Sam Barrett looks at the changing investment landscape and explains why it will be important to remain on guard in 2018.
With interest rates set to rise, uncertainty around equity markets and continued geopolitical risks, the investment landscape is set to change significantly in 2018. Ensuring they adapt their investment strategies will be essential for insurers wishing to take advantage of these new dynamics.
While investment has been an important part of an insurer's remit for many years, the concept of having to adapt to the prevailing market conditions is a relatively new phenomenon. "Prior to the global financial crisis, insurers used to be able to get a liquid return of 5%-6% without too much worry," says Ravi Rastogi, European advisory leader of the insurance investment team at Mercer. "They have to have a much more dynamic and deliberate approach to their investment strategy now."
TIME FOR CHANGE
The key turning point came in 2008 when stock markets plunged, with interest rates following closely behind. This has meant insurers have faced two key challenges according to Iain Forrester, a member of the Finance and Investment Board at the Institute and Faculty of Actuaries. "As well as the challenge of low yields, insurers have had to deal with the fact that it's been a sustained low yield environment," he explains. "This has forced insurers to adopt broader and more sophisticated investment strategies. On the fixed interest side, a wider range of asset classes is being explored, including infrastructure debt, equity releases mortgages and real estate finance, while there's also been more willingness to consider the global investment market."
This is illustrated by recent research from the European Insurance and Occupational Pensions Authority (EIOPA), outlined in its Investment Behaviour Report. This analyses the investment trends of insurers for the last five years, identifying a search for yield trend, with insurers increasing exposure to lower credit rating quality fixed income securities.
Regulatory influences have also made insurers' investment strategies more important. For instance, while equities can deliver higher returns than fixed interest, appetite has waned as a result of the double whammy of the financial crisis and Solvency II. "A decade ago, the three largest EU insurers had around 10% invested in equities but this has fallen significantly," says Stephan Kalb, senior director in the insurance team at Fitch Ratings. "A 25% capital charge on equities means they don't offer the same level of return on capital they once did."
Although this low interest rate environment has persisted for the last 10 years, market forces are expected to change in 2018. "Interest rates are creeping up slowly but there's also plenty of political risk," says Gerard-Jan van Berckel, head of delegated solutions -- European insurers at Aon Hewitt, pointing at Brexit and the German elections as examples. "Insurers will need to remain prudent and ensure their investment programme won't be adversely influenced by any of these events."
For Mr van Berckel, diversification will be key as the dynamics change. "Insurers must ensure they have a well-diversified portfolio that delivers the yield and liquidity they require without compromising their appetite for risk," he adds. "Understanding liabilities, and matching investments to these, will be essential."
A variety of investments have already started appearing in insurers' investment portfolios including infrastructure, mortgages, loans and real estate. In addition, Mercer has flagged up a trend for integrating environmental, social and governance factors into investment decision-making.
With further interest rate rises expected at some point in the next 12 months, Mr Rastogi says that insurers are considering their investment position carefully. "Insurers are reviewing any material asset-liability mismatches but are increasingly looking further afield for assets that don't have embedded duration. This will enable them to take advantage of opportunities if rates rise differently than expected," he explains.
As well as the liquidity to be able to respond to market changes, it will be even more important for insurance companies to determine their overall investment framework and risk appetite. Mr Rastogi explains: "On investment committees, there's more scope for different views to be legitimately expressed in times of change, so insurers are trying harder to get pre-emptive consensus on the fundamental investment approach to aid their decision-making."
Establishing these fundamentals could include determining principles such as the approach to active management, asset allocation and illiquidity premia. It can also be prudent to benchmark the approach against industry standards to ensure it is fit for purpose.
The value investment returns can bring to an insurer also means that many are outsourcing elements of the process. Mr van Berckel says this can involve dedicated third-party asset managers or a specialist insurance fiduciary manager who looks after the investment portfolio on their behalf. "As portfolios have become more diverse, insurers value the additional insurance investment expertise outsourcing can bring," he adds. "They can provide a holistic view that takes the insurer's objectives, operations, underwriting and liabilities into account."
But whether or not insurers outsource these processes, with plenty of challenges expected in 2018, it will be important to be prepared and stay close to what's happening in the investment arena.
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