Insurance outlook 2022: three transition year themes – inflation, capital, ESG

Across Asia, we have observed a noticeable uptick in insurer requests for strategic asset allocation studies, a spike in demand for actionable ideas to advance ESG integration broadly and a growing desire to understand how to address climate-related risks and opportunities. We have also seen insurers focus on risk capital amid new regulatory regimes across the region, with the goal of optimising their portfolios. Finally, the industry is beginning to think about ways to combat the mounting threat of higher inflation in the period ahead.

Our 2022 outlook for global insurers is framed around the three key themes of: 1) inflation; 2) capital; and 3) ESG (taking into account that these topics do not neatly lend themselves to cookie-cutter solutions because no two insurers are exactly alike).

Theme 1 – Inflation: an unwelcome blast from the past

Insurers, with their often-significant exposure to fixed income assets, along with liabilities that can grow as costs rise, now need to take stock of what this new inflationary paradigm could mean for their industry. Many have begun to do so, while looking for investment strategies that can help alleviate inflation’s potentially negative impacts on their business.

While natural resources equities and commodities may be poised for strong performance in the next few years if inflation persists, these assets present other investment considerations for insurers, including much higher historical volatility versus other asset classes. In line with this greater volatility, the capital charges for commodities under most global regulatory regimes are typically higher than for other types of invested assets (for example, as high as 50% to 70% in some Asian markets).

However, there may be strategies through which to reap the potential benefits of positive beta to inflation, but without necessarily exposing the corporate balance sheet to excessive volatility, such as:

Convertible bonds
From a total return perspective, convertibles provide equity market upside participation, which is cushioned on the downside to some degree by a bond “floor” that can help limit the equity drawdown risk. The case for convertibles strengthens when you consider that under some risk-capital calculations they are treated as fixed income positions. And in the current macro environment, convertibles have the added benefits of low interest-rate sensitivity and a historically negative correlation to 10-year rates.

Bank loans and collateralised loan obligations (CLOs)
We have a positive outlook on both of these related asset classes, driven by generally strong underlying fundamentals. We are seeing bank loan credit downgrades peak and expect defaults in the space to remain below longer-term historical averages. In addition, both bank loans and CLOs have low rate sensitivity and can provide diversification versus other, more traditional assets in an insurer’s portfolio.

Real estate investment trusts (REITs)
Real estate is well known to be an effective inflation hedge. Our global property team has noted that, by most measures, REITs trade at a discount to private market real estate. Additionally, this asset class can offer attractive dividend yields relative to most bonds. Finally, regulatory treatment of REITs has been changing, with some regulators (such as in Hong Kong and Thailand) lowering the capital charges for insurers.

Theme 2 – Capital: what’s the true cost?

When making the economic case for a given asset class, the realities of capital charges can change the picture quickly.

While some insurers must monitor and control each unit of risk capital, the truth is that since the 2008 financial crisis, the global insurance industry has never been stronger and the Covid-19 market shock was a real-time case study in just how resilient the industry has become.

However, recognising that no two insurers have the same circumstances and flexibility, our thoughts on capital consumption here range depending on the capital position of each insurer – as illustrated by this table.

Theme 3 – ESG: a little less talk, a lot more action

To date, most insurers have been scrambling to digest countless data sets, screening tools and measurement methodologies in order to gauge their level of exposure to ESG risks and to meet various global regulatory requirements.

This year, however, we believe the focus will begin shifting toward how best to integrate these ESG concepts into their strategic planning and execution across their insurance enterprises. Yet there is no “silver bullet” answer for every insurer (given differing lines of business, regulatory regimes and insurance company sizes).

Uncouple the “C” from the “E”
The importance of isolating climate risk (“C”) from environmental risk (“E”) remains a core focus for us as practitioners, as we believe it should for investors as well. If you examine the distribution of potential outcomes across the “E,” “S,” and “G” categories, climate risk certainly has the largest left tail, yet is also perhaps the most fertile ground for actionable opportunities in the decades to come.

In moving the conversation to greater action in 2022, tackle this challenge head on:

• Finalise (and review annually) a consistent source of data for carbon footprinting, understanding the gaps and shortcomings of the selected methodology
• Establish a framework for managing the carbon exposures of existing positions
• Align forward-looking views for the carbon emissions of the invested assets with the broader commitments of the firm
• Adopt a physical risk measurement technique for the most directly impacted assets and overlay with underwriting location details
• Integrate climate into SAA, for which our investment strategy team has created a three-pillar framework (see below)

Utilise thematic investment approaches to tackle the “S”
Given all the uncertainty around the future financial impact of climate change, it is a bit strange that of the three main ESG components, “E” is the only one for which forward-looking projections are currently available.

We believe the other two components deserve equal attention but are often overlooked or
underrepresented. Analysis of both social and governance factors should begin with a thorough look at an insurer’s own business practices, with a focus on establishing areas for improvement and specific actionable items.

Navigating a year of transition

We believe 2022 is going to be a year of transition for the global insurance industry, with the three big themes of inflation, capital and ESG coming to the fore and likely to occupy much of our insurance clients’ agendas in the months ahead — but you don’t have to go it alone.

We are here to serve as a trusted thought partner as you manage this transition with an eye toward navigating the challenges and the opportunities it will bring.

Click here to learn more about our 2022 outlook for global insurers

About the author
Based in Hong Kong, Max supports Wellington Management's insurance business across Asia and is part of the broader global insurance solutions team that works in consultative partnership with insurance companies, helping to identify and address the major business trends that are affecting insurers and the associated investment opportunities.