The global life insurance company AXA sees investment in real assets that are linked to energy transition – an approach dubbed “greenflation” - as one of the effective ways to hedge against high inflation.
This is part of the life insurer’s strategy to utilise real assets that are in the short- to long-term correlated to inflation to protect its participating portfolio against rising prices, Richard Chan, AXA Hong Kong chief investment officer and Asia head of asset-liability management, told AsianInvestor.
As a life insurance company, AXA’s liability does not have much explicit linkage to inflation. So, unlike some pension funds or property and casualty insurance companies, persistently high inflation will not be the major factor that affects AXA’s liability and balance sheet.
However, it has a big participating book, in which policyholders can share the profits of the life insurer in the form of bonuses or dividends.
Although the book doesn’t have a link to inflation contractually or mathematically, Chan said AXA still wants to provide policyholders some long-term non-guaranteed benefits under an inflationary environment to accumulate wealth.
“If we look at longer term, real assets are almost by default correlated to inflation,” Chan said from the stage during AsianInvestor’s Insurance Investment Briefing last week, elaborating:
“So, if you can have real assets, for example, something that is a sustainable way of generating electricity, or to produce those materials or instruments, they can ride on the ‘greenflation’ trend as a sort of hedge against high inflation due to the energy or the ESG (environmental, social and governance) transformation.”
Current energy transition creates a source of inflation as the raw materials of solar panels or electric cars, for example, are subject to inflation. They can also offer carbon offset credit, he noted.
This includes real estate investments in the forestry sector, and infrastructure investments in renewable energy.
Within real assets, Chan stressed the importance of diversification, or even barbell, which means investing in the extremes of high-risk and no-risk assets while avoiding middle choices to strike a balance between risk and reward.
In that sense, he said AXA is interested in innovative and trendy sectors such as logistics, data centres, natural capital, and buildings for science or medical research.
Meanwhile, it still invests in traditional real estate sectors like offices, which are good liquidity providers and offer stable rental income. This cashflow is either contractually linked to inflation or leases can be repriced upon renewal based on the latest market price.
AXA saw such types of core real assets with low deferment risk as fixed income replacements, from which it didn’t expect much price appreciation rather than recurring rental income that was higher than interest rates. But that approach worked better when the interest rates were only 1% to 2%.
As it becomes more challenging under today’s high inflation and rising interest rate environment, Chan thinks a low single-digit return without leverage could already be something of interest for real estate investments replacing fixed income.
“And of course, people will add leverage. It really depends on how much interest rate will go up. If interest rates continue to go up, the leverage increases, the return will be much less,” he noted.
On another extreme, AXA also has value-added and opportunistic projects, which can almost be seen as listed equity replacements, or diversification from listed equities.
For those types of real assets with higher risk profiles, AXA expects similar levels of return as listed equities, meaning probably high single-digit or even mid-teens after leverage.
“But we all need to bear in mind that they're just expected internal rate of return (IRR) projected by asset managers. As an asset owner, we always need to be sceptical about how aggressive their assumptions are, and if we do the same for similar projection, do we expect the same IRR?” Chan stressed.
As major economies continue to hit record inflation and the concern over slow growth piles up, stagflation has become a worst-case scenario that the market starts to talk about.
If such a scenario occurs, traditional diversification may not work when most asset classes can be highly correlated to negative returns, he said.
“In that case, hedging becomes more important,” he said. “But it doesn’t mean you need to give up all the risk premium. It could be tail risk hedging, which is very important for insurers.”
Tail risk is the chance of a loss occurring due to a rare event, as predicted by a probability distribution.
A life insurer should also think about non-directional risk. “They are not depending on whether the market is going up or down, but it's more about whether the market is more volatile or less volatile,” Chan said.
Derivatives can provide real diversification and risk reduction under such scenarios, including swap options, funding valuation adjustment (FVA), and equity put options. But they have become quite expensive this year, Chan noted.
“But if people are well planned and bought when they were still cheap, then when the worst case happens, we don't see non-directional risk, but we can have other long position volatility that hedges against such poorer stagflation scenarios,” he said, adding: "Luckily, I’m one of those people."