Weighing up risk and reward in a low-rate world

Daniel Teng is responsible for the asset allocation strategy of Taiwan’s largest life insurer, Cathay Life, which has $120 billion in assets under management. With more than 18 years’ industry experience, he has held positions on both the asset and liability sides of the business in areas including investment, risk management and actuarial analysis.

Q How is your portfolio broken down by asset class and geography?

A The majority is allocated to financial assets, with the rest in real estate and loans. We have allocated 17% to domestic fixed income, 8% to Taiwanese equity investment, 10% to domestic mortgage loans, 6% to policy loans and 6% to real estate investments.

Further, 40% is allocated to overseas fixed income, 4% to overseas equity, including private equity and alternative investment, with the remaining 8% in cash-equivalent short-term investments.

Q How has your overseas fixed income investment changed since 2008?

A Prior to 2008, we invested heavily in Europe and America, mostly in agency MBS and agency callable bonds, with each accounting for approximately 40% of our fixed income portfolio.

However, the cash flow of agency bonds became unstable. After 2008, we changed our portfolio mix, increasing our overseas exposure, in particular in emerging market and corporate bonds.

Our allocation to corporates has increased to 50% of our fixed income portfolio, while emerging market [bonds] account for 15-20%, including sovereignty debt, corporate bonds and equity.

Q What is the lowest bond rating you can invest in?

A Our current minimum rating for corporate debt is BBB+. However, the regulator has made public its intention to loosen the limit to BB+ in April. So after we have completed the required legal and internal processes, we will be eligible to invest in BB+ grade bonds.

Our internal requirement is a yield above our long-term funding cost, which stands at 4.6%. We will consider diversification in issuers and countries to reduce the risk of default.

Q What is your criteria when you pick an external manager?

A We will consider hiring an external manager when we step into foreign markets that are new to us, or where we have limited sources of information. We hope to take advantage of the fact that external managers are on site and closer to the targets being invested in.

For example, it is important to watch credit changes of high-yield issuers closely, and an external manager who sits together in the same market as the issuers will be of great assistance to us. Additionally, we want to find managers who understand the mindset of an insurer.

Most managers run their portfolios in attempt to beat a benchmark, but a life insurance company seeks absolute return. We need someone who has the same philosophy as us, who takes into account our asset and liability requirements at the same time.

Q How have you responded to the low interest-rate environment?

A On the product side, we can launch insurance product denominated in foreign currency, so it is easier to find suitable assets to match our liabilities.

We have also lowered the guaranteed rate of new insurance policies, such as launching more products with mortality gain or medical insurance, but fewer which earn return by interest-rate spread. These new policies helped the company to bring down its overall liability costs.

On the investment side, we have increased our equity investment and overseas exposure. We have also increased the proportion of domestic loans in our portfolio, particularly mortgage loans. The good thing is, these loans have a floating interest rate and are more defensive in the low rate environment.

Q How do you hedge interest-rate risk?

A When there is an interest rate hike, we use swaps to hedge the inflation risk. However, local swaps usually have a duration of only 3-5 years. Therefore we need to be more actively involved in asset allocation to hedge the risk when interest rates rise.

We also invest in real estate, mainly in commercial buildings both onshore and offshore to hedge inflation risk.

Q What’s your asset-liability management strategy?

A A life insurer usually has a liability of more than 10 years, and nowadays it is very difficult to find safe assets with duration more than 10 years. We always find it difficult to match asset and liability duration.

One challenge of asset liability management in Taiwan is that yield in the local market is too low and it is too shallow. Therefore we need to search for yield in the offshore market. In 2007 and 2008, we could still search for yield in Europe and the US.

However, the yield in these markets has gone down now. Moreover, foreign exchange posts another challenge, because even if the yield in the foreign market is attractive, we have to be aware of the currency risk. Looking ahead, when Taiwan’s FX reserve pool expands, we can have a longer-term overseas investment.

Q Do you use derivatives for hedging or investment?

A We do not use derivatives as instruments for investment, we tend to use them as tools to hedge price and currency risk.

Q How do you choose and use exchange-traded funds in your portfolio?

A ETFs are the tools we commonly use, particularly when we enter a market which we are interested in but where we are not familiar with single stocks. In those markets where we don’t hire an external manager, we deploy ETFs. We also invest in commodity ETFs.

We like exchange-traded funds with good liquidity and seldom deploy capital to sector-based ETFs because of liquidity issues and low trading volume. We use ETFs to capture returns for market growth. Therefore we actively manage our ETF portfolio and deploy a range-trading strategy.

Q Do you plan to increase your investment in private equity?

A We have approximately NT$25 billion ($836 million) in committed capital in private equity, and there remains availability, given our legal cap of approximately NT$60 billion.

We are seeking new investments to diversify our private equity portfolio, with a priority on small- and medium-sized enterprise buyouts, credit opportunities and real-estate-related strategies.

Q Will you consider raising your commodities exposure to hedge inflation risk?

A We will not invest in commodities directly because of current regulations. However, we can consider ETFs or stocks that exhibit similar performance to commodities. Commodities can be a tool to hedge inflation.

However, the price of a commodity needs to be backed by actual demand. At the present stage, demand from China seems to have become weaker. Therefore we are monitoring the commodity market closely and we will adopt a wait-and-see approach to see how the world economy moves.