- Head of Multi-Asset Strategy – Insurance
United States, Institutional
Change
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Insurers are no strangers to managing risk. With the performance of their invested asset base designed to bring stability to the net margins of their businesses, they generally have little appetite for taking on uncompensated risk. In recent years, the insurer’s “risk mosaic” has included recessionary fears, geopolitical shocks, and the impact of higher-for-longer inflation. While all of those risks should be monitored and managed, insurers planning for 2025 should be careful not to overlook a potentially larger and more immediate risk over which they have even more control: recency bias.
It’s a key tenet of behavioral finance: Investors put an outsized emphasis on recent information or events, projecting them into the future while ignoring long-term relationships. This is a primary driver of the dreaded herd mentality that comes alongside performance chasing. For a variety of business-specific reasons (regulations, taxes, etc.), insurers generally aren’t actively reallocating to the best-performing assets or making large bets on duration, but I think there are structural elements of recency bias that they should resist. In this year’s Outlook, I dig into three areas where I see this challenge and offer ideas to counter it and build portfolio resilience for 2025 and beyond:
- Don’t count on current yields — look for opportunities to lock in structural allocations to high income
- Make surplus assets more than an afterthought — increase dynamism in pursuit of a smoother path of returns
- Don’t miss the “risk-capital” forest for the trees — weigh the economic case for an asset prior to considering the capital charge
Yields today, gone tomorrow
CIOs were the saving grace for insurance company profitability in recent years, as portfolio performance helped to offset underwriting struggles. Core fixed income, the seemingly sleepy part of the balance sheet, was earning 90th plus percentile all-in yields, at a time when concerns about defaults were virtually non-existent. For the most part, the only pain point was unrealized losses in portfolios as market rates increased, with the ability to turn over the portfolios and reinvest capped by realized loss budgets.
In my recent conversations with insurers, two cohorts have emerged: 1) those anchored to the recent all-in yield experience, and 2) those who recognize recency bias in their investment strategy and want to evolve their approach for what is to come. While it may not be possible to substantially change allocations given the constraints mentioned earlier, I see several ways to expand the investable asset universe that can potentially help lock in incremental yield generation while helping to diversify against traditional investment-grade fixed income assets.
Capital securities — This often-overlooked part of the insurer’s investable asset universe is comprised of hybrid securities that share characteristics of bonds and equities. I have mentioned convertible bonds in this space before — they are a subset of capital securities. For issuers, structural features of these securities provide regulatory and rating-agency capital benefits without the dilution of common shareholders. For insurers, I believe the investment case is straightforward: potential for higher coupon rates (versus senior or subordinate debt), diversification (versus traditional fixed income and equity), capital efficiency under most risk-capital calculations, and tax benefits from issuance that qualifies under the dividends received deduction (DRD). Capital securities may be more volatile than some other fixed income assets, but in a fixed income market dominated by historically tight spreads, I think they could be “hidden gems” as a plus allocation for insurers (Figure 1).
Figure 1
Asset-based finance — We are on the precipice of another sea change in the lending construct of the global financial system. Due to increased banking regulation and the corresponding risk-capital requirements (Basel III Endgame), banks are looking to offload some of their balance-sheet exposure to achieve capital relief, structured in a way that will not trigger onerous regulatory requirements around insurance or asset swaps. These structures must comply with both risk-retention rules and the Volcker Rule, and, in my view, should clearly be on the radar for insurers looking to diversify their asset portfolios.
This is far from a homogenous asset class — it varies by structure, collateral type, quality of borrower, and duration. Such diversity allows for lenders to negotiate specific terms with banks to fit their desired risk/return profile. Collateral types include consumer loans, residential mortgage loans, commercial real estate loans, hard-asset-backed loans and leases, financial claims, and other contractual cash-flow-backed loans. Goldman Sachs Research estimates the addressable market for asset-based financing at $11.5 trillion, with residential mortgage and consumer loans making up nearly $7.25 trillion.1 And while the last two years have seen the European market dominate issuance, the US market appears poised for growth over the coming years. Insurers appear to be excited for the opportunity; per a Moody’s survey of insurers, asset-based finance and private placements are the top two focus areas for future allocations.2
Private placements — Speaking of private placements, I think insurers in all business lines should consider carving out a portion of their reserve-backing fixed income allocation to include investment-grade private placements. This is no longer a life-insurance-only phenomenon, and I expect it to be a growth area in the interest-rate environment we are heading toward, as insurers of all liability durations may want to take advantage of the potential to source varied tenor issuance while pursuing healthy yield premia versus similarly situated public debt.
Like other parts of the private credit market, private placements cannot be painted with a broad brush. Yield differentials within different areas of the market can vary substantially, with agented markets representing a significant slice but also the lowest spread advantage relative to publics. I think insurers should consider working with a portfolio manager who can source club deals or seek to directly originate deals and potentially capture more spread while tailoring exposures to insurers’ asset-liability management needs. Figure 2 shows some of the spread differential across time and deal type. In fact, my preferred approach is to employ a hybrid mandate that allows a core fixed income manager to build exposure to investment-grade private placements when the spread differentials are most favorable. While the spread premium can vary greatly from deal to deal, I think managers with the ability to be selective and participate in differentiated origination sources could potentially achieve spread premiums of 50 – 100 bps or more.
Figure 2
Dividend income — On a relative basis, dividend equity income has taken a back seat to fixed income in recent years. Even as the total return of equity indices reached new highs, a sub 2% index dividend yield left something to be desired. Of course, all dividend income is not created equal, and a concentrated active equity dividend strategy could potentially provide a premium versus a passive index dividend. I think the historical risk/return profile of dividend growers and dividend payers is compelling (Figure 3). A core/satellite approach that can produce healthy dividend income and supplement it with higher-conviction total return ideas has the potential to provide current income today while growing surplus in the future.
Figure 3
Surplus assets deserve more than a passing glance
Ask insurance companies how they manage their reserve-backing assets and they will wax poetic about the importance of holistic oversight anchored to an understanding of their business, liabilities, and balance-sheet volatility goals — with each asset class playing a distinct role in the pursuit of financial stability. But ask those same companies how they manage their surplus assets and the responses will be more diverse than the insurers’ asset mixes themselves. It is not uncommon for surplus asset allocation decisions to be based on an interesting news article, the recent outperformance of an asset class, or even a hunch — all fertile territory for a case of recency bias.
For insurers who lean into strategic asset allocation, the implementation of these “one-off” ideas is not as simple as buying market beta — “how” the ideas get into the portfolios matters just as much as the ideas themselves. After those allocation decisions, judging the “success” of the surplus can be difficult, as the sum of the parts may not produce a collective result that aligns with the broader investment strategy. To that end, I encourage insurers to take a fresh look at their surplus assets in 2025 and design a cohesive solution that looks across asset classes and strategies to allow for more alpha potential, holistic risk management, and hopefully a smoother path to surplus growth in an increasingly complex market environment.
Here, I outline a four-step guide to this process:
1. Define the role of the surplus assets
Link the performance of the business to the investment strategy. As shown in Figure 4, insurers could assign a score for each major variable and tie it to one of the two primary objectives of the surplus: income generation or capital appreciation.
Figure 4
2. Establish the risk/return parameters of the surplus
Among the parameters that should be considered are:
- Maximum loss thresholds (e.g., dollar amount or percentage for one month, one year, etc.)
- Portion of the return that should be driven by income
- Portion of the surplus that should remain liquid
- Constraints on investments in certain asset classes/regions, use of risk-mitigating derivatives, tax-related constraints, etc.
3. Develop a bespoke surplus solution
- Consider a core/satellite approach to help pursue a cohesive return profile with holistic risk management. The core allocations may be used to drive income generation while targeting lower volatility. They could also include illiquid assets paired with liquid satellite allocations in areas with high alpha potential. Finally, structuring the core as a separately managed account may allow for more explicit consideration of tax and capital consumption issues.
- Opportunistic strategies may allow for more dynamism and tilts when relative value shifts. Multi-sector fixed income approaches, for example, may consider all flavors of surplus fixed income, including bank loans, high yield, emerging market debt, convertibles, and securitized assets. And public/private hybrid strategies can tilt toward one market when it is more attractive than the other, with the potential added benefit of keeping cash invested in advance of capital calls for private assets.
- Extended (140/40) strategies could have an important role in this era of market concentration. With their ability to combine long and short exposure, managers of these strategies may be able to neutralize large benchmark weights (e.g., the Magnificent Seven) without sacrificing active share, while anchoring to fundamentally driven stock selection. In other words, the extended strategy manager has more flexibility to own the largest benchmark names at a market-cap weight if they don’t have a differentiated view on the names, while still allowing them to be highly active in the remainder of their opportunity set. For skilled stock pickers, this may be especially beneficial at a time when benchmark concentration is so extreme (~87% of MSCI World companies are below 0.1% in the index3) and there may be attractive opportunities to take advantage of market dispersion (e.g., within sectors, as shown in Figure 5). And when the strategy is run in a fund format, short positions won’t be directly on an insurer’s balance sheet, helping to reduce accounting or operational hurdles.
Figure 5
I also think insurers should consider employing solution-level guidelines that reflect a level of discretion that is in line with current governance structures. This can range from permitting full discretion across a variety of pre-approved asset classes or strategies to structuring an advisory mandate where potential shifts are communicated and approved by the investment committee/board.
4. Ongoing surplus management
A few thoughts on ensuring that the chosen approach to surplus assets remains appropriate over time:
- Focus on a longer-term strategic asset allocation but complement it with nearer-term analysis of capital market assumptions.
- Keep the investable universe broad enough to ensure all appropriate ideas are in scope (the capital markets are constantly evolving).
- Evaluate managers relative to the role they are expected to play in the solution. Does their outperformance/underperformance make sense relative to expectations? Are there signs of style drift or performance chasing?
- Regularly reevaluate broader business needs in terms of surplus results. Has the underwriting experience shifted materially? Is there more or less appetite for investment risk? Have capital adequacy targets shifted? Are there top-level corporate sustainability goals that must be considered?
What worked for surplus assets in recent years will likely not work in the years to come — in capital markets, change in the winners and losers is perhaps the only constant. Insurers who look past recent performance and embrace dynamism may be best positioned to navigate challenges and pursue alpha.
Don’t let the capital charge drive the decision
Rating-agency and regulatory risk-capital charges are top of mind with global insurers. While I acknowledge the importance of being mindful of capital consumption, I think there are times when the incremental risk-capital charge is given too much weight when making an investment decision. I believe capital charges need to be considered holistically, in the context of the insurer’s entire risk-capital calculation. In the spirit of helping insurers create a decision framework, I would offer the following considerations:
Insurance business rules of thumb
- Life insurer rule of thumb: Asset risk typically accounts for about two-thirds of risk capital.
- Non-life insurer rule of thumb: Asset risk typically accounts for about one-third of risk capital.
- Multinational insurers: Examine risk-capital differentials across regimes.
- Multiline insurers: Examine risk-capital differentials by business.
Position specifications
- The larger the exposure, the more important capital efficiency may be.
- For risk-capital calculations that are liability relative (e.g., Solvency II), consider the net impact on interest-rate risk or currency risk.
Capital calculation specifications
The ability to look through funds is critical for regulatory and rating-agency calculations.
- This typically ranges from no look through, to partial, to full look through.
- Insurers should inquire about position-level detail from the manager.
- Note that rating agencies will typically work with an insurer to understand positions within a fund if the capital charge reduction is meaningful.
Consider covariance or diversification adjustments for each risk module and in aggregate.
- Market-risk adjustments can range from asset-class level to total market risk.
- Total risk aggregation across all risk modules can help reduce the net capital charge.
Consider multifaceted risk charges.
- Duration and credit quality — Short duration and higher credit quality can improve charges in Solvency II and many APAC risk-based capital (RBC) regimes.
- Security type — For example, securitizations may be treated differently than corporates.
- Regional differences — For example, consider emerging market vs developed market equities.
- Adjustments to risk charges for green and brown assets — For example, Hong Kong RBC has an offset for green bonds.
Analyze the treatment of risk-mitigating hedging programs
- Does it reduce capital charges?
- What derivatives are permitted?
- How must the hedging programs be structured (e.g., the duration of contracts) to achieve risk-capital improvement?
Be mindful of external factors
- Rating agencies have different measures of risk assets as a percentage of surplus where a rating action may be triggered.
- Regulators have minimal capital levels that must be met.
- Certain reinsurance deals could be impacted by capital consumption.
Stepping back from the details, I think one of the keys to this process is striving to proactively answer questions other c-suite members may ask the investment professionals. By making the economic case for an asset class initially and supplementing the analysis with the change in required capital on a net basis, insurers may be able to provide a more complete view on whether the asset return story is worth the capital charge. This could help make the case for diversifying strategies with uncorrelated returns, including investments in parts of the private credit or private equity market that offer potential for more stable return profiles, rather than spending time on higher-return options that don’t really fit an insurer’s objectives.
Final thoughts
As insurers make their 2025 resolutions, I encourage them to push back against recency bias and embrace change. Consider:
- Expanding the income-generating opportunity set
- Bringing a “reserve” like mindset to the management of surplus
- Avoiding the use of risk capital as the sole determinant of the viability of an investment
By challenging convention and managing portfolios with an eye on the future, insurers will be better prepared for what promises to be a new economic regime marked by volatility and uncertainty.
1Goldman Sachs Research, “The outlook for asset finance: Powering the next growth leg,” 31 October 2024 | 2Moody’s Ratings, June 2024 | 3As of 30 June 2024
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