Niched in the middle of the North Atlantic ocean, Bermuda is not immune to the low rates storm. In part one of this Insurance Asset Risk / Aviva Investors roundtable Re/insurers discuss their approach to cautious portfolios.
Sylvia Oliveira, chief executive, Wilton Re Bermuda
Kevin Hovi, chief financial officer, Kuvare Life Re
Jelena Strelets, senior manager, actuarial services, EY Bermuda
Wendy Yu, chief actuary, Athora Life Re
Thomas Olunloyo, chief executive, Legal & General Reinsurance
Josh Braverman, chief investment officer, Somerset Re
Steve Hales, chief executive, Resolution Re
Alex Wharton, head of insurance relationships, Aviva Investors
Iain Forrester, head of insurance investment strategy, Aviva Investors
Chaired by Vincent Huck, editor, Insurance Asset Risk
Vincent Huck: In the past 12 months, what has changed in your ability to do business in Bermuda? What has been more challenging than expected and what has been smoother than expected?
Sylvia Oliveira: There has been a lot of talk of an imminent recession, but the anticipated start date keeps moving later and later. Low interest rates is a concern – they seem to be sticking around at these all-time lows. This has negatively impacted insurers' appetites to unload large blocks of legacy business.
Josh Braverman: For direct writing insurance companies in the dollar-based asset-intensive product markets, it is harder to create products that are of value to the retail consumer in such a low interest rate world, which means that flows could be lower and reinsurance volumes could be lower as well, without innovation.
Kevin Hovi: The spread environment typically compensates you somewhat for the low yield environment, but investment-grade credit is staying incredibly tight – despite all the headlines about 'where we are in the credit cycle', and all these things that you think would push spreads out a bit wider – they do not.
Thomas Olunloyo: We have seen spread compression in real assets as well, so recently we have not seen the same amount of value as in the past, or the pick-up relative to traded credit, although there remain advantages. In addition, there is increased competition for those assets.
Kevin Hovi: Everyone uses the baseball analogy. It used to be the seventh inning in the credit cycle, the eighth inning, and I think we are in about the 20th!
Alex Wharton: How is that affecting conversations with the CRO, and running the business more generally?
Sylvia Oliveira: Well, I am the group CRO too. Investment managers are suggesting different strategies. Some suggest credit tightening. As a firm, we need to consider this as we evaluate our appetite for credit risk.
Alex Wharton: Are you finding that portfolios are going more cautious as a result of that?
Wendy Yu: I focus on pricing, so the conversation we are now having is: given where we are in the cycle and what we are comfortable with investing today, should pricing be focused on today or should we consider maybe more of a range of outcomes as we go through the next cycle?
There continues to be a lot of companies that want to offload business, and sometimes the gap is too wide, but sometimes it is maybe narrow enough that, if we are confident that we have enough dry powder to deploy in the next market dislocation, perhaps there is enough basis for us to bridge that gap.
Josh Braverman: The equity market has done well, yet interest rates are low, so there is something of a divergence between the return expectations for investors in insurance businesses and the level of interest rates. Can you really expect to make double-digit returns in a zero-rate world? I am not sure the equity investors have fully adjusted expectations downward as rates have come down.
Thomas Olunloyo: And also, the flow of capital into this space just continues to increase. Longer duration and more complexity are becoming increasingly attractive to investors globally who are looking for return. Whereas this used to be the preserve of more sophisticated investors, now we are seeing a broader range of investors in this space. As a result, returns may trend lower over time as competition increases.
Vincent Huck: Sylvia, you say that 'some argue' you have to be more cautious on portfolios, are you implying that you don't agree?
Sylvia Oliveira: Well, it depends. It is back to what Kevin said: Is there a recession around the corner? Or is it going to be next year or the next year after that? And are companies willing to give up that extra yield?
Kevin Hovi: Sometimes being early on calls, like when the credit cycle is going to turn, can be just as damaging as being wrong. Because if you had called three years ago that there was going to be a turn in the credit cycle, you would have had three years of missing spread compression [and carry].
A lot of it is just the opportunity cost, particularly when you are trying to grow a business. It is hard, because you cannot sustain growth and be ultra-conservative on your portfolio. You can take an in-force block and de-risk it more easily than trying to take live business and take yields off that. Because you have at least already transacted on the [in-force] business, so you have a proven history [and likely a profitable starting point], whereas flow business blocks that you are currently bidding on, you only have one chance to invest those the first time.
Vincent Huck: Going back the baseball analogy do you think we are in the 7th inning, 20th inning, 25th inning?
Josh Braverman: In the third quarter the 10-year [Treasury bond] made a new low, below 150 basis points. At that point in time, a common reaction at insurance and reinsurance companies was: '"What does the ALM look like? Where are we at from a duration mismatch perspective?".
The question we are asking ourselves now is: Is new business coming on the books appropriately matched from an interest-rate perspective? We are ensuring there is no interest rate mismatch that is going to materialise over a long period of time.
Iain Forrester: And is achieving that match a challenge? There are certainly a number of restrictions around use of interest-rate derivatives to extend duration, but do you find it challenging to match that duration with physical assets?
Josh Braverman: On the life side, generally not if it is a focus. For structured settlements and payouts and the 15, 20-year books of business, it has always been a challenge.
Alex Wharton: On the debate about more cautious portfolios, what is actually meant by 'more cautious'? Are we talking about moving into higher-quality assets, or is it about trying to smooth volatility?
Steve Hales: We definitely focus more on the volatility. We take a long-term view, and we try to make sure the short-term results are not distorted by volatility.
Wendy Yu: In the reinsurance business we obviously all care a lot about collateral requirements and, to the extent that there are asset portfolio ratings requirements in those collateral packages, we are definitely monitoring what kind of credit migration the asset portfolio could experience in a stress scenario. Not necessarily because we are not comfortable with the credit migration risk, but to know if we have the right assets to meet the collateral requirements.
Thomas Olunloyo: And does that have direct impact on your pricing?
Wendy Yu: Definitely. We want to not only hold onto our current portfolio in the next market dislocation, but in fact to have dry powder at that point to go into more credit. To ensure we can do that, we need a buffer in the initial asset allocation.
Kevin Hovi: Our US companies are managed under book-value-based regimes, so it gives you a little bit of wiggle room to look through some of the short-term volatility. We are really focused on avoiding default, avoiding downgrades, because of the capital impact on the US side, but it gives you a little bit more breathing room to ride out the volatility.
Thomas mentioned the alternative space: it is hard to think about it as a volatility-improving trade, but it does technically, because it is one of these things where you just do not get the marks as frequently, so in most models it smooths out some of your volatility. Fundamentally it may not be real, which is one of the hidden risks of the asset class.
Josh Braverman: One sector where there was not a lot of issuance and which was very hard to source in dollars was taxable municipal issuance. And now with rates going down, there has been some refinancing supply from US municipal issuers.
Kevin Hovi: That spread has really come in, though, hasn't it?
Josh Braverman: Yes, it has in line with most other investment grade sectors and supply has increased.
The BB vs BBB spread is tight and that has reduced the attractiveness of below-investment grade debt. A lot of people have said for a long period of time that some of today's BBB debt is tomorrow's BB debt. There were a number of leveraged issuers in the BBB space – AB InBev was one of note – that were very large in the credit indices, who were perceived to have very high amounts of leverage for BBB issuers.
That has improved, because many of those corporates have been determined to keep investment-grade ratings and they have the capital structure flexibility and cash flow in many cases to do so.
Alex Wharton: Are you concerned about over-exposure to BBB-rated assets in investment-grade books?
Kevin Hovi: You have to break it into the financials and the non-financials, because the reason the size of the BBB market has increased is most of the US financials are huge issuers and were rated A- or high pre-crisis. That feels like a different animal than a company who has done a ton of buybacks or gone M&A crazy and levered up the balance sheet like a high yield, so I feel like it is just credit selection. If you are just going to buy the BBB market as a whole, in coming years you are going to get burned by some of that, but if you are able to look at the fundamentals and sort out what is mispriced, there are still opportunities.
Jelena Strelets: We had seen practical examples of companies in the market considering equity investments to back long-term liabilities. Companies are trying to see how they can optimise their balance sheet using different investment strategies including investing in equity, and whether there is a benefit in doing that.
Thomas Olunloyo: And what is your view on how the regulator will respond to equity investments to back long-term portfolios in this current environment?
Jelena Strelets: Our discussion was positive.
Kevin Hovi: Has anyone done that?
Sylvia Oliveira: Use of equities is permitted per the BMA guidance. I have had detailed conversations with the BMA about how exactly to implement. To me, it not as advantageous as it first seemed when I read it.
Josh Braverman: They view certain cash flows differently. 20-plus cash flows are viewed a little differently than shorter.
Sylvia Oliveira: First of all, equity returns can only be used in the liability valuation for cash flows beyond 30 years. Furthermore, the BMA requires a haircut of the expected equity return by the standard deviation. In year 31, the return is reduced by the one-year standard deviation. In year 32, you use the two-year standard deviation, etc. This produces negative returns in the initial years, so use of equities is not likely to produce a balance sheet benefit.
Jelena Strelets: That's right, it may make more sense for a sufficiently long tail liability, but for a company that does not have that long tailed liability, probably not so much. The outcome also depends on the underlying equity investment, its return and volatility. Equity is often very capital-intensive as well, so the positive impact on reserves needs to be much more substantial than the adverse impact on the capital position for it to work. So, one needs to be looking at both capital and reserving positions and figuring out the optimal balance of impacts on these two.
Sylvia Oliveira: We have conducted extensive optimisation and structuring analyses, but we have not been able to make equities work for our portfolio. Also, new BSCR rules go into effect this year that impact the risk charges for both equities and the correlations between the different market risks. The changes will transition in over the next 10 years. The current equity charge of 14.4% will migrate to 35% or 45%, depending on the type of equity.
Wendy Yu: We also have strategic equity that has a lower, 20%, charge.
Sylvia Oliveira: As an additional offset, the BMA allows grandfathering, such that if a company has been holding equity for the past few years, they can maintain the capital charge at 14.4% for those equities.