By Richard Roberts, Director EMEA & APAC Insurance Solutions at AllianceBernstein
Most institutional investment strategists believe that global economies, politics and climate are undergoing profound changes—but we find that relatively few have amended their strategic asset allocations to prepare. Here are key areas for insurance investors to focus on, based on perspectives from industry experts and participants at our recent insurance forum, “Navigating Disruption & The Future of Insurance.” These viewpoints derive from a panel discussion including questions and answers from the attendees.
Plan for Different Scenarios
On the face of it, current trends point to higher structural inflation. Three major forces threaten much higher costs for society, and hence higher prices: a declining working-age population, deglobalization and climate change. While the arrival of AI may counter this somewhat by raising productivity and possibly unemployment, the signs seem pointed to a secular shift to higher inflation ahead.
An aging world means fewer productive workers commanding higher compensation, and much greater retirement and healthcare cost burdens. The breakdown of globally integrated supply chains adds to production costs. And combating climate change (through decarbonization) could be as momentous as the industrial revolution—only more expensive. In the short term, the shift to renewables could be very costly, though over time further advances in technology will likely provide adequate sources of cheap and reliable renewable energy.
Equally, it’s important to recognize that other scenarios are possible and/or may play out at the same time, and that we’re emerging from a highly unusual economic regime. The era of ultra-low/negative rates was unprecedented in human history—and was ended by a global pandemic that prompted drastic economic shutdowns remediated by huge stimulus programs. The world experienced an inflationary surge as economies reopened and businesses rushed to restock, but there’s no guarantee that global growth levels can return to pre-pandemic norms or that deflationary pressures won’t reemerge. Nor can we be entirely sure that China—formerly the main engine of global growth—will escape “lost decades” comparable to Japan’s.
One certainty is that very high levels of sovereign and other debt will be a persistent problem for governments and economies globally. History suggests that governments will be tempted to rein in the independence of their central banks and monetize their debt. In this scenario, we should expect a period of very low or negative real rates, with governments eroding the real value of their obligations at the expense of savers.
Be Flexible with Strategic Asset Allocations
Given these major uncertainties, it’s vital to have an investment strategy that’s flexible enough to respond to changing scenarios. And in a changed strategic investment regime, the importance of stress-testing against those scenarios is greater than ever. It also makes sense to provide the most flexibility for scenarios that could inflict the greatest portfolio damage. For instance, forum participants with direct experience in inflation-prone regions emphasized the risks of a period of high inflation, or a series of inflationary spikes. Without enough inflation sensitivity on the asset side, a portfolio will likely suffer permanent and irrecoverable losses in these scenarios.
The uncertain environment also highlights the importance of a diversified portfolio, both geographically and across asset classes, and including appropriate hedges to ensure that risks in the asset portfolio best neutralize liability risks. Effective tactical timing of hedges can take advantage of periods when protection is cheap. One example would be diversifying with overseas assets during periods when the cross-currency basis is favorable and the assets can be acquired without the associated currency-risk exposure. Another case might be considering inflation-linked bonds when they’re pricing in an implied inflation level that’s in line with or lower than an insurer’s base-case expectation.
In an era of increasingly adversarial geopolitics, multinational insurers can also find operational ways to reduce risk. For instance, the practical implications of a potential conflict between rival nations can be mitigated to some extent by removing equity exposure to the foreign country from the insurance balance sheet of the home country.
With so many variables and uncertainties, it’s prudent not to over-engineer. A popular approach is to adopt a through-the-cycle strategic asset allocation, but one with enough tactical flexibility to cope with widely differing scenarios.
Navigate Multiple Risk Constraints—and the “Triangle”
For insurers, risk takes many forms. In the investment world, risk typically equates with volatility, or sometimes a loss of purchasing power. For insurers, it also means the risk of diverging asset and liability values, the risk of an increase in solvency-capital requirements and the risk of adverse financial statement impacts. Our forum participants highlighted the complexity of “the triangle”—an industry investment problem of optimizing against three competing priorities. The three points of the triangle are: economic risk and return, solvency efficiency and accounting-impact management. It takes further flexibility to accommodate all three within a strategic asset allocation approach, in amongst day-to-day investment decision-making.
Inflation risk should be a key asset-allocation consideration, but participants flagged that there’s little regulatory incentive to hedge this risk on the asset side. Solvency II doesn’t provide for specific inflation-risk charges, and discounts liabilities at a nominal, rather than real rate. Further, equity may be an effective long-term inflation hedge, but higher solvency-capital charges disincentivize significant allocations. Also, short-term equity-market downturns can be very painful—as we saw in 2022.
Pick Your Asset Exposures Carefully
Coping with high inflation rates or negative real interest rates requires more sophisticated assets that are able to perform well across the three metrics within the triangle. This is leading many insurers to alternative asset classes, often on the private debt side.
More cautious insurance investors have preferred the conservative end of the private-lending market, including social housing. Investors who are focused on inflation protection have added exposure to real assets, such as real estate. But real estate cash flows may not always be a good match for inflation, because rental payments operate differently across various jurisdictions and depend on specific contractual terms. It’s important to be aware of the payout mechanics in each case.
Of course, practical implementation for such investments can be complex. For instance, building a portfolio of private investments takes a long time. Finding the right asset managers may not be straightforward, and building mutual trust and understanding is a long process.
Strengthen Links Between Your Business and Investments
A robust strategic asset allocation and accurate modeling depend on reliable information. That’s why it’s important to discuss investment planning and asset/liability modeling with business units. For instance, regular interaction with the actuarial department can help quantify risk and assess the potential for adverse solvency impacts. These conversations should help improve assumptions about asset-side risks over the long term—although the short term is less predictable.
A tendency to overoptimize could risk creating a false sense of security. Participants at the forum agreed that we’re entering a changed investment regime. They cautioned that, while numerous objectives need to be met, insurers shouldn’t rely too much on balance-sheet engineering. Instead, they should lean toward a focus on diversification, increased assessment of potential stresses and a heavy dose of scenario analysis.
To sum things up, the new regime makes it critical to prioritize both close communication among business units and a flexible mindset. Insurers face profound evolutionary changes across global economies and societies, but those that can adapt their strategies will survive.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.
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