Articles - Insurers should rethink approach to fixed income investing

Eight years into the current credit cycle insurance company investors are understandably apprehensive about when and how it will end. But while insurance company investors continue to search for yield and take on more credit risk in a low return environment, we don’t think the coming of the end of the credit cycle is something they can ignore just yet.

 By Valérie Stephan, Executive Director, Global Insurance Solutions, JPMorgan Asset Management
 Instead, JPMorgan Asset Management says a new framework is needed to maximise capital-adjusted returns, which relies on strategy & analytics to help build and maintain balanced portfolios.
 Solvency II means insurers have to look at their investment mix with an eye on risk and capital management, but those who don’t consider all the dimensions of risks – across issue, sector and curve exposure – might be unwittingly exposed to potential pitfalls.
 To achieve the complex juggling act of meeting investment objectives, managing investment constraints and getting the most out of their portfolios, JPMAM calls on insurers to rethink their approach to fixed income investing.
 This involves rigorous credit research to limit ratings volatility (and thus overall capital requirements) while maintaining maximum portfolio returns relative to an insurer’s objectives and risk appetite. In practice, it starts with a consideration of an insurer’s particular objectives which may include regulatory capital or accounting constraints, along with book yield management, asset liability-matching, among other factors.
 SCR awareness in this context involves managing investments globally with a view to staying within a given SCR limit, but also taking into account the more important dimensions of return and credit quality. Filtering across a large universe of securities to consider the return, quality and SCR of an individual security helps in selecting the most optimal holdings. Traditional measures, such as Z-spread (spread over government bonds) or spread risk SCR are helpful in this process, but insurers also need to consider using flexible analytical tools to avoid the significant pitfalls of “simple” optimisation— unintended concentration in issuer, sector and curve exposure.
 In-depth credit research can be used to identify companies that have stable to improving fundamentals and appear cheap on a relative basis. For many insurers who employ buy and maintain (book yield focused) strategies, the focus is on fundamentals given that bonds are likely held to maturity. Along with credit fundamentals, event risk and market liquidity should also be taken into account. Using this analysis, an investment ranking can be assigned to each issuer in our investment universe. Deploying a qualitative screen, securities with low liquidity, a large bid-offer spread and/or an issue size below €300 million, or any off-the-run bonds, can be excluded from consideration. Then, a line-by-line optimisation can be run, following guidelines based on an individual insurer’s objectives and constraints. This framework seeks to build balanced, well-diversified portfolios that can help to minimise the spread risk SCR for a given level of expected return.
 This approach can be particularly attractive in market segments where there is a wide dispersion of expected return relative to spread risk SCR (e.g., USD corporates, global credit and emerging market debt). For example, an optimised portfolio of global corporate bonds can deliver a spread-risk of 6.8%, vs. 11.4% for the Bloomberg Barclays Global Aggregate Corporate Index.
 Simple optimisation can only take insurers so far: Investing solely on the basis of capital-adjusted returns can easily lead to unintended concentrations by issuer, sector or curve exposure. A superior optimisation process should rely on flexible analytics to build—and maintain—a balanced portfolio. An SCR-aware and optimized approach can help insurers not only meet, but surpass the challenges they are faced with.

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