Many insurers have been reassessing their investment portfolios in light of low rates and Solvency II. In the first part of this InsuranceERM/bfinance roundtable, participants discuss concerns about diversification and liquidity, and whether they can be opportunistic enough in today's fast-moving markets
Hugo Coelho, assistant editor, InsuranceERM
Anisha Gangwani, head of illiquid investments, Direct Line Group
Chris Jones, head of investment advisory, bfinance
James Kenney, investment and capital actuary, Novae
Alexandra Martinez, director, bfinance
Gareth Quantrill, group investment manager, RSA
Samit Shah, chief risk officer, Atrium
Achilles Sofroniou, senior portfolio strategist, Canopius
Rob Vetch, chief financial officer, W. R. Berkley Syndicate
Derek Williams, managing director, private markets, bfinance
Chaired by Christopher Cundy, contributing editor, InsuranceERM
Chris Cundy: Is your portfolio more diversified than it was a year or two ago? If so, what have been the drivers for that change?
James Kenney: We went through a big project this year to come up with a new investment strategy with a new investment manager. We wanted to be more holistic in the way that we manage our balance sheet, and to try and be more efficient in the way that we allocate our risk. Our risk appetite stayed the same, but we recognised that previously we invested on an accounting basis resulting in a very short-duration portfolio to minimise asset only volatility.
On an economic basis, that was not very efficient. So we moved to being strategically matched in duration and adding some growth assets to our portfolio. We have a much more diversified spread of risk within the portfolio now.
Derek Williams: Is duration one of the key priorities in terms of that diversification?
James Kenney: Yes. We have moved to an asset-liability view and, as a non-life insurer, FX and interest rate sensitivity are two of the key economic risks, so we have modelled those. We actually use PV01 [price value for a 1 basis-point change in yield] rather than duration and try to match interest rate sensitivity.
Samit Shah: Obviously interest rates are very low, so the search for extra yield is a driving factor. Another driver comes from the underwriting side: margins are shrinking as the market softens, so sweating investments a bit more can bring some extra value. If you do move into more diverse assets, individually you might think they are a bit riskier, but when you put it in the context of an overall portfolio, the diversification means it does not add that much risk.
Achilles Sofroniou: Diversification is a tricky word. A portfolio may at first glance look very diversified, but during periods of market stress it all points in the same direction, because it's mainly credit and equity risk that are driving your volatility. You find that when you really need to have diversification, it is not actually there.
Chris Jones: People essentially look for things that are uncorrelated, and far too often they end up with things that are uncorrelated in good times, but are very highly correlated in bad times. What you need is assets that go up when other assets are coming down.
To take that thought further, one thing that concerns me is the growing coincidental loss between bonds and equities. Correlation does not tell you a lot about bonds and equities, because it moves all over the place. But if you count the coincidental down months – and I looked back for 15 years at global equities and global bonds – in the 12 years from 2000 to 2012, there were 45 significant equity-down months (where they were down more than 2%). Bonds went down for four of those months.
However, in the past three years, there were seven significant down months. Bonds went down for six of those. Clearly something has changed.
Now, most risk management is backward-looking. Most correlation analysis has to be backward-looking. People are really underestimating the chance of their portfolio being absolutely annihilated in a correlated bond and equity sell-off...
Achilles Sofroniou: ...and that ties into time horizons. We are trying to move to a three to five year time horizon that will allow us to take more risk and to absorb more downside losses. This will enable us to increase the return of the portfolio while at the same time ensure that the investments are working as hard as possible.
Samit Shah: One of the key things is making sure you have enough liquidity, so you are not a forced seller in those down periods.
Derek Williams: How do you reconcile the lack of liquidity in assets like private credit with the overall requirement for liquidity from your portfolio?
Samit Shah: The liquidity is absolutely key. You need to look at your stress scenarios and make sure you have enough liquidity to cover those, and only then you can start looking at more diverse asset strategies. You are at massive risk if you expose yourself to liquidity risk.
Chris Jones: The thing that damages people in big sell-offs are assets that are semi-liquid that turn illiquid. There is a strong case for barbelling liquidity in the portfolio: you have illiquid assets that you never touch, and then you have your liquid assets. If the illiquid assets are really locked up, then that is going to benefit when everybody is forced-selling, because you are going to be the buyer of last resort.
Anisha Gangwani: Our asset strategy has changed a lot in the past three years. When we separated from RBS we started with a simple portfolio of credit and gilts. We undertook optimisation exercises to maximise our return on the basis of economic risk, while also taking into consideration the return maximisation on Solvency II capital basis. Solvency II is definitely something that is considered while defining our investment strategy. In addition, we performed an ALM review to find appropriate assets to back the liabilities.
Most of our liabilities are quite short term, so we find short-term, fixed-income, high-grade bonds to match and invest. We also have some annuity-like liabilities called PPOs [periodical payment orders], which are inflation-linked, so we have property and floating-rate infrastructure loans to back those.
The end result is that compared to a lot of other non-life insurers, Direct Line's portfolio looks very diversified – and not just on the asset class basis, but also if you measure underlying risk exposures: liquidity, inflation, fixed/floating rate split and credit exposure.
Chris Cundy: How did you go about building that process?
Anisha Gangwani: It started with laying down a few key considerations. Liquidity is key, so we assessed what the stress scenarios were and how much liquidity was needed to meet those scenarios. That aside, it is the asset and liability matching. We decided on which assets to throw in the mix on which we optimised. In addition to that, there are things like the key messaging that is going to shareholders. Do we want to position ourselves as a conservative company, or do they expect us to take more equity risk, for example? Other considerations include the rating agency and Solvency II capital. After all those considerations have been laid out, we undertook a very detailed portfolio optimisation exercise. That gives out a few different portfolios, which are then looked at from our internal economic capital basis. It is a very detailed step-by-step exercise.
Implementing the investment strategy
Derek Williams: In terms of running the portfolio, can you boil all that down to delegation? Or is it literally a collaborative exercise, and then you allocate?
Anisha Gangwani: We had the option to design our perfect portfolio because we practically started from a blank sheet of paper. More often than not, you would not, because there would be so many transaction costs to moving a portfolio into a completely different optimised portfolio. We regularly reassess liquidity, the ability to hold illiquid assets and asset-liability matching to see if there is scope to add different kinds of risks and matching assets.
James Kenney: We took a hierarchical approach. At the top is the strategic asset allocation that we have to decide upon. Then there is a dynamic asset allocation overlay that the manager runs for us, where, as markets move and valuations change and their underlying assumptions change, they can flex that asset allocation on a medium-term basis. Below that, there is the actual active management of the underlying core fixed-income portfolios, which is fully delegated.
Achilles Sofroniou: We start by identifying our return objective and then we structure the portfolio to meet that within our risk tolerance. If you start the other way round, you might find yourself with a portfolio that meets all your risk numbers, but there might be another portfolio out there that can give you much more return.
Anisha Gangwani: Where do your liabilities fit into that?
Achilles Sofroniou: We have a lot of premiums coming in every day, so we are a very cash flow-positive entity. We have a strategy that ensures our asset duration is broadly matched to our liabilities however as long as our assets are generating sufficient return we are less concerned about the duration gap.
Rob Vetch: Our business is new – we have been going for six years – so we have a relatively small investment portfolio, all pretty much in highly liquid assets or cash. We write worldwide business, including catastrophe risks, and we are therefore exposed to liquidity risk through claim severity and frequency and currency exposure, so the important thing has been to keep cash flow-positive and with sufficient liquid funds to pay our expenses, reinsurance and claims as and when they fall due.
Chris Jones: A lot of it is about managing your expectations. You are only going to crystallise a loss if you are a forced seller or if you choose to sell because something deeply unexpected and negative has happened. People far too often just look at (a) the past and (b) a normal distribution, and therefore infer what the worst could be in the future. We should recognise that the financial markets, and specifically the more complex assets, give you fat tails. Therefore, if you have your expectations managed, you are less likely to be a forced seller. The other mitigating argument for going into less liquid assets is that in a market sell-off, it will be more insulated from the domino effect.
Gareth Quantrill: On this concept of the barbell with government bonds when yields are so low: from a risk point of view, you have to change the conversation. I do not think I have an asset that is inversely correlated to government bonds. At these yield levels, government bonds don't give me protection, but what they do give me, if I ladder my investments, is opportunity.
So I am prepared to accept the low yield on government bonds, because if I ladder them I have liquidity coming through, giving me an opportunity to make an investment when I think it is a good investment, not because the yield in my book is falling and I am forced to do something.
Chris Jones: Is there enough nimbleness and opportunistic intent in your portfolios to be able to take advantage when markets are crashing?
James Kenney: We have set up an overlay specifically for that kind of crisis, but we do not expect it to get used very often. It conflicts with the barbelling of liquidity, which we don't do, because to make use of those opportunities you must have liquidity to be able to put to work.
The other difficulty with some of the theoretical ways of doing things better is the operational complexity. Imagine you are going through that crisis. You have some assets underwater. You have illiquid assets that you want to hold onto, but where are they placed within your legal entity structure? Are you having to move money around at that point in time? That can present a real headache.
Samit Shah: Management is more willing to go down that opportunistic route now, compared to two or three years ago, but there are some issues. If you have quite a conservative portfolio now, you can take advantage, but obviously if you are one of those organisations panicking, then you are just not going to be able to do it.
Achilles Sofroniou: We have very specific allocation to opportunistic strategies. This allows us to invest in opportunities that look mispriced and whose valuations look attractive over our time horizon. We also have an overlay ability, so if we think, for example, that equity markets are cheap, we can equitise our cash holdings in order to gain exposure. Conviction and governance are key to all our investment decisions. If you have conviction in an idea and you implement that, then explaining the investment if it goes wrong is much easier: you need to make it clear to the managers what you want and make sure they are not doing the opposite.
Gareth Quantrill: I do not think we are particularly opportunistic, but we have feasted on a higher allocation to corporate bonds, so arguably we are already opportunistically invested.
Anisha Gangwani: We are not very opportunistic, but we are able to take small, tactical overweights and underweights and that of course is where we have a view. And that does require investment committee sign-off. We have been able to get into illiquid assets that are becoming available because of banking regulations.
Continue reading part two of this roundtable