ASI Global Head of Multi-Asset and Macro Investing Guy Stern discusses how multi-asset strategies can help insurers in today’s market environment.
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, prompting insurance companies to explore more innovative investment strategies.
Aberdeen Standard Investments Global Head of Multi-Asset and Macro Investing Guy Stern shares insights on how insurers might approach this challenge. A version of this Q&A was originally published by Institutional Investor.
What might cause insurers to reexamine their asset allocation in this current return environment?
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 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 aid the diversification and risk characteristics to be aligned to a client’s objectives. We 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, and so 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.
The 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, how 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. How 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.
Diversification does not ensure a profit or protect against a loss in a declining market.