21 November 2019
By Kelly Superczynski, Head of Americas Capital Advisory, Aon and Duke Williams, Associate Partner, Aon Investments
For an insurance company executive, most of the focus has traditionally been on the liability side of the balance sheet. Investment assets have often been overlooked opportunities – but investment strategies now exist that allow insurers to create capital efficient investment portfolios to help enhance yield, improve returns, and optimise capital.
Trends in yield
The low yield environment has a direct financial impact on insurers due to the higher exposure to fixed income securities represented in property and casualty (P&C) investment portfolios. P&C industry bond yields have fallen 140bps since 2009 to 3.4% (Source: Gross Bond Yields as reported by S&P Global Market Intelligence). That represents a 29% decrease in yield over the past decade. The search for yield has led to a different approach to capital allocation in insurer portfolios.
Bonds represent the majority of P&C investment portfolios, nearly 70% of the U.S. P&C Industry. Insurers have traditionally invested in high quality fixed income portfolios to preserve capital and reduce balance sheet volatility, with a focus on yield and not returns. With assets marked-to-market, having less exposure to asset volatility has been the most ideal approach and can yield more predictable net investment income, but at the expense of yield and returns. Additionally, fixed-income durations have shortened as a result of the lack of incentive to invest in longer-dated maturities at lower yields. This has led to an asset/liability mismatch for insurers with longer-dated liabilities.
Opportunities in insurer investment portfolios
The low-yield environment has caused insurers to consider expanding their investment toolset in search of greater yield. The traditional 'three main food groups' (fixed income, equities, and cash) are evolving, and insurers' expansion into additional strategies has typically occurred in a phased approach. The first stage involves reviewing the existing makeup of the fixed income asset class and allocating into additional fixed income asset classes. Investment grade credit has been the primary exposure, but does not present the most capital-efficient opportunity set. A capital-efficient investment portfolio is one that maximises investment yield and return within regulatory, credit quality, duration and other constraints. Asset classes such as high yield, bank loans, structured credit, convertible securities and emerging market debt create an opportunity to enhance yield and return, through additional diversification. Expanding the investment toolkit, however, involves a greater degree of investment sophistication and knowledge of National Association of Insurance Commissioners (NAIC) ratings and an understanding of the degree of impact the additional securities may have on risk-based capital and other ratios.
In the next phase, insurers have differentiated their investment portfolios by expanding into other asset classes beyond fixed income and equities. Private debt, private real estate and multi-asset credit strategies further expand the investment toolkit for insurer investment portfolios. These asset classes require a unique investment skill-set which may be outside the scope of the existing in-house investment team at the insurer.
Real estate strategies could offer additional benefits that have produced past returns that have been higher than traditional fixed income and with lower volatility than equities. Real estate rental yields are moderately higher than core bonds and can also serve as an inflation hedge.
Rating agency and regulatory considerations
As P&C insurers evaluate other asset strategies, questions often arise relating to rating agency and regulatory views – both from a qualitative and quantitative perspective. Qualitatively, insurers should be able to explain their asset risk tolerances, their expertise in managing new or growing asset classes and how any changes in overall investment strategy fit in with their underwriting risk.
Quantitatively, P&C insurers should consider capital model charges and stress testing (including asset decline or liquidity scenarios). AM Best's Capital Adequacy Ratio (BCAR) model and the NAIC's Risk Based Capital (RBC) model both use a covariance formula which materially reduces the overall net required capital. Most P&C insurers' BCAR and RBC models are driven by underwriting charges, therefore reasonable changes in asset allocations would not materially affect the overall scores.
As P&C insurers get less reduction in the S&P capital model for diversification than they do under BCAR or RBC, every increase in asset allocations with higher capital requirements results in an equal (or 1:1) increase in capital requirements.
Investments and governance matters
Investments can be a major factor of net income in years of profitability challenges – and investment income could offset weak years of underwriting profits. In addition, investment yield plays an impactful role in budgeting and forecasting. Lower yields and returns could result in lower future profitability and growth, and less expansion. That is why it is important to build a robust governance foundation for corporate assets, which creates the framework for the asset allocation. So, when considering your corporate investments, make sure you have invested the time to conduct an asset/liability study, to develop your governance structure, and to create an Investment Policy Statement.
The outcome of proper governance structure and asset allocation can lead to a more capital-efficient portfolio that enhances yield, improves returns and helps improve overall net income.
Industry dependence on investment strategy
There is pressure on P&C carriers globally to exceed their weighted average cost of capital (WACC), estimated to be in the range of 6.0% to 7.0% as of October 18, 2019 based on Aon Capital Advisory's Weekly Public Market Recap. A sustained competitive underwriting environment across most lines of business, and increasing capital on balance sheets, have led insurers to either return capital via buybacks or to seek improved returns to supplement underwriting returns (for example, by chasing yield, fee-based business).
As we look ahead, sophisticated investment strategies will continue to play a key role in achieving adequate returns on capital and meeting investors' risk-return thresholds. The recently-published Aon Insurance Risk Study from October 2019 states that the Global P&C industry produced an underwriting profit in 2018 with a combined ratio of 98.9% on $1.52T of premium and $1.32T of capital. Adjusting for the above-average insured catastrophe losses ($98.6B in 2018 vs. $80.4B 10-year average based on Aon's Impact Forecasting Catastrophe Insight report) implies an expected combined ratio of 97.7%. When factoring in industry premium to capital leverage of 1.15x, this implies a 2.6% pre-tax underwriting contribution to return on capital. At a minimum, companies need to return 3.4% to 4.4% of capital through pre-tax investments and other income. The relative spread of returns on equity to cost of equity - or return on capital to WACC – is closely linked to valuation, which adds additional pressure to investments' consistent and increasing contribution.
Companies often report their adjusted returns on equity, which ignores realised gains (losses) and unrealised gains (losses) to normalise results, which means opportunistic strategies may not be fully appreciated. Carriers with significant accumulated other comprehensive income (AOCI) holdings may not get the credit for these strategies on a return on equity (ROE) basis in favourable markets. On the flip side, operating returns may be insulated from a market-wide unfavourable equities market.
If you would like to discuss the investment challenges facing insurers, and potential solutions, please feel free to contact us.