What is your outlook for interest rates across currencies?
MS: After a long struggle with low interest rates, we are seeing central banks start to raise rates. It means that insurers have to prepare for rates to increase a bit earlier than they may have previously expected and think about the implications of that on their balance sheets.
CP: The Bank of England is likely to be very cautious about raising rates because of the economic uncertainties around Brexit. So while the BoE – like insurers – would like rates to rise, they’re conscious of the possible impact on growth of a rise. So I think there’s a smaller chance of unexpectedly fast rate rises in the UK compared with the Eurozone or the US.
Inflation is above target in the UK, but the BoE is probably willing to accept that in order to protect the wider economy. Another difference for the UK is that QE has been stopped, whereas it continues in the Eurozone and still affects spreads.
MS: Yes, but we expect QE in the Eurozone to end in 2019, or certainly no more than one or two years after the US. I think there won’t be a sharp increase in interest rates and it will be more like ‘normalisation’ by end of 2020.
What are the implications of an increase for insurers?
MS: It’s the end of a four-year period of insurers looking at yield and return at any price, for example reducing the average credit rating, lengthening duration and moving into less liquid credit. That’s behind us. Now insurers are assuming that rates will normalise and they’re asking how they should adapt their investment strategy to the new environment.
Higher rates is certainly a better scenario. The question for insurers is how to make sure that the valuation of their balance sheet will not be negatively impacted due to the rise.
There are two aspects for insurers to consider. First, at what point will they reinvest their assets? Second, from a stock balance sheet perspective, rising rates means the devaluation of their assets and the resulting deterioration of their balance sheet.
CP: One way to manage that risk is to shorten the duration of their assets to protect their balance sheet (to an extent) and also capture the higher investment returns sooner. Of course that leaves the risk that rates don’t increase as quickly as expected. That means giving up ‘carry’ all the time rates are not going up from having shortened the duration of their portfolio. So there’s risk on both sides.
MS: Yes, it’s a question of using risk management to limit the effect of rates not rising as quickly as expected. The simplest way is to shorten the duration of the assets compared with the duration of their liabilities, albeit not drastically. Some insurers have shown a willingness to shorten durations by 1-2 years, compared with their liabilities. However, it’s worth remembering that insurers are constrained from a Solvency II perspective as to how wide the duration gap between assets and liabilities can be.
CP: The shape of the curve is important as well, for life companies especially. In the near term we will see the short end of the curve rise as policy rates increase - but the longer end is a bit more anchored.
MS: Returning to risk management, derivatives have a role here. Swaps and also swaptions can reduce the duration of your assets. Insurers have also used floating interest rate instruments.
What about managing the linked risk of rising inflation?
CP: In terms of inflation and the need to match assets and liabilities, some liabilities are explicitly linked to inflation. So, if you are a life insurer doing pension buy-out business, for example, inflation is really a key risk. The same is true for motor insurers’ Periodical Payment Order (PPO) liabilities. In both cases, insurers are trying to earn ‘inflation plus’ on the asset side. The problem is that the returns on inflation linked assets like gilts and other inflation linked government bonds elsewhere is there’s been a shortage of supply – and that depresses the returns you can get from those assets. It’s a big issue for life insurers in the UK.
MS: Yes, everyone ideally wants to be protected against inflation but the problem is finding that protection at a good price. The inflation/deflation profile of PPO liability settlements is close to long-term annuities in the UK.
CP: Again an alternative is to use derivatives and swaps to try to cover the inflation risk element. That said, some insurers are assuming a correlation between rates and inflation and that drives them to buy floating rate instruments.
How are insurers adapting their investment strategies in this uncertain environment?
MS: A lot depends on the accounting treatment insurers are subject to. Some are reluctant to change their investment strategy because it has a direct impact on the P&L. In Europe, investments are valued at their historical cost and the value is only recognised when they are bought or sold. So, European insurers often use derivatives to protect their direct investment.
Using derivatives requires insurers to possess a certain level of expertise internally – or have sufficient understanding to delegate it to a third party. Either way, using swaption derivatives enables investors to maintain an asymmetric profile - meaning that when you reduce duration you obtain protection only if interest rates increase; if interest rates remain stable there will be zero impact on your investments.
We are seeing some clients looking for a multi-asset solution that deals with a rising inflation scenario and delivers a return of, say, ‘inflation plus 2%-3%’. It’s a strategy that’s independent of the insurer’s liability profile, though the mandate usually stipulates a maximum solvency capital ratio budget in relation to Solvency II.
CP: From a UK perspective, insurers are not making dramatic changes. We’re seeing portfolios evolve rather than change radically. But insurers are becoming increasingly sophisticated. Even mid-tier insurers are getting to grips with derivative strategies because they need that kind of skillset to manage their risks. Not surprisingly, small and medium sized insurers often need to turn to their asset managers for that sort of expertise.
What specific alternative assets are insurers looking to address these risks?
CP: The inflation rate challenge has made collateralised loan obligations (CLOs) more attractive because they are floating rate instruments. Equally, in relation to inflation, long lease property often entails inflation linked leases. At AXA IM, we have a long lease investment strategy where over 75% of investment leases are inflation linked. It makes long lease an attractive proposition when there is a shortage of quality inflation protected asset classes.
Commodities are another asset class that can help protect against inflation. And, with the advent of Solvency II, commodities are no longer regarded as a speculative asset, making them a more attractive option than they used to be.
Equities can be a good hedge against inflation for insurers although they are quite expensive from a capital point of view. As an asset manager we have strategies that can reduce the capital impact of equities by providing some downside protection mechanisms.
MS: Yes, where insurers were once very focussed on traditional, fixed income investments they have diversified into lower-rated corporate credit, for example. This significant trend will continue and insurers will pick and choose investments where they know they can also gain a measure of protection from rate increases. Personally, I’m less convinced that they will invest more heavily in equities, because the capital charge is too expensive – unless they do it in a way that limits the capital charges imposed on pure equities, as Chris mentioned.
CP: Obviously, from a capital point of view, insurers obtain a credit for diversification under Solvency II. In that sense, diversification is the nearest thing to a “free lunch” that an insurer could wish for.
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