06 April 2020
Insurance Asset Risk surveyed the industry to find out how it is rethinking asset allocation in the wake of COVID-19's impact on the economy and financial markets. Vincent Huck presents the results
Nearly two-thirds (62.9%) of respondents to an Insurance Asset Risk survey said they were either rethinking their allocation (33.3%) or close to doing so (29.6%) in the wake of the COVID-19 crisis.
As the survey closed in the last week of March, one could expect that this figure would have been higher if the question was asked at the time of publication. However, some of the concerns and challenges expressed in the respondents' answers remain relevant considering the accrued market volatility.
Respondents were split on the level of preparedness to the Q1 turbulences at insurers' investment team with 30% saying teams were 'prepared in allocation but not in hedging' and an equal number of respondents saying they were 'insufficiently skilled in navigating such high volatility'.
For Erik Vynckier, interim CEO at Foresters Friendly, insurers were "totally unprepared for the Q1 turbulences".
"This sort of scenario was on no one's dashboard," he says. "Everybody was positioned for a further rally in an admittedly overvalued and ageing equity bull market, for narrowing credit spreads from more quantitative easing and accumulating exposure to leveraged illiquid financing and alternative fixed income."
The investment grade corporate credit had become dominated by BBB corporates, Vynckier continues. "This will have a massive impact on the asset side of the balance sheet. Virtually no one was hedged against a drop in the equity market. People were also not positioned for a significant spread worsening, supported by the now inevitable downgrades. I don't think people had an understanding of the embedded credit risks in the illiquid assets on their portfolio."
For Vynckier, the post COVID-19 crisis will require active investment management and not smart beta investors, as insurers have become.
"I don't think that insurers have the capacity to quickly revert to being an active investor, when they have spent the past ten years travelling the opposite road," he says. "They don't have the equity and credit research input, nor do they have the portfolio managers to implement active portfolios."
A thought share by Mark Fehlmann, head of insurance for Europe at DWS, who believes that while maybe not totally unprepared, insurers are insufficiently skilled in navigating such high volatility.
"I don't want to generalise and some insurers are better off than others," he says. "However, the skills level across the industry as a whole is maybe not as good as in the asset management industry itself. Such that when everything is all clear, blue sky, calm waters, everything is fine. But once markets get choppy I'm not entirely convinced that everybody is in the best position to make a decision on staying on course, derisk, taking risk and at which point in time to do so."
For Bruce Porteous, global insurance investment director at Aberdeen Standard Investments (ASI), issuers were prepared in allocation but not in hedging. He says: "Generally speaking, insurers had hedges in place but the hedges were designed to protect against less extreme events than the one we are seeing now. So we are seeing companies re-hedging taking into account where the market fell to."
Solvency II models
Answers to the survey were emphatic when it came to the adequacy of insurers' expectations, modelling and scenario analysis, with 65.3% responding 'no'.
In their SFCRs, insurers test the balance sheet to various stresses and the balance sheets are pretty robust to those tests, Porteous says, but what is happening in certain areas - like equity - reality has gone beyond their stress tests' assumptions
"Solvency II is really a quantitative system which mechanically says, if you hold these assets, you could face this deterministic magnitude of loss and therefore you need such amount of capital," Vynckier explains. "That is not a risk mitigation approach, since it forces us to simply invest in what we can afford in terms of capital stresses but we are not really managing emerging risks in a forward looking mode."
The quantitative macro stress test needs to be complemented with a more granular understanding of risks and opportunities, which investors at the moment simply don't have, he believes.
"In contrast to the standard stress tests, there is the continuous ORSA process (Own Risk and Solvency Assessment) documented in an annual formal submission to the regulators, which puts the onus on insurers to evidence the understanding of their balance sheet beyond mechanically punching the regulatory rules," Vynckier says. "Potentially there is more interesting information in the ORSA than in the publicly available data."
Most impacted asset classes
Asked which asset class should be most concerned about, rather unsurprisingly, high yield corporate bonds took the top spot for 47.4% of respondents followed by equity (39.1%).
Nearly a quarter (23.8%) of respondents identified funds as the second most concerning asset class closely followed by equities (21.7%).
Property was the most cited third concerning asset class with 27.7% of the vote.
Insurers are relying on internal credit models to rate private market assets, and therefore ASI is seeing companies revisiting those ratings in light of what has happened, Porteous says. "And we see insurers stressing credit generally - because the impact of serious credit rating downgrades may not be fully allowed for in Solvency II, for example, so we are seeing quite a bit of activity there."
We are likely to be in in a recession, and the risk of downgrades of debt as risen. Although insurers tend to avoid sub investment grades, if a BBB gets downgraded to sub-investment grade, they might end up in a situation of forced selling of sub-investment grade credit and reinvestment in investment grade will crystallise losses, he says.
"Private market assets may be vulnerable too because they have been internally rated and essentially they may be untested through a cycle, so that is the area we need to look out for," Porteous adds.
For Fehlmann, at the time of speaking with Insurance Asset Risk, it was difficult to predict what would happen from an asset class to asset class perspective, but where he is most concerned about is US high yield given the high exposure to energy markets.
Drilling into the different asset classes and looking at OECD countries govvies, insurers said the main concern lay primarily in the continued role of these assets in the portfolio (62.5%).
This asset class has been problematic for insurers for a number of years now in an environment of low, in some cases even negative, interest rates. From a capital point of view they may not be able to replace them, as unlike all other asset class they carry no capital requirements under Solvency II.
"The question is 'is that business model sustainable?'," Porteous asks. "It depends what they are using those assets to pay for, what type of liabilities they are matched with. It is a very tricky situation for insurers at the moment. "
For high grade bonds and high yield bonds the primarily concern for survey respondents was credit worthiness with 90.9% and 56.2% of the votes respectively.
But at the same time there is an investment "opportunity of a lifetime" in investment grade credit, Fehlmann argues. "Risk return in spread market have a fair element of risk, but it is an opportunity to lock in running income if you have the skills to do so."
It's an opportunity that might trigger a reversed journey for insurers, according to Vynckier. In the last few years, insurers searching for yield piled into alternative fixed income such, he believes they could now come back to the core asset class they know better.
"Today you can harvest material spread in investment grade debt, in an asset class you understand in companies you know," Vynckier says. "If you have cash in your pocket this will be your first destination. The opportunity set has materially changed now that the market reflects the risks of the COVID-19 pandemic."
When it came to equity and real assets the main concerns were on asset value with 90% of the votes, 66.7% for property and 37.5% for infrastructure, although respondents seemed fairly concerned all round for infrastructure with 37.5% citing credit worthiness as the main concern and 25% citing its continued role in the portfolio.
Vynckier would consider tactically stepping back into equity now that the prices have gone down so much.
"If countries succeed at restarting the economy in two to three months' time, I think there will be good returns to be had in investment grade and equity of corporate entities with sound business models, good operations and cash flows," he says.
Private funds on the other hand are likely to suffer as they struggle to attract fresh investment.
"There is uncertainty about the intrinsic resilience of highly leveraged private companies, often having borrowed in support of ambitious acquisition projects," Vynckier explains. "This market may be idle for the time being, with loans valued at historic and possibly stale prices and problems crystallising over time. Investors will be looking for evidence of the acquisitions generating good cash flows in a likely depressed economic environment."
Fehlmann says he is curious to see how insurers are going to come out of this. DWS is seeing low client activity at the moment except for "selectively increasing fixed income allocation and credit allocation".
Insurers are still trying to figure out what it all means from an asset allocation perspective, and a lot will depend on the nature of the recovery whether it is U, V or L shaped.
"Sentiment wise, the worst may yet to come because the US is way behind the curve on a time perspective and preparedness perspective," Fehlmann concludes.