Market views: How should insurers handle ultra-low rates?
Last Friday (July 31), the real yields on the benchmark 10-year US Treasuries hit minus 1%, as investors lost faith in risky assets and rushed to quality instead.
Meanwhile in Asia, the Philippines’ real interest rates have turned negative as the country’s annual inflation rate rose to a six-month high of 2.7%, tarnishing the local government bonds’ appeal. The yields on the nation’s 10-year sovereign bond stood at 2.759% as of August 6, down 174.8 basis points (bp) from six months ago.
The impact of the Covid-19 pandemic and the resulting rate cuts and drastic quantitative easing measurers by central banks globally has plunged government bond returns to fresh lows. And there is little sign this will change.
They will have to adapt. Economists and asset managers alike predict that these unconventional monetary policies and abundant liquidity – and lower fixed income returns – will become the new normal as a consequence of the response to the coronavirus.
This has prompted insurers to broaden the search for better yielding assets; some firms have raised their allocations to credit, others have opted to exchange some long-dated local government bond investments, and many intend to raise equity and alternative asset exposures. However, insurers also need to take into account the risk-based capital (RBC) requirements of their respective regulatory regimes.
Five experts told AsianInvestors how insurers in Asia will cope in this even lower for even longer environment.
The following extracts have been edited for clarity and brevity.
While Thailand ranks one of the countries to have recovered best from Covid-19, its economy is one of the hardest hit as it is relatively small and open, with significant exposure to tourism. As the policy rate and bond yields in Thailand have declined, the major challenge for us as a life insurer is how to find the right balance between risk and return.
During the market sell-off in the past few months, we have seen opportunities that emerged in the local corporate bond market as credit spreads soared. As such, we increased exposure in bonds of established issuers with very strong credit profiles given that the risk-return profile has become more favourable compared to other asset classes.
Meanwhile, we are paying more attention to credit migration risk for foreign bonds and continue to look to gradually build up our private equity programme.
Thibaut Ferret, senior solutions director of Asia Pacific
Aberdeen Standard Investments
Today’s ultra-low-yield environment in the US and Asia will have a big impact on the solvency, profitability and product strategies of Asian insurers if interest rates don’t rebound in the near term. Insurers have a few options to mitigate this, which we expect to accelerate the following existing investment trends:
The continued search for yield will drive further diversification by asset class and geography. Strategies encompassing private markets, lower-rated bonds and emerging market debt allow insurers to capture additional spreads and illiquidity premium.
The construction of more holistic investment strategies that embed asset-liability management considerations to address any increase in risk from targeting enhanced yield (i.e. take into account an insurer’s asset liability profile, the amount of risk-based capital it can hold and any matching adjustment requirements).
Greater use of interest rate derivatives to manage duration gaps as investors replace government bonds with higher-yielding, lower-duration assets. Of course, this approach depends on the size and depth of local derivatives markets.
Reduction in unhedged FX exposures by taking advantage of cheaper FX hedging costs courtesy of decreases in interest rate differentials between the US dollar and some local Asian currencies.
Development of innovative unit-linked products to reduce sensitivity to market risk on insurers’ balance sheets.
Rick Wei, head of insurance for Asia ex-Japan
JP Morgan Asset Management
The global zero rate environment, high volatility and waves of RBC reforms in many markets across Asia represent important paradigm shifts in investment for Asian insurers. Before reaching out to riskier assets and more complex securities to maintain return target, we believe it is very important that insurance companies build a fortress balance sheet in terms of capital and liquidity, and redesign their strategic asset allocations (SAAs) around the new capital and risk metrics.
Strong solvency ratio and optimised SAAs will be key for insurers to survive the Covid crisis and pursue yield-enhancing strategies. We see more and more chief investment officers are making or considering making SAA changes, and our conversations with clients have gradually shifted from specific products to solutions or goals-based lens.
By optimally allocating to both core and non-core alternative strategies, insurance companies can achieve true diversification, higher risk-adjusted return, lower accounting volatility and optimal RBC capital efficiency in their portfolio. We believe the alternatives allocation in Asia will increase from today’s low-single-digit number, up to 15% to 20% of total invested assets in the next five years.
Jaijit Kumar, head of Asia insurance solutions
Invesco
The unprecedented drop in yields has put some pressure on life insurers from both a solvency and a returns expectations standpoint.
While there has been a move into alternatives/illiquids over the past few years, the pace of investment has been quite mixed. From a returns point of view, diversifying into such asset classes – private credit, real estate (core plus, value add), private equity – has the potential of generating long-term attractive returns.
However, a careful and thorough analysis of such asset types is a necessity, including their fit within an existing portfolio – taking into consideration diversification, liquidity requirements, and the like. Selection of managers and strategies remains key. Portfolios of these types of assets can still be designed to generate some on-going level of yield/cashflow, complemented by potential periodic expected returns of higher magnitude from time-to-time.
We generally expect this trend of investing in private markets to continue. From an insurance perspective, while the capital charge on some of these assets may be at the higher end of the spectrum, the correspondingly higher expected returns should make them fairly efficient asset classes. Plus, they can also be a good fit with the long horizons of most life insurers.
The low interest rate environment is a prolonged challenge that regional insurers have been experiencing for several years, and most have been working on their business strategy optimisation to tackle the issues from both assets and liabilities aspects.
Insurers have been adjusting their policy mix to better align with falling investment returns. For example, life savings-type products with relatively high guaranteed return have been reduced or even withdrawn.
It also makes sense for life and non-life insurers to shift towards investment assets with higher returns. Regional insurers have increasingly moved to risky assets investment such as stocks, lower credit-quality corporate bonds, foreign bonds, or real estate in order to source higher returns.
However, we would not expect drastic moves. Each insurer will need to consider local solvency margins, with investments in riskier assets requiring higher capital charges under regulatory capital frameworks. Hence, we would believe they will gradually shift into riskier assets, especially those that have relatively stronger local solvency margins.