By Dr Bruce Porteous FFA, FIAI, Investment Director, Insurance Solutions, Aberdeen Standard Investments
Additionally, there is a requirement for greater collaboration between actuarial and investment teams, a need to consider alternative means of growth and consideration of using external managers.
In order to better understand the challenges, we commissioned two independent research studies. The first examined the European insurance industry but more recently we have turned our focus to Asia-Pacific insurers.
Mind the gap
The conclusions of the research highlighted some commonalities across the two regions. Notably, low returns and asset-liability mismatches are posing a significant challenge for insurance companies. Increasingly, insurers in Europe can no longer generate sufficient returns to meet guaranteed rates for policyholders and the issues are broadly the same with many Asia-Pacific markets. Interestingly, China and Hong Kong are at an earlier stage in the crystallisation (and perhaps realisation) of this issue.
Asia-Pacific insurers currently allocate nearly half of their investments (46%) to domestic sovereign and corporate fixed income. The current low yield on these investments means they are likely to struggle to meet target returns and guarantees.
However, insurers in China and Hong Kong have delivered the required return to date. That said, it is important not to overlook the significant duration and liquidity mismatch between their assets and liabilities. Inappropriate risk taking can bring challenges in a number of dimensions, including liquidity risk, credit risk and profit risk.
Alternatives, global opportunities and local challenges
In response to asset-liability mismatches, insurers intend to increase exposure to alternative assets while reducing holdings of domestic fixed income securities. Alternative assets not only provide higher expected returns but include longer-dated assets that better match longer-dated liabilities. In general, solvency regimes in the Asia-Pacific region demand lighter capital requirements when investing in alternatives, compared to Europe.
A further development of this theme is that insurers also intend to increase their overseas allocations in response to the need for higher returns, increased diversification and better duration matching of liabilities. However, the hurdles of hedging costs, regulatory barriers and gaps in internal capabilities need to be overcome. In general, there is a strong home market bias to asset allocation due to local currency liabilities and regulatory incentives. Insurers in both Europe and Asia-Pacific are constrained from increasing their risk exposures by a wide range of factors; however, the strong desire for more international exposure in Asia-Pacific was not generally observed in Europe, where local and domestic markets have wider and deeper pools of investment opportunities.
Solving the outsourcing puzzle
While insurers have acknowledged increased exposure to alternatives and overseas assets as a means of delivering additional returns, diversification benefits and better duration matching of liabilities, the lack of in-house expertise prevents them from doing so. In Asia-Pacific, we noted a number of insurers are becoming increasingly open to the use of external managers as a means of addressing this shortcoming. This offers unique opportunities for active managers, who are expected to deliver alpha, demonstrate knowledge of local regulations and fill the investment knowledge gaps. Despite this, barriers exist that external managers will need to navigate and some insurers are still not totally convinced.
This contrasts with our experience in Europe, where there is an acceptance of allocating more assets with external managers. Some insurers in both regions have indicated a desire to build an in-house capability, but this takes time and money. In particular, investing in private equity, property and infrastructure requires specialist skills just to access the investments, let alone add value.
The shape of the industry will depend on whether insurers decide to outsource more expertise to external managers, develop their own expertise or forego the opportunities in alternatives and global assets.
The missing link
The investment implications of the regulatory changes underway are also similar across the two regions. There is a clear trend towards transparency of risk, which is moving towards more risk-aware, outcome-based investing and, in turn, the need for a sharing of understanding between insurance experts and their investment colleagues. The consequences of investing in risk assets will become more transparent as accounting and solvency regimes become market-based and more sensitive to risk. So too will the risks of running mismatched assets and liabilities. This has real and potentially significant commercial consequences for insurers.
The challenge increases when there is a disconnect between accounting and solvency standards, as both transition from book-based to market-based regimes. When these changes are not aligned, the investment decisions are further complicated.
A key insight from our research is the closer collaboration between actuarial and investment teams before investment decisions are made. If an investment creates a duration mismatch, for example, the resulting potential increase in both profit and loss volatility and regulatory solvency capital may mean that the investment no longer makes sense.
Despite these challenges, it is clear that the insurance sector is simply at the start of a process of ongoing regulatory and industry change. This process will require insurers to consider unfamiliar approaches and embrace unconventional and innovative investment solutions. Importantly, these solutions will come from genuine partnerships with asset managers.
Ultimately, we expect both European and Asia-Pacific insurers will follow similar journeys and eventually reach the same end point. However, Europe is further ahead on this journey due to the earlier implementation of risk-sensitive and market-consistent solvency regimes.
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