficient extraction of returns for the risks taken. This could include active management of exposures where appropriate and leveraging the considerable research capabilities of fund managers to help optimise portfolios from risk, return and capital requirement perspectives.

Once defensive portfolios are appropriately sized and structured, thoughtful allocation of additional capital to include seeking alternative return premiums not necessarily associated with traditional assets, such as fixed interest and equities, may enhance return potential and diversification within portfolios.

One example is real assets such as infrastructure or property which can provide a degree of inflation protection if underlying securities are carefully selected. Others include seeking to harvest the complexity premium within certain asset classes such as securitised assets.

The landscape for insurers is demanding and shifting and the risk and return outlook for traditional defensive portfolios is challenged. While there is no easy answer, adopting an active and innovative approach to investing can help insurers chart a secure path through a changing world.

https://i3-invest.com/2020/10/insurers-need-to-cast-net-wider

 

Greg Wilkinson