insurance undertakings investment strategies in a low interest … · insurance undertakings...

Insurance undertakings investment

strategies in a low interest rate

environment

Goran Pavlović, CFA, FRM

UNIQA Capital Markets

Zagreb, 20th November 2019

Agenda

� Overview of typical investment strategies of

insurance undertakings

� Recent trends on the fixed income markets

� Challenges of low interest rates for the

insurance industry

� Possible investment strategy solutions to low

interest rate environment

Overview of typical investment strategies of insurance undertakings

LIFE INSURANCE (ENDOWMENT)

� Typically long term contracts with

relatively predictable liability

structure

� Clients can cancel the contract

prematurely, but usually with

penalties

� Historically sold with some

guaranteed interest rates

� Profit allocation mechanism– in

Austria, the clients participate with

at least 85% of annual investment

profit - Asymmetric business model

� Significant interaction between

assets and liabilities

NON-LIFE INSURANCE

� Mostly short term contracts

� Need to hold sufficient liquid assets for

sudden claims

� Clients can cancel the contract before

maturity, but no surrender values etc.

� No interest rates guarantees, no profit

sharing mechanism

� Investment losses can be compensated

in the next business period

� No significant interaction between

insurance assets and liabilities

� Main Non-life performance KPI is

combined ratio � not investment

performance

Characteristics of life and non-life insurance

Insurance share of

extra investment

result

Policyholder

share of extra

investment

result

Insurance

bears the

lossesGuaranteed

interest rateExpected return

Investment return (%)

P&L (absolute)

Probability of expected P&L

returns based on asset

allocation and capital

market expectations

� (Annual) Investment result has to be higher than the guaranteed interest rate

� If the investment result is not sufficient, the insurance company bears all the losses and has to make it up to the

clients out of own capital

� When the investment result is higher, the company must (Austria) or can allocate (significant) part of the

investment result to the policyholders

� As (painfully) learned through the financial crisis, due to this asymmetry, no specific incentive to have significant

risks in the portfolio

Asymmetric business model of the life insurance companies

Solvency II LDI / SCR

IFRS

Local GAAP

� Taking different dimensions into account at the same time can lead to conflicts of interest

� Choosing the steering dimension dependent on the business model and company preferences

Accounting & regulatory requirements lead to additional challenges when

defining investment targets and setting the investment strategy

Some examples:

� In the local GAAP balance sheet, the values of liabilities

usually rely on deterministic interest rates and cash flows

� The local GAAP balance sheet does not contain sufficient

information about the future solvency of the insurance

company and therefore is not useful to manage assets in an

ALM-framework

� But local GAAP is relevant for profit allocation and/or dividend

payments. P&L volatility (equity investments, derivatives,

carrying bonds at high purchase yields) crucial

� IFRS (in case of insurance groups) - relevant for

communication to investors and analysts. IFRS affects mainly

reporting and steering on the group level

� SCR (market risk) as additional constraint in setting up the

investment strategy – Target capital ratios

LIFE INSURANCE (ENDOWMENT)

� Asset-liability management (ALM) is

a fundamental element of life

insurer strategy, especially after the

introduction of Solvency II

� Typical investment Target: Earning at

least guaranteed liability

requirement in short and the long

term.

� Typical investment constraint:

minimize the risk of future liabilities

for shareholders - no substantial

increase in market risk

NON-LIFE INSURANCE

� Business model not necessarily

dependent on investment income

� ALM relevant only in case of long tail

liabilities

� The insurance company can take a

longer term return and risk view and

adjust investments on a tactical basis

� Typical investment target: maximize

investment return

� Typical investment constraint: defined

level of market risk or defined P&L

volatility

Strategic alignment and setting the investment target function (illustrative)

* Liabilities = Guarantee requirements (best estimate basis) / Analysis of existing business only

Typical cash flow profiles of some Investment portfolios (illustrative)

DUR Assets 12

DUR Liab. 15



DUR Assets 9

DUR Liab. 18



DUR Assets 6

DUR Liab. 3

* Liabilities = Guarantee requirements (best estimate basis) / Analysis of existing business only / Health insurance – illustrative example for Austrian market


DUR Assets 8

DUR Liab. 30

� As of 31.12.2018, total investments of EU insurers amounted to 10,3 billion EUR

� Major part of overall asset allocation in fixed income instruments

Investment split in Q4 2018 by type of undertaking

Actual asset allocation reflects these characteristics of insurance companies

� Source: EIOPA Financial stability Report, June 2019

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e

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EQ EQ

Euro area holders of debt securities (data as of end 2016)

Insurance companies are one of the main holders of EU debt securities,

especially on the longer end of the curve

� Source: ECB Working Paper Series: Insurers’ investment strategies: pro- or countercyclical? (July 2019)

� Importance of issuer quality for ALM strategies – predictability of cash flows

Credit quality of insurers bond portfolio across EU countries

Majority of fixed income allocation invested in investment grade bonds


Investment grade

(average)

Recent trends on the fixed income markets

Overview of recent trends on the fixed income markets

� Source: JP Morgan guide to the markets (Q4 2019)

Interest rates have reached new historical lows in 2019…



…despite some pickup in second half of 2018, the latest inflation (CPI) readings are lower across the board…



…in fact, in the Eurozone, in spite of the massive QE programs, core inflation (purple line) remains stubbornly low for almost a decade now…



… not only that, but the current mid to long term inflation expectations remain suppressed in spite of recent (September 2019) ECB restart of QE…



The current expectations imply accommodative monetary policy and long term negative policy rates in Europe…



… but it seems that in the USA, the market also expects continuous decrease of future policy rates, in spite of official FOMC forecasts…



… so after years of expected rebound of the future interest rate developments, current projections of policy rates are vey subdued…


� Source: S&P Global – EMEA Insurers 2020 Outlook, November 2019

…the same is currently projected for long term bonds – „lower for longer” is again the name of the game…



… so almost all fixed income categories (not just govies) are currently at historical lows


� Source: https://www.blackrock.com/institutions/en-gb/insights/charts/capital-market-assumptions

Expected returns for EU investors for all asset classes are moving south; only selected markets provide positive medium term return

Challenges of low interest rates for the insurance industry

� Falling interest rates have especially high influence on the life

insurance companies – long term contracts with guaranteed

interest rates are highly dependent on the performance of the

capital markets

� Although the effect of falling interest rates affects the investment

performance and profitability of the non-life industry, the non-

life insurers can adapt by for example improving the core

operating profitability (Combined ratio)

Falling interest rates have a negative effect on the insurance industry,

especially for life insurance companies

Average reinvestment yield for EU life companies still mostly holding up…

� Source: S&P Global – EMEA Insurers 2020 Outlook, November 2019

… but bonds that are maturing have higher yields than actual reinvestment

rates (and probably better credit rating)

� Source: ECB Financial Stability Review, May 2019

� Companies usually publish investment returns on P&L basis – companies can hide the

economic reality for quite some time by steering realized gains on the existing bond portfolio

� As a rough guestimate, each year of low interest environment lowers the average investment

result for ca 20bps (depending on back book, carrying bond yields and CF mismatches for each

individual company)

In majority of EU countries, negative duration gap through time (DURL>DURA)

� Source: EIOPA Insurance stress test report 2014, 2016, 2018, EIOPA Risk Dashboard, October 2019

Duration of Liabilities vs Assets (2014)

� German life insurers among the most impacted by the decline in interest rates (High guarantees / high duration gap)

� According to Moody's (2019), despite positive mortality/ morbidity expense results, the overall result of the German life market may turn negative in less than five years if interest rates remain low

Challenge: to close or not to close the ALM gap in the current environment?

� Closing the duration gap is the optimal solution from the risk (Solvency II) perspective, especially when performed with EU government bonds (in standard SCR formula)

� However, matching liability cash flows with asset cash flows in low interest environment does not necessarily ensure sufficient earnings to cover guarantees over the long term.

� In practice, one cannot separate interest rate risk from spread and concentration risk of long term bonds

� Prolonging asset duration is the right strategy if interest rates remain subdued and inflation remains low – but medium term danger of in case of rising inflation / rising interest rates (lapse risk could be higher than modelled in case of significant increase in interest rates)

Possible investment strategy solutions to low interest rate environment

Possible responses to low interest rate environment for insurance companies

� Investment strategy optimization� Going down the credit curve

� Increasing portfolio duration to capture higher yields

� Search for additional yield – alternative assets

� Purchase of floating rate assets

� Derivative overlay strategies

� Make a tactical duration call (for example, shorten duration)

� Product features� In-force management in the life portfolio

� Lowering guaranteed rates

� Steering of profit allocation mechanism

� Change of product mix (eliminating unprofitable products, focusing on capital light products without guarantees etc.)

� Strategic options � Reconsidering exiting the business completely (low profitability and high capital

requirements of life business under SCR)

� Improving operational profitability in the non-life portfolio (combined ratio)

Recent data shows that there is still no significant credit worsening of the bond

portfolio. The portfolio duration is however increasing


Alternative assets – illustrative example of possible asset classes as vehicles for

enhancing yield

Conventional classes

�IG Bonds

�HY bonds

�Global bonds

�ABS

�Equities

�Emerging markets

�Hedge fonds

�Real estate

�Commodities

Conventional “Plus”

�Global bonds with currency hedging

�Interest rate hedging – Bond futures

�Yield curve strategies – for example swaptions

�Implementation of tactical views

Alternatives – private markets

�Private lending

�Leveraged loans

�Commercial real estate lending

�Private placements

�Infrastructure debt

�Infrastructure equity

�Private equity

Mostly considered as alternative assets

Alternative assets as possible vehicle for enhancing yield

� Classical solutions imply

walking along the efficiency

curve (taking on more risk)

� Inclusion of alternative

assets can increase the

expected returns with the

same (economic!) risk

exposure due to illiquidity

premium

� Source: KKR Global Macro Trends, April 2019

Switch toward alternative asset classes is already happening…

� Source: ECB Financial stability Review, May 2019

… In fact, this shift to alternative assets should continue further

� Source: Goldman Sachs Asset Management Insurance Survey, April 2019

Planned allocation change over the next 12 Months

(increase minus decrease, %)

� European insurers plan to

increase exposure mostly to

infrastructure debt and

investment grade corporates

� Infrastructure equity also

among the top five priorities

over the following period

According to Blackrock, in three years, over a fifth of insurers will have more than 10%

of the investment portfolio allocated to the private markets

� Source: Blackrock Global Insurance Report 2019

� Private markets (when appropriately selected) can provide uncorrelated returns with appropriate risk/return trade-offs which is one of the main reason for the recent popularity of this asset class

� Caution still needed - risk of crowded trades?

Possible responses to low interest rate environment for insurance companies

(continued)

� Purchase of floating rate assets� Goal: ensuring sustainable long term yield once the business cycle reverts back

to normal

� Challenge: pricing, negative relative returns in the first years

� Derivative overlay strategies� In theory, efficient solutions possible (duration matching / protection of tail

risks / protective put equity strategies etc.)

� In reality, around 80% of global insurance companies still do not use derivatives, total gross derivatives exposure currently less than 1% of assets

� Product complexity, accounting issues (P&L volatility) among the main obstacles for efficient implementation

� Make a tactical duration call (for example, shorten duration)� Requires bravery (the markets have been expecting a recovery of interest rates

for years and have been consistently proven wrong) and sufficient capital buffers to survive the periods of low interest rates

Summary, how to set up the optimal asset strategy for insurance company in

the expected lower for longer yield environment?

� Finding the right balance between the factors of return, risk and liquidity

� Diversification across as many asset classes as possible and increase of alternative asset classes in the portfolio – catching the illiquidity premium

� Exploring market inefficiencies whenever possible

� Shift asset allocation toward riskier assets to generate excess returns when appropriate

� Strengthen portfolio resilience using risk mitigation techniques

� And most importantly, incorporate ESG factors in all investment processes and activities in order to align with best practices and requirements from internal and external stakeholders

Appendix


� Source: Bloomberg

Overview of EUR swap curves development (risk free rates)

Appendix: Japanese experience shows that it is possible to remain profitable in

the life business, even when investments are not a main profitability driver

� Source: BIS, Financial stability implications of a prolonged period of low interest rates, July 2018

� Main actions taken on the

asset side:

� Significantly increasing asset

duration

� Systematically explore

inefficiencies in the financial

markets - internationalization of

asset allocation – both hedged

and unhedged

� Diversification of investments to

new asset classes

� No significant increase in equity

exposure

� Product mix:

� Variable life insurance policies

� Introduction of FX issued policies

(customer bears the FX risk)

� New profitable products

Recommended reading

The ‘Low for Long’ Challenge: Socio-economic

implications and the life insurance industry’s

response

https://www.genevaassociation.org/research-topics/financial-stability-and-regulation/low-long-challenge-socio-economic-

implications

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