Unlike previous years where CIOs focused on capital preservation and the hunt for yield, 2023 will be marked by a focus on managing volatility and the duration gap. Josh Adcock reports
The high degree of volatility in financial markets combined with the general expectation of global recession just over the horizon suggests that insurance chief investment officers (CIOs) may have to rethink their risk appetite, begging the questions of what to do with private assets and allocations to illiquids, and how to manage duration risk.
According to Goldman Sachs Asset Management's (GSAM) annual survey of insurers, CIOs are 'risk on' for the year ahead. While 18% of CIOs and CFOs plan to add risk to portfolios this year - marking the second-highest net bullishness GSAM has unearthed among them since 2015, if debt and other core fixed-income is their destination, they may not need to take more capital risk.
According to the GSAM survey, a risk insurers seem willing to take in the coming year is duration risk, with 30% of insurers (2022: 2%) planning to significantly increase duration risk exposure, consistent with the market pricing in rate cuts following a year of intense hiking.
Matt Armas, global head of insurance asset management at GSAM, said: "There is a desire to add yield, and we see that in an interest to add duration, and usually that comes in the form of longer duration, high-quality securities."
Yet the macroeconomic landscape is blurry at the moment, and to decide whether to take duration risk now, or stay short in duration on the asset side, is somewhat of a conundrum for CIOs.
Forks in the road
Erick Muller, Muzinich's head of product and investment strategy, describes the current environment as a "bifurcated scenario".
On one hand there might be more recessionary risk in three months, which would be positive for yield in a long-duration strategy, but on the other hand inflation could continue to rise, meaning interest rates will have to continue to move up.
"If the central banks reverse their monetary policy, then being on the short end helps, and we've seen the curve steepening recently," Muller says. "An inverted situation means that the long [end] has already captured a lot of the premium from the potential pivot of central banks, so, if you are on the short end today, you benefit from the change of monetary policy, if there is any."
He adds: "And if the central banks continue to raise rates and surprise the market on the upside in rates, then [by being short in duration] you diminish your sensitivity to interest rates. If you want to take much more risk in duration, you really need a good reason, because, given the shape of the curve, if you go too long duration, you pay for that."
At GSAM, Michael Siegel, global head of insurance asset management and liquidity solutions, says that the survey result reflects a general view "that we're approaching the peaks of long-term rates, so it's an opportunity to lock in these rates through their investments".
He adds: "Secondly, what has changed is the shape of the curve: you can now buy on the long end, and also invest on the short end through securitised assets that are floating rate, and you get to ride the very high short rates while locking in the duration on the long end."
Managing volatility and the duration gap is the clear theme of this year compared to last year where the focus was on capital preservation, according to Andrew Douglas, head of institutional sales for UK & Ireland at Muzinich. It's a scenario with no clear, obvious wins or losses, he explains. "You're in this inflection point where it doesn't really pay to take a bet either way. So, it's probably better to have that duration liability alignment, to be neutral on rates, as it were, rather than being short your liabilities, as some insurers were previously."
Another risk almost two-thirds (61%) of GSAM's survey respondents are willing to take is an increased allocation to private assets.
"You can see a very significant amount of insurers anticipate increasing their private asset allocation, continuing a trend that we have seen now for several years. And, more importantly, very few insurers anticipate decreasing their allocations to private assets," Armas at GSAM says.
Douglas tells Insurance Asset Risk that private assets, notably private credit, had been an investment of choice for insurers searching for yield in a low-rate environment.
"But, at the end of last year, you saw a pause in that assessment. Insurers were revisiting the public markets and thinking relative value had improved dramatically," he added. "I think insurers will continue to look to make commitments in private markets, but it will be selective. I think they'll be focused on lower leverage, they'll be focused on financial covenants within the transaction."
The reality is that private assets remain a relatively small part of balance sheets, particularly among non-lifers, where insurers probably have less than 5% allocated to illiquids, Douglas says.
However, he notes that the huge boost in demand in bulk annuity markets among life insurers will create a huge demand for illiquid assets among insurers.
Muller notes that, indeed, in the current volatile environment, illiquid assets are preferred over the high-yield, lower quality credit of liquid assets. First, they benefit from a better capital treatment and second, compared to the end of last year, yields are only marginally lower than the riskier liquid assets.
"If you want to go into high-yield you have to think of the right entry point, which is probably higher spreads – if you go there, you want to guarantee that you have a sufficiently large extra yield, to justify the risk you take. But at the moment, while spreads have widened, they are not very wide."
"In 2023, if you want to boost your yield out of IG, it's through the illiquid part [of portfolios] more than [in] the [more] liquid [part] – unless we have a fantastic spread-widening to 650 basis points. Then people will jump into it - but this is not where we are today," Muller said.
Douglas adds it's important to have "the right governance and framework in place, to be in a position to do that when spreads do move, or if they do move, because [with] insurance companies, it takes a lot of infrastructure in order to put that governance in place."
As for the future, Douglas suggests there's still space for innovation and opportunities in a tense market. "The space to watch is certainly life insurers and the UK Solvency II reforms, particularly the ability to find new ideas and new asset classes within the matching adjustment. I think that's the exciting space to watch, for the next 18 months."