Flexibility key in hunting investment yield

Flexibility key in hunting investment yield

Interest rates may finally be on the rise, at least on one side of the Atlantic, after years of low rates. Despite this, caution is evident among re/insurers’ chief investment officers (CIOs), treasurers and chief financial officers (CFOs). A focus on maintaining flexibility within the investment portfolio is a common thread, as unpredictable geopolitical events have schooled CIOs into staying cautious.

Most CIOs Reactions spoke to seem to be keeping investment risk appetite relatively low or unchanged, despite traces of optimism about economic prospects. “Our risk appetite remains the same. There’s a greater focus on political volatility this year,” says Paul Cooper, chief finance and operations officer at Sompo Canopius.

Politics represent the biggest fear among insurers’ investment heads. The art of the possible it may be, but after a year of political upsets in 2016 – particularly the UK’s Brexit referendum shock result to quit the EU, followed by Donald Trump’s surprise election to as the 45th US President – anticipating political fallout is fraught with difficulty.

Political risk

“Politics is the real wild card,” says Bryan Fagan, CIO at Zurich Insurance, the Swiss insurance group’s EU subsidiary in Dublin. “If we have what amounts to a trade war, then all bets are off. The ability to plan for such border tax scenarios is limited.”

Event risk concerns James Kenney, CIO at Novae, suggesting flexibility is essential for navigating political risk pitfalls. He highlights the upcoming French election in the spring and then Germany’s elections in the summer. “Those two are key events for this year,” he says. 

The Netherlands also soon goes to the polls, while a rise in populist politics has been seen across countries. “This could cause an excessive amount of market volatility,” warns Ian Coulman, CIO of Pool Re, the UK’s terrorism mutual reinsurer.

“Marine Le Pen wants to get rid of the euro, and redenominate approximately 80% of French euro denominated debt to a new French franc. Such a move, according to ratings agencies, would be a technical default, as well as imperilling the future of the single currency in Europe,” says Coulman, responsible for an investment portfolio, about 10% of which is denominated in euro currency.

Fagan says his firm has cut back its holdings of French and Italian treasuries. However, if insurers play too much at being political pollsters and then get it wrong the market would be unforgiving, he notes. “If we think the French election will have a negative outcome we’d reduce our risk, but if that doesn’t happen then the market will run away and we’ll have lost an opportunity,” says Fagan.

Kenney also notes China’s economic slowdown as a source of market unrest. “We’ve seen China causing volatility in the market on a few occasions over the last couple of years, with an equity market sell off from poorer than expected economic growth and worries about China’s debt markets,” he says.

Greece’s ongoing economic woes are on the radar again, Kenney points out, with concern about whether the European Commission and the International Monetary Fund can come to an agreement to extend the southern European country’s bailout package.

He reveals Novae has nudged its risk levels back to target, after Brexit-related volatility caused the London market firm to reduce its tolerance slightly before and after the UK referendum, which sent the pound tumbling against the US dollar. The re/insurer ran the rest of 2016 at the lower end of its target risk levels.

“We’ve now increased our risk levels back to target, after the November US election. That’s not a change in our central expectations but a change in the potential upside,” says Kenney. “We think there’s now a greater possibility for increased economic growth in the next few years. This change is a result of policy statements on infrastructure spending and a reduction in the corporate tax level. Both those things can raise economic growth, although there are serious concerns over trade.”

This is itself a best guess for a more optimistic scenario, based on the ability of broader Republican economic interests to trump President Trump’s wilder protectionist tendencies. It is still too early to predict how Trump’s tweets might turn into policies. Nevertheless, the basic forecast remains unchanged, hinting at the potential downsides as much as the ups.

Coulman is similarly taken up with geopolitical worries, particularly regarding Trump in the US. “There’s the potential for trade wars,” he says. “There’s also talk of spending billions on infrastructure, which, while good for economic growth, has inflation implications. Where are all those dollars coming from?” There is also reduction in corporation tax planned, which is also creating some optimism, while immigration reform, in terms of who is allowed into the country, has big implications for employment.”

While staying cautious about the next political shock, Fagan notes that Brexit’s effects have so far been limited – the UK economy has performed better than expected – while in the longer term it is still expected to slow down UK productivity and growth. “Over the past six to 12 months I would say the economic fundamentals have improved. The indicators are good, but political risks remain high,” says Fagan.

In recent quarters, investment performance has been largely determined by foreign exchange (FX) volatility, depending on assets’ denominations, closely matching their liabilities, and converting into insurers’ reporting currencies. Much of this followed political developments, such as the pound’s fall after Brexit. In response, various FX hedges have been widely employed.

However, two related risk factors are set to change the investment environment in 2017 – albeit gradually – as the year rolls on: one is inflation; and the other is rising US interest rates. The latter is expected to be led by the US. Federal Reserve chairwoman Janet Yellen heralded up to three US interest rate hikes in 2017, after one rise in December 2016, which was only the second since the 2008 financial crisis.

“There is talk of rate rises but when will they come and by how much?” asks Cooper at Sompo Canopius. “While rising interest rates are good for the sector’s long-term returns, volatility has caused mark-to-market losses and any rate rise will cause short-term losses. Month by month there have been conflicting factors causing yields to rise and fall,” he says, while noting that failing to anticipate interest rate changes, or the lack of them, has seen some carriers caught out more than others.

Kenney is not too worried about when the US rate rises will come. For Novae, the US dollar is its biggest underwriting exposure after sterling, which is closely reflected on the assets side. “The US rate rising cycle doesn’t keep me up at night,” he says. “For a number of years markets have been anticipating a rise in rates but the outcome has consistently been less than expected. While we see initial steps being taken it looks like a gradual path, and we have strategic hedges in place for whether it happens or not.”

For Pool Re, Coulman notes that a US rate rise could be positive for short dated fixed income assets. Some mark to market losses might be expected in the short term from rising interest rates, but these can be partly offset by the ability to invest in higher yields.

Coulman is keen to know whether the Fed will make two or three rate rises, and even more so how well the Fed will react to a rise in inflation. “Inflation risk is definitely up there as a concern,” says Coulman. “The concern is more about central banks being as adept at controlling inflation risk. While a little might be a good thing, if it becomes too large will central banks be strong enough to tighten monetary policy sufficiently to rein it in?”

In Europe, Fagan notes that the job of the European Central Bank is complicated by its role across economies moving at different speeds. Germany would rather see an ECB rate rise due to inflation, while Italy’s economy is not yet in a healthy position to deal with such a rise. Inflation is more of an issue in the UK, which has seen a steep fall in the pound.

“Structural issues in the background include that debt levels are globally high,” says Fagan. “That is hindering interest rate rises, particularly for countries such as Japan and Italy. We’re relatively optimistic, expecting interest rates to gradually rise, and for deflationary risks to gradually decline.”

Divergence is expected in central bank interest rate policies, with Europe expected to keep interest rates low, while the Bank of England is also expected to keep rises on hold. “We expect the Fed will lead but there will be a bigger divergence than we have seen in the past,” says Fagan.

Rising UK inflation but a slowing economy and interest rates kept low mean that the UK could face stagflation, suggests Coulman at Pool Re. “We don’t see a change in interest rates in 2017. There was good growth in 2016 but it’s expected to slow this year. With the uncertainty of Brexit the UK could be faced with a period of stagnant or low growth but rising inflation, partly attributed to the sharp fall of sterling,” he says.

Novae’s Kenney says inflation risk is limited. “We’re a short-tail insurer with few long-tailed exposures that can be hit by increased inflation,” he says. “We’re confident that with an efficient allocation of risk across the portfolio, the investment portfolio return should cover an inflation rise over the medium term.”

Staying flexible

Short durations in a strategic approach help non-life insurers to keep their options open. Rip Reeves is CIO and Treasurer at Aegis Insurance Services, a US based global insurer. Although primarily focused on US interest rate policy, it has a portfolio also containing allocations in Canadian dollars, sterling and other currencies through its London syndicate.

“We have a short duration, relative to liabilities, because of uncertainty over our US interest rate outlook. Some people have been early in trying to predict rising rates, so we’ve continued to shorten our duration in the past few years. We’ve reduced our duration from 3.5 years to approximately 1.5 years,” he says.

“Being a strategic investor, our asset allocation investment decisions do not change on a dime. We’re not that nimble on any given day; we move a bit more gradually,” says Reeves.

Coulman at Pool Re thinks allowing longer durations can be beneficial. “Of our seven investment managers three focus on investment grade corporate bonds and were given different parameters 12 months ago. These three can now invest in bonds up to three years’ maturity, rather than 18 months as it was previously. That gives more flexibility,” he says.

Reeves highlights the importance of diversifying – a hedge echoed by several other CIOs. In Reeves’ cases, a concentration of energy exposures on the underwriting side make this particularly important.

“We’re very aware of overlapping energy positions on the investment side with our liabilities on the underwriting side. We prohibit our asset managers from purchasing our policyholders, for example, to minimise that overlap,” says Reeves.

Cooper at Sompo Canopius also highlights adding more diversification across asset classes. Along with hedging strategies, this is helping dampen volatility, he notes. Cooper cites use of equity puts and bond collars, as well as increasing use of derivatives. He also suggests adding yield through illiquid assets, such as bank loans and infrastructure investments.

Fagan cites similar investment choices, including buying up physical real estate assets, infrastructure and real estate bonds, increased holdings in privately placed bonds and bank loans. However, despite the illiquidity premium to pick up additional yield for such investments, the market for such relatively illiquid assets, opened up by the retreat of the banks after their own liquidity crisis in 2008, is still restricted by its limited size. 

Kenney notes the liquidity trade-off in investing in such instruments. “Increasing exposure to illiquid assets has been a recent trend within the market that we’ve been cognisant of, but actually we haven’t taken steps in that direction,” he says.

A sign of the caution in the market, he is instead prioritising flexibility over a potential yield pick-up from illiquid exposure. Instead he has opted to reduce holdings in government bonds and also equities, while adding in more investment grade corporate bonds, plus a holding in emerging market debt. He emphasises the diversifying effect of this broad mix.

Diversifying managers

Diversification across asset classes, broadened mandates, as well as increased use of hedging strategies and derivatives – all useful to offset political risk and market volatility – is contributing to a trend observed of insurers employing a broader pool of asset managers. More specialists are being used to do the more niche or sophisticated work, it seems. Cooper highlights this trend, as well as Reeves at Aegis.

Reeves suggests taking an opportunistic approach to below investment grade assets, bank loans, collateralised loan obligations (CLOs) and high yield debt. He uses approximately a dozen managers for a $4.2bn portfolio.

“When you start to look at infrastructure, MLPs, CLOs, etc, although there are some large asset managers who say they manages these sectors, best in class analysis starts to suggest some smaller players,” says Reeves. “By the nature of the mandate, you’re going to consider a range of managers different from the typical core bond managers in the insurance space.”

However, Reeves notes that by running the forecasts of various asset managers, as well as the insurer’s own outlook, their investment strategy is still a cautious approach in uncertain times, slightly reducing their risk appetite in 2017. “We’re cautious...when you look at the efficient frontier, regardless of the risk, you’re not picking up much forecasted return for increased levels of risk,” says Reeves. For example, we analysed a risk appetite that was doubled from our base case, and the amount of extra return was estimated to be no more than 0.30%. “That’s not a healthy risk/reward level,” he adds.

 

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