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In search of tactical opportunities and new return potential, risk pros are turning to investment pros.
A decade ago, a typical investment portfolio held by a U.S. insurance company primarily consisted of bonds and more bonds — a relatively predictable stream of income to cover liabilities without undue risk.
Since then, insurers have diversified their portfolios, increasingly turning to experienced firms to manage their allocations to equities, mortgages, private credit, real estate, and specialized asset classes.
“Insurers face the dual challenge of low rates and tight spreads,” says Michael Pagano, head of insurance portfolio management at Voya Investment Management. “Their legacy books of fixed-income securities deliver higher earned yields than those now available in the market. When those securities mature or are called away, or when they have new premium income, insurers should consider fresh approaches to reinvesting those funds in the market.”
Overall, U.S. insurers reported more than $5.8 trillion of cash and invested assets, on a book/adjusted carrying value (BACV) basis, for 2015, according to the latest figures from the National Association of Insurance Commissioners (NAIC). However, approximately 67 percent of insurers’ assets consisted of bonds, indicating that many companies have taken a go-slow approach to broadening their investment mandates. But there is plenty of activity on the margins of insurers’ portfolios, creating new opportunities for third-party management firms.
“We are seeing many insurance companies increase allocations to equities,” says Don McDonald, president and CEO, Prime Advisors Inc., an affiliate of Sun Life Investment Management. “One reason is the overall rise in equity market values; but others are moving small amounts of their assets to this sector. They are willing to pay a higher capital charge for carrying equities in order to gain exposure to potentially higher returns.”
Growth in outsourcing
“More insurance assets are being outsourced and more investment managers are competing for those assets,” says David Holmes, principal, Insurance Asset Outsourcing Exchange, who surveyed 52 investment managers for a May study, “Increasing Competition in a Growing Market.” He found that insurance general account (GA) assets managed by third-party (non-affiliated) investment managers totaled $1.9 trillion globally as of December 31, 2016.
In North America, third-party managers posted a gain of 10.2 percent in assets under management (AUM) in 2016, according to the report. That was a strong turnaround from the 1.2 percent decline in 2015, which was caused largely by mergers and acquisitions and associated insourcing.
“Outsourcing continues to be a major theme among insurers, and we expect this trend will continue,” says Pagano. “Rather than building an in-house team in private credit, for example, insurers can engage a management firm that already has those resources in place on behalf of its own balance sheet or [that of] a third party.”
An evolution of strategies
Life, health, and property and casualty insurers are seeking tactical opportunities for additional yield from their fixed-income assets — an objective that may be supported by a third-party adviser. “Interest rates remain stubbornly low, and the intermediate and long end of the yield curve has remained low,” McDonald says.
He adds that it’s important for insurers to take a focused approach to duration risk. “That means modeling a custom portfolio with laddered maturities and cash flows that align with the liabilities of an insurance company,” he says. “That includes having cash available for a situation involving catastrophic claims.” Along with seeking incremental gains on their core holdings, insurers have been expanding their mandates to new types of credit, equity, and alternative assets.
“Initially, the insurance industry looked at allocations to specialized fixed-income mandates like high-yield bonds, emerging-market debt, and structured products,” says Holmes. “But higher demand has compressed the spreads on high-yield bonds, which are not particularly attractive now on a risk-adjusted basis. More recently, insurers are investing in private equity and private debt, which are less liquid but can generate cash flows and a premium over public debt.”
To serve insurers’ growing interest in equities, McDonald’s firm recently created two separate account solutions. “As insurers looking at the equity sector can consider several strategies, we have developed both a passive strategy based on the S&P index and an active strategy focusing on large-cap stocks that pay high dividends,” he says. “Both approaches can reduce volatility and be tailored to an insurer’s specific investment needs.”
Pagano points out that the NAIC is revamping its risk-based capital requirements. “We are seeing increased allocations to structured credit, which is tied to the U.S. consumer,” he says. “With the pending changes in corporate credit charges, this strategy can be more capital-efficient, as well as offer opportunities for higher yields.
“In the private credit arena, we continue to see attractive global issuance from borrowers in developed and emerging nations,” adds Pagano. “In some cases, a lender that can purchase credit in the issuer’s local currency, rather than in U.S. dollars, can gain greater access to attractive deal flow. Depending upon the nature of the buyer’s liabilities, those returns may need to be converted into dollars on the balance sheet.”
Insurers seeking to capture risk premiums are also shifting funds into alternative asset classes, and tapping the specialized expertise of third-party managers. Holmes notes that newly outsourced allocations to alternatives grew from 12.5 percent in 2009 to 21 percent last year.
“Large and midsize insurance companies are also allocating higher amounts to the real estate sector,” says McDonald. “There are also opportunities in dollar-denominated commercial mortgages, and private placements in international markets.”
New risk management tools
Along with broadening their exposure to alternative asset classes, insurers are deploying sophisticated risk management tools and models. “They are expanding their thinking to include geopolitical and enterprise risks, rather than continuing with a narrow definition of investment risk,” says Holmes. “That modeling may also call for broader exposures to nontraditional investments.” Foley lauds insurers for moving beyond traditional portfolio diversification models in addressing today’s risks. “Diversification needs a stable asset correlation matrix in order to work,” he says. “But under severe market duress, those correlations collapse and traditional assets may move down together.” Foley adds that insurers should strive to address the risk factors that can influence multiple asset classes, which he says is “a simpler and more intuitive approach to risk modeling.”