02 September 2020
In recent years, equity has come to dominate non-life insurers' balance-sheet risk, with increased allocations fuelled by stable economic growth, strong dividends and low yields from fixed income. The COVID-19 crisis has changed these drivers dramatically. However, insurers' need for a solution for the low-yield environment has only intensified. Furthermore, weak expected economic growth has cast a shadow over underwriting results, putting additional pressure on insurers to deploy capital efficiently.
I believe insurers can address some of these challenges by reassessing the quantity and quality of their equity exposure — in particular, by adding convexity and lowering volatility.
The average European non-life insurer holds only about 20% of its investment portfolio in equities, with the rest in low-volatility assets1. Yet investment risk is overwhelmingly concentrated in equities. And the greater uncertainty caused by the COVID crisis has significantly increased the total amount of underwriting and investment risk non-life insurers carry.
As a result, non-life insurers' investment portfolios tend to be highly correlated with equity indices, sharing their pro-cyclicality and tendency towards extreme variations in prices. Such a risk profile displays close to zero price convexity2: when equity prices rise, insurers achieve positive returns proportional to the market; when they decline, returns are negative proportional to the market.
While low-convexity risk profiles can help insurers address the low-yield environment over the long term, they have a higher probability of incurring large losses, which some insurers may wish to avoid at present. Others may be uncomfortable with the large capital charges associated with equity allocations. In addition, aligning investment performance more closely with equity market moves could be considered inconsistent with Solvency II's Prudent Person Principle.
In my view, adding convexity can help to overcome these concerns while still aiming to achieve insurers' investment goals. I have identified two ways of increasing convexity while potentially making only small changes to the existing asset allocation.
Strategy 1: Adding interest-rate risk
Equity and interest-rate risks' historically negative correlation has continued during the COVID crisis. Unfortunately, most non-life insurers haven't benefited from this, as their asset allocations lacked interest-rate risk.
My analysis suggests that adding interest-rate exposure through an asset duration overweight in excess of liabilities can help insurers pick up some convexity. However, current ultra-low yields require a substantial amount of incremental interest-rate risk to gain meaningful convexity.
Strategy 2: Using convex equities
Long-only benchmark-tracking strategies are simple and easy to implement but non-convex. Fortunately, actively managed strategies that seek to mitigate downside risk or take an absolute return approach can add convexity and reduce total volatility. Figure 1 shows the impact of using an actively managed convex equity exposure to replace long-only benchmark-tracking strategies.
Figure 1: Change in risk profile from replacing long-only with convex equities
Source: Wellington, as at 24 April 2020| For illustrative purposes only.
Although long/short equity strategies exhibiting price convexity do not benefit from regulatory capital relief, they can improve the economics of non-life insurers by adding convexity and lowering volatility. Strategies that seek to limit the downside (for example, via put options) can have a positive economic impact on convexity and volatility. In addition, they can potentially provide regulatory capital relief.
In conclusion, the COVID-19 crisis has exposed the size and procyclicality of equity risk on non-life insurers' balance sheets. I believe reassessing the quantity and quality of equity exposure — specifically by generating convexity and lowering volatility — may help insurers to address the challenges of the post-COVID world.
The characteristics presented are for illustrative purposes only and are not representative of an actual strategy. Actual experience may vary.
ALM & Regulatory Capital Strategist at Wellington Management
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1. Source: EIOPA, 2019
2. Price convexity refers to the change in portfolio value due to changes in overall asset prices. It differs from interest-rate convexity, which is the change in duration in fixed income assets due to changes in interest rates.