16 April 2018
Insurance, especially non-life insurance, is all about risk. In this article, the first of three, we will look at asset risk (or market risk), how it sits alongside other risks and how the market risk appetite in the UK compares to France and Germany. We will then focus on asset allocation and the constraints to optimisation in the second article, before closing our trio with the evolution of asset allocation in the last piece. Although we are only concentrating on non-life insurers, the lessons we learn can also apply to life insurers despite market risk featuring heavily in their product design and liability management.
This article has looked at the key European non-life markets of Germany, France and the UK to gain insight into asset risk appetite. In Figure 1, it can be seen that the average French insurer allocates over 10% more of its total risk budget to market risk than the average UK insurer. This additional allocation to market risk can be seen at each of the 25th, 50th and 75th percentiles. At the 25th percentile level, French insurers' allocation to market risk is just under double the allocation from UK insurers', and German insurers' almost half as much again of UK insurers'.
In this analysis, we have decided to exclude pure health insurers as their liquidity needs are so different to other non-life insurers. In addition, unlike other insurers, health insurers can often be oriented towards providing healthcare facilities. All of the following references in this article to non-life ignore these health insurers.
Market risk typically diversifies well with underwriting risk and, for most insurers, this diversification benefit can increase with a higher allocation to market risk. We see evidence for this in Figure 2, where we have plotted our UK non-life insurer database. The graph shows market risk as a percentage of total risk (vertical axis), plotted against the amount of diversification benefit (horizontal axis). It can be seen that insurers who (up to a certain limit) allocate more capital to market risk, enjoy greater diversification benefit. As with underwriting risk, the additional market risk could be thought of as adding a new line of business, along with the acceptance that there will be good and bad years.
One reason why French and German insurers may feel able to take on added market risk is because they are more strongly capitalised. Figure 3 shows their solvency ratios (own funds/SCR) roughly follow the proportion of their assets allocated to market risk. However, if you deduct their investments in related undertakings and strategic holdings (assuming these are assets an insurer would not want to sell when the going gets tough), the UK looks much better placed to take on risk. Some of the market risk will be due to these related undertakings, although these holdings often enjoy a preferential equity SCR of 22% under the standard formula compared to the more usual 39%*.
*39% is the equity risk stress before the addition of the symmetric adjustment for equities listed in countries that are members of the European Economic Area or the Organisation for Economic Cooperation and Development
This appetite for market risk can be seen in the average asset allocations shown in Figures 4, 5 and 6. When looking at both the German and French insurers, we see they invest less in government bonds than the UK. The average German insurer invests over 50% of their portfolio in corporate bonds and 5% in property, whereas a typical French insurer invests along similar lines to the UK in more ways than one. Insurers in France and the UK have approximately evenly weighted allocations to both government and corporate bonds, with a modest allocation to loans, mortgages and equities.
However, for the average French insurer there is a 28% allocation to "collective investments". This could be an allocation to hedge funds and other investment strategies or it could be to more vanilla equity and corporate bond portfolios. Perhaps by the time we receive the next set of Solvency II disclosures, we will get a better insight into that black box. Unfortunately, the disclosures say nothing about the riskiness of any of these portfolios.
In summary, asset risk is just one piece of the risk jigsaw. All the pieces have to fit together to reflect an insurer's business model, capture its attitude to risk and fit its capital base. When we analysed the average German and French non-life insurer and stripped away the investment in related undertakings (which, on average, is in excess of own funds over the SCR), it looks like UK insurers have a lower appetite for market risk.
Whilst UK non-life insurers focused on allocating their capital to underwriting risk, there could be an investment case to be said for reallocating some of their risk budget to take on investment risk.
When looking at where and how to deploy their market risk budget, there are modern investment strategies that are well suited to non-life insurers. In my next article we shall look at the optimisation of asset allocation from both an economic and Solvency II perspective that explains the types of strategies that now appeal to insurance investors. These include absolute return funds, capital aware strategies, alternative and illiquid credit.
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Dick Rae, Director, Insurance Solutions