Re/insurers will need to pay increasingly close attention to their investment strategies in the face of changing economic conditions as the symptoms of the financial collapse abate, says Patrick Liedtke.
The insurance industry is facing unprecedented headwinds. For the past fi ve years, the ultra-low interest rate regime, regulatory uncertainty and constrained liquidity have challenged insurers’ income prospects. Looking ahead, the recent rise in US yields and the volatility that followed the Fed’s announcement that it will taper quantitative easing (QE) suggest fi xed income investors will contend with higher rates, higher volatility and decreased liquidity for several years. Responding effectively will be critical to success.
According to new research conducted by the Economist Intelligence Unit on behalf of BlackRock, the industry is only too well aware of the need to adapt. Global insurance: investment strategy at an infl ection point surveyed more than 200 insurers globally, including qualitative feedback from 17 industry leaders, to gauge how the industry is responding to these external pressures.
Below we consider the key investment-related views and insights shared by the survey respondents and examine how they are planning to evolve their investment portfolios. We then assess unconstrained and absolute return fi xed income solutions in light of insurers’ current predicament.
Responding to external pressures
Almost one-third of respondents predict large scale change for the insurance industry over the next three years, driven by the low-yield environment and restrictive regulation. One global insurer said: “One of the big challenges we face is the low yields we are earning on our investment portfolios. As time goes by, that bleeds more into our book yields as higher coupon bonds are maturing.”
QE has also reduced the supply of fi xed income available to investors such as insurers. “The supply of fi xed income is minimal, whereas the demand is greater than ever on the part of institutional investors,” said another global insurer.
Against this backdrop, 80 percent of insurers say that their businesses will have to change to produce adequate shareholder returns over the next three years. Insurers are revisiting investment strategies, product lines and operational processes to improve efficiency and maintain profitability.
Preparing for upcoming central bank action
With the news that QE in the US will be coming to an end in the near future, insurers also recognise that they must adapt some of their strategies as the conditions created by QE change. The most notable shift in strategy observed between the fi rst round of surveys in May 2013 and a follow-up survey in July 2013 (after the US QE tapering dialogue) is in duration management. Whereas insurers increased duration in the low-rate environment created by QE, they plan to shorten duration in preparation for the unwinding of QE.
Differing views on issues such as the expiration date for US QE are reflected in respondents’ preparations. Asian respondents are more likely than their European or North American counterparts to increase credit exposure and shorten duration in order to prepare for the unwinding of QE.
The prospect of QE tapering has borne much of the blame for recent market volatility, but survey respondents seem more focused on the result rather than the cause. A majority of survey respondents say that they plan to take action to prepare their portfolios to deal with ongoing market volatility, rather than to prepare for the unwinding of QE. Seventy-six percent of respondents said they are shortening duration in preparation of continued market volatility, while the majority will be increasing exposure to non-core instruments: credit (66 percent), derivatives (63 percent) and risk assets (66 percent).
Broadening investment horizons
The low-yield environment has led insurers to diversify across asset classes and implement tactical strategies. More than half (52 percent) of respondents say that they have diversifi ed into new fi xed-income asset classes, while 48 percent have diversifi ed across all asset classes, exploring new instruments such as derivatives and alternatives. Nearly three-quarters (73 percent) of survey respondents say that they have increased allocations to higher yielding fixed income; more than half (58 percent) plan to do the same. Nearly half (47 percent) have implemented a tactical asset allocation framework.
Insurers are increasing their exposure to emerging markets, both for yield and for diversification benefi ts. Two thirds of respondents say that they are likely to increase investment in emerging markets in the next 12 months. Insurers in the Asia-Pacific are most likely to increase allocations to emerging markets (82 percent), followed by EMEA (75 percent) and North America (60 percent).
The industry is also showing a greater willingness to look beyond traditional long-duration bonds to match long-dated liabilities and capture an illiquidity premium—with more than two-thirds (68 percent) of insurers planning to allocate more to less liquid strategies such as infrastructure debt.
While looking to illiquid assets for higher returns, insurers are also using exchange traded funds (ETFs) to keep cash invested and access certain asset classes, while remaining liquid. More than four-fi fths (83 percent) of survey respondents agree or strongly agree that more insurers will use ETFs over the next three years. Some 70 percent agree that these vehicles are suitable as a long-term strategic holding for both core and satellite holdings. However, 70 percent said that they needed to know more about these ETFs before making an investment.
Unconstrained approaches to fixed income
Fifty-two percent say they will move away from the benchmark to adopt more absolute return strategies, a trend that we strongly support. We believe that fi xed income strategies unconstrained by benchmarks should become a core holding in an insurer’s diversified portfolio in light of an imminent rate rise. As fixed income markets respond to global deleveraging and government intervention, sufficient flexibility to protect against rising interest rates and exploit tactical opportunities will be paramount.
"The preospect of QE tapering has borne much of the blame for recent market volatility, but survey respondents seem more focused on the result rather than the cause."
A non-benchmark constrained strategy gives the portfolio manager greater flexibility to adapt as markets change. This can improve the likelihood of enhance yield, income and total return while mitigating the risks associated with a volatile interest rate and credit environment. In particular, an adaptable approach can allow the manager to find the optimal balance of exposures in the portfolio between interest rate risk and credit risk that contribute to the total fixed income risk of the portfolio.
An adaptable strategy can invest without sector, quality, maturity or geographical limitations. It is therefore vital to have a guiding structure and active risk budgeting process designed to determine and manage appropriate levels of risk while responding to market opportunities. This type of approach requires a dynamic combination of top-down analysis (to set risk level, allocate risk across geographic and credit sectors using macroeconomic views and return/price factors) and indepth bottom-up analysis (to identify the most attractively valued securities across each fixed income sector) seeking to tactically take advantage of the changing fixed income environment.
While the survey results show that insurers have taken great strides to adapt, there is still much work to do. Insurers are exploring ways to broaden their portfolios, looking further along the risk curve at higher-yielding asset classes such as bank loans for credit risk with low duration, or illiquid assets such as infrastructure to fi nd increased yield and insulation against interest rate volatility. Unconstrained or absolute return strategies that allow managers to fi nd the optimal balance of exposures to perform in all environments are also garnering renewed attention.
However, there is one element above all that insurers need to think hard about and that is resilience.
In the challenging and uncertain times ahead, insurance clients and shareholders expect them to achieve stable income with limited downside risk. The industry needs to have the proper strategies in place—now.
For a full copy of the report, visit BlackRock.com/intlfig
Key survey findings
In addition to investment portfolio adaptation, survey respondents gave insights into attitudes to risk, business strategy, partnership and likely sources of future profi tability. They include that: 90 percent of insurers have increased investment in risk management;
Insurers will develop closer working relationships with third parties to improve risk management and product design/development;
Regulatory change will stop nearly two-thirds of insurers writing certain lines of business; and
A quarter of insurers will grow their businesses via acquisitions, with their home regions the key target areas for future organic and acquisitive growth.