Insurance companies essentially invented the concept of professional risk management, and at their core they understand that everything, including how they invest their assets, requires a holistic strategic view of the world, its economies, and the investment landscape. Insurers are not novices at asset management, but many today realize that it’s worth exploring new and expanded relationships with outside asset managers in order to complement their internal capabilities, and to expand that holistic view they know is so valuable.
With fixed income yields seemingly stuck in “modest” mode, US insurers have been looking to third-party asset managers with greater frequency, and with the purpose of accessing innovative strategies and asset classes beyond those that insurers have historically relied upon. The trend of working with managers outside of the insurer itself is measurable – and growing.
Seeking Opportunities in Private Assets
In today’s low-rate financial environment, it’s not surprising that insurance companies are looking beyond traditional fixed-income allocations for higher yield opportunities. But despite the robust U.S. economy, savvy insurance asset managers are also striving to reduce risk exposures.
One such manager is Lisa Longino, head of insurance asset management at MetLife. “We are using our global investment capability to focus on private assets that can provide portfolio diversity and capital efficiency,” she says. “At MetLife Investment Management, we focus on taking smart risks, rather than simply chasing yield. We do our own fundamental underwriting of credits to be sure we understand the issues and pick the right assets.”
Turning to alternativesIn talking about asset allocation strategies with industry peers, Longino says the key themes are a search for yield and an increased focus on risk management. “To improve returns, we have seen insurers increasing their BBB holdings and turning to alternatives like private assets, including private equity, private placement credit, and commercial mortgages,” she says.
Longino notes that MetLife has a long history of investing in private assets, which can deliver incremental yield over public securities. “With private assets, we can diversify risk and our liquidity base, as there can be different buyers and sellers in the private markets,” she says. “We also take advantage of our diversified private origination platform to negotiate deals and covenants that can help protect our interest in the event of a market downturn.”
Currently the U.S. economy is “firing on all cylinders” with the tax cuts and increased fiscal spending. Corporate earnings have been strong, commercial real estate is in good shape, and inflation is not an immediate concern, according to Longino. “At the moment, fixed-income spreads are tight,” she says. “While there is not a lot of risk priced into these assets, we are mindful of issues such as geopolitical risk, potential trade issues, and a flattening yield curve.”
MetLife is also looking carefully at factors that could cause a cyclical downturn, such as aggressive growth in the credit markets. Globally, BBBs have grown significantly in the past few years and now make up more than half the investment-grade bond index, according to Longino.
“A lot of that growth is due to companies that have levered up in pursuit of mergers and acquisitions, or other corporate objectives,” she says. “While the rating agencies now give these credits some leeway, there is a risk that these companies would not be able to de-lever in the event of a rapid cyclical downturn. If not, some of these issues could be downgraded to the high-yield sector and the number of fallen angels could be significant.”
As a result, MetLife is taking a selective approach to investing in BBB securities and collateralized loan obligation (CLO) structures. “At this point, we believe we are in the later innings of an economic expansion,” Longino says. “While there are no signs of a downturn, we are taking a prudent approach to managing risk.”
As they seek to diversify, US insurance companies look to emerging market debt to beef up their portfolios’ performance
Emerging market debt (EMD) is a very large and diversified asset class. A cohort of nearly 800 issuers represent a market of nearly $2 trillion – in other words, a market that is 20% larger than U.S. High Yield, with strong credit fundamentals to go along with its size and potential.
In this interview, Aberdeen Standard Investments’ Sanjay Yodh (below left), Director US Insurance, and Karen Bater (below right), Senior Fixed Income Specialist, talk about why many insurers are showing increased interest in EM corporates.
Why is EM corporate debt of particular interest to insurers at the moment?
Yodh: Insurance companies tend to allocate to EM debt on the surplus side of their balance sheets. They are generally trying to create some additional diversification while potentially outperforming the US investment grade and High Yield credit markets, two asset classes where they tend to have strategic allocations. Whether they are total return or yield focused, more than half of the conversations we’ve had with insurance companies have included some variation of these two questions: We’re not invested in emerging market debt, should we be? Or: We are invested in EMD, should we be investing more?
Bater: Valuations have significantly improved in emerging market debt, compared to the beginning of the year. We’ve seen tremendous spread convergence between US High Yield and EM corporates, and that makes the emerging market corporate universe look a lot more attractive. EM corporate debt is a large and diverse $2 trillion universe, with around $1 trillion of quasi-sovereigns – they’re generally structurally important to the EMD sovereign, so the default rate is a lot less.
In a Fixed Income report published on Sept. 11, 2018, Joseph F. Kalish, Chief Global Macro Strategist at Ned Davis Research Group, said: “We continue to recommend overweighting corporate credit globally. And except for Italy where we are neutral, we are overweighing European peripheral debt. We remain overweight French sovereign debt. We are neutral dollar-denominated EM bonds.”
What to Look for in a Third-Party Manager
Varied motivations and goals inspire relationships between insurers and third-party asset managers. The size, complexity, and objectives of the investment strategy tend to be bespoke, thus in many cases the managers can be expected to bring substantial scale, scope, and flexibility to the investment process. Here’s a brief list of traits to keep an eye out for in a potential third-party manager.
A dedicated insurance solutions team. Expertise and services this team might provide include:
- Strong insurance pedigree (actuarial, accounting, rating agency, regulatory, etc.)
- Deep understanding of accounting standards and methodology (GAAP, Statutory)
- Understanding of NAIC process, ratings methodology, risk-based capital
- Rating agency knowledge (AM Best, S&P, Moody’s, Fitch, etc.)
- Insurance regulatory expertise and practical application
- Balance sheet, income statement, and risk analysis
- Liability cash-flow modeling and assessment
- Familiarity with asset allocation concepts, portfolio construction, capital efficiency impact
- Insurance sector knowledge; peer group segmentation and analysis
Insurance-specific capabilities across a broad range of asset classes: Such capabilities ideally offer significant diversification and capital-efficient qualities through a wide range of components, including active equity, quantitative equity, absolute return, government and corporate debt (including emerging markets), real estate lending, infrastructure lending, real estate equity, private equity, high yield and money markets.
Additive resources and insights (including technology): Partnering with a large third-party manager can give small to midsize insurers access to insight and resources they would be challenged to acquire on their own due to a lack of scale. Even for larger insurers with significant in-house resources and technology exposure, having perspectives from outside the firm can be valuable not just within an insurer’s investment division, but across the entire company, too.
Strong risk management: Asset managers with proprietary risk systems and analytics can add considerable value to insurers via portfolio optimization, factor sensitivities, and global impacts that may require a robust application. Also, additional client-focused human resources to address these areas of concern for insurers can aid in speed to delivery and resolution.
Cost reduction: When resource and cost intensive strategies that are not easily replicable appeal to small and midsize insurers, third-party investment managers can allow them to explore these opportunities while remaining focused on core aspects of their businesses. Even large insurers are increasingly taking more of a “satellite” approach by deploying up to 20% of non-core asset allocations – private markets, absolute return, and other asset classes the insurer would not replicate – to third party managers because, from a cost measurement standpoint, they simply do not have the volume of deal flow or need to warrant building the capabilities and team in-house.
Capabilities in optimizing asset-liability matching goals: Optimization and modeling analytics lend themselves to generating a multitude of heuristics, which require substantial interpretation to arrive at specific results and, more importantly, create the roadmap necessary to achieve different objectives. Expanding the solution tool-set can offer benefits on the micro entity liability level as well as the macro strategic asset allocation level.
Business, operations, and regulatory proficiency: Typically, insurers buying other insurers or assets outside their home country fall subject to outsource requirements, and often need assistance meeting unfamiliar reporting and regulatory requirements.
Large global investment firms offer broader access to investment and risk management solutions, while smaller firms or individuals may offer niche or very specific investment offerings. There are no one-size-fits-all scenarios, as asset liability and surplus investing tend to be company, entity, sector, and business line specific. As such, a single third-party partner may suffice in a few cases – but, in most cases, multiple external managers may offer better optionality.
Big Block Asset Classes Face an Unfriendly Return Environment. Multi-Asset Strategies Might Just Be the Solution
What insurers want to achieve with their investments hasn’t changed, but the current investment landscape may require a reassessment of their asset allocation. Historically, insurers have relied predominately on duration, credit, and in some cases equities – big block asset classes – to maximize their returns and minimize the risk of shortfall in relation to liabilities. The return environment for those big block assets is looking less and less ideal, however, prompting insurance companies to explore more innovative investment strategies.
For insights on how insurers might approach this challenge, we spoke with Guy Stern, Global Head of Multi-asset and Macro Investing, Aberdeen Standard Investments.
What about the current return environment might cause insurers to reexamine their asset allocation?
Guy Stern: We know interest rates are low right now almost everywhere in the world, and it’s much more likely they will be going up from here rather than down. As we approach the end of a 35-year bull market in sovereign bonds, allocating to sovereign debt will get you, at best, the coupon. If we extend that to credit markets, credit spreads are relatively tight right now. If you allocate to corporate bonds, and you assume that interest rates will go up over the next few years, and if the end of the economic cycle comes about, those credit spreads again will widen and you will get, at best, the coupon. In short, two of the three great big blocks of assets ¬– duration and credit – look particularly unattractive for generating returns. We still think there are some good returns to be had in investing in equities, but the kind of returns we’ve experienced in equity markets over the past 20 years or so are probably not going to be available going forwards. I don’t think insurers can say, ‘I’ll just have a big slug of duration, a big slug of credit risk, and a big slug of equity risk and we will meet our return objective.’ I don’t think that would be a successful strategy going forward.
Given the return environment you’ve described, what strategies should insurers be considering as they look forward?
Stern: As an organization we have significant experience working with our insurance clients on their overall asset allocation. We can tailor portfolios to ensure that clients can manage their capital and cash-flow matching requirements but at the same time seek attractive returns.
The way our multi-asset team constructs a portfolio can be really valuable as the diversification and risk characteristics can be aligned to a client’s objectives. You do that by accessing ideas that enhance expected returns without increasing the directional exposure in the portfolio. Our multi-asset team allocates only to ideas that are liquid and scalable. Examples of these ideas may include, but are not limited to, relative value equity, interest rate curve positions, option-based strategies, and currency. Because they aren’t highly correlated you can better manage risk associated with big cyclical swings in single asset prices.
Our multi-asset team focuses on allocations to liquid assets, but we understand that insurers, with longer dated liabilities, can allocate to less liquid assets. Insurers can diversify from their traditional fixed income portfolio and can seek opportunities with higher yields driven by an illiquidity premium. There are opportunities to allocate to assets classes that are “bond-like” in nature – that maintain the cash flow matching qualities required but offer a higher yield. For example, infrastructure debt, commercial real estate debt, etc.
Insurers have to consider liabilities in the very near and very long term – and everything in between. In that context, can a multi-asset strategy allow them to better manage drawdown risk?
Stern: If you think about generating higher levels of return, it’s generally accepted that, over the very long term, things like global equities have a high level of return – except that in between you experience big swings and roundabouts. If you don’t have to worry about drawdowns for the next 20 years, you can afford to invest in global equities. But we know insurance companies don’t think that way. Therefore, if you have a liability that comes due in two or three years, you can’t afford the potential of a 20%–40% drawdown.
With true diversification and multiple sources of return you can achieve a better risk-adjusted portfolio that can manage downside risk. When a multi-asset portfolio is constructed to manage downside risk, it allows an insurer to hold return-seeking assets in a surplus or general account, and potentially in accounts with shorter dated liabilities because there isn’t nearly as much drawdown risk as traditional assets.
Insurance companies have to model their risks very carefully based on regulatory compliance. Does your team help insurers model risk on a multi-asset portfolio?
Stern: Risk management is at the heart of our multi-asset portfolios, and we have a strong understanding of how insurance companies model risk. Portfolio construction requires a deep understanding of the underlying investment risks, including how risks inherent in individual strategies might change over time, the correlation and covariance of those strategies with each other, and the overall risk of the portfolio when you put individual strategies together.
We are also aware of the extensive reporting burden that insurance companies undertake. We partner with our clients to ensure our risk management, modelling, and reporting capabilities help them meet their internal and regulatory requirements when allocating to multi-asset portfolios.
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