What if low interest rates are not an anomaly?

Low interest rates are often talked about as an anomaly that might go away in the short, medium or long term, but what if it is not the case? In part one of this Insurance Asset Risk / Aegon Asset Management roundtable, insurers discuss their views and the actions they are taking on their fixed income portfolios.


Corrado Pistarino, chief investment officer, Foresters Friendly Society
Daniel Blamont, head of investment strategy, The Phoenix Group
Emily Penn, capital initiatives and investment director, LV=
Gerard Moerman, chief investment solutions officer AAM Europe, Aegon Asset Management
Hayley Rees, strategic assets consultant, Pension Insurance Corporation
Mike Ashcroft, head of investment capital analysis, Scottish Widows
Prasun Mathur, private assets lead, Aviva UK
Russell Baird, senior investment solutions consultant, Kames Capital

Chaired by Vincent Huck, editor, Insurance Asset Risk

Vincent Huck: The topic of low interest rates is the flavour of the month, it is what everyone talks about. Is the low interest rate environment something that you are worried about?

Corrado Pistarino: When we refer to low interest rates the message we effectively convey is that we are experiencing some form of deviation from a level perceived to be the norm. Implicitly, we assume that such a deviation, as any other anomaly, will dissipate in time through a process of mean reversion.

But what if this was not to be the case? With the 50-year gilt just above 1% in yield terms, the market believes that we are going to be in this position for a very long time indeed, so 'low' may not be that low after all.

My point is that, if we accept that we have shifted to a different paradigm in terms of absolute level of interest rates, this would change our perception not only in respect of current asset valuation - assets may not be as expensive as people are led to think - but also in terms of our expectations as to how those same prices will evolve in time.

I think where we allocate is one of the biggest challenges that we have to face in the current macro environment.


Emily Penn: In life insurance, we have to buy assets to match our liabilities, so in some sense low interest rates are just something we have to live with. It has a greater effect in regards to the product that we are selling and the price we are able to offer to consumers, rather than what choices we have in terms of the investment portfolio.

Perhaps, with with-profits funds you have a bit more flexibility to take some view around duration. I am, until the end of this year, responsible for the general insurance portfolio as well, and they have perhaps been hit a bit more by the low rate environment, because investment return is a key part of their profit.

Emily Penn

However, on the life side, when you are managing an annuity fund, you have no flexibility around duration. However, some firms have been badly hit by not having hedged the interest rate sensitivity of the capital requirement. The SCR [solvency capital requirement] and risk margin are sensitive to interest rates. Falling interest rates has meant these capital requirements have increased.


Corrado Pistarino: The fact that different books of insurance business behave quite differently is a very important point. In particular, a key consideration is the notion of 'risk-free asset' is different for different books of business.

If I consider the cost of guarantees, the risk-free asset is the interest rate duration-matched zero-coupon bond in the replicating portfolio. In that respect, the absolute level of rates is irrelevant: the cost of guarantees should be hedged from inception and consume ideally a zero risk budget.

When it comes to the asset share portfolio, interest rates represent a source of total return alongside any other asset class. In this framework, cash is the risk-free asset.

In the annuity book, the risk-free asset is the interest- and credit duration-matched asset. Again, the absolute level of interest rates is of marginal importance.

The business does not make money from the interest rate component of the asset allocation; the core value driver comes from credit spreads vis-à-vis the actual default experience. The absolute level of interest rates is relevant to the extent that it is a key signal for the state of the economy and therefore a major determinant of asset valuation. It propagates its effects into the economy through different channels: funding costs for businesses and households, debt sustainability, asset supply, etc.

In summary, as Emily said, insurers have different books of businesses, and in some of these books of businesses the absolute level of interest rates is not a major value driver.


Russell Baird: I agree that the liability is paramount to insurers and insurers should not lose sight of that, but there are parts of the yield curve, especially at the short-end, where we see a growing interest from insurers. It is about making a risk-aware investment, being mindful of liquidity as well, and about moving up the credit spectrum where they can actually take a modest increase in return.


Vincent Huck: What are you doing in the current low interest rate environment on your fixed income portfolios?

Daniel Blamont: For me, there are two impacts. First there is the direct impact. If you are well duration matched, as Solvency II encourages you to be, the only impact you really have of low interest rates is the risk margin.

If you hedge it you have to put capital aside. If you do not hedge it, your balance sheet is exposed to rates falling. There are probably a lot of companies using swaptions to try and strike a balance between the two. Secondly there is the indirect impact. As Corrado was saying, in itself low rates do not really have an impact, other than if yields are depressed everywhere, if the European Central Bank and other central banks are pumping money into the system for example. The indirect impact is where probably a lot of us are trying to diversify as much as we can, precisely if we need to be exposed to an asset that has been inflated by someone else. But we are forced buyers of fixed income, to a certain extent.


Hayley Rees: That is very true, and it does drive diversification, but it is also about what is available in the market to actually buy. And so you still have to buy a lot of these assets, because that is what is available. However, it does make everybody think about more a diverse range of assets. That goes back to what Russell was saying - some people might think about where they are in the risk curve. However, obviously, as insurers with annuities, you are governed with what you can and cannot do by the UK regulator the Prudential Regulation Authority. You have to work within certain parameters.


Mike Ashcroft: Just to reiterate what Emily said, the customers are the ones who ultimately lose out, because the pricing we can offer them for the products are driven primarily by longevity assumptions and achievable investment yields, and yields have been low for a long time. That is an issue for the viability of insurance companies. Those of us on the investment side are forced to buy the assets at these yields to make sure they match the liabilities.

There is a real risk, which ultimately hits the customers. Insurers have been be trying to manage that by potentially taking more risk to get more yield, and whether that is through more direct credit risk, or 'complexity' risk or illiquidity risk. The focus for many is taking on more potential illiquidity risk to gain enhanced liquidity premia. Those are the levers that most large annuity-writing insurance companies have to pull in this space.

Gerard Moerman

That is nothing new. This environment has been around for a while now. Every conference I have gone to in the last five, six, seven years has been about low interest rate environments. It is all the same solutions people talk about. There is not very much really new coming out to solve it, because there are not really very many brand new solutions. It is about trying to reach out into wider markets to make sure you are diversifying if you are taking those extra risks in different places, so you do not have the problem of concentration.


Prasun Mathur: In this environment of lower rates, we are very cautious of the credit risks that are in the market, so active portfolio management and active stock selection is extremely important. We are firm believers in that, and it certainly drives our appetite for different kinds of credit.


Hayley Rees: There are two aspects to it. There is the existing book and how low interest rates affects the metrics on the existing book; and then there is the new business. You can actively manage the existing book, diversify it and look at different risk brackets. When it comes to the new business side, that is about what portfolios you are able to purchase, and that affects the price that you are willing to pay, or willing to offer customers.


Russell Baird: There is also now a lot more institutional money chasing the same assets, which is a problem. It is causing more insurers to look to diversify their books, and become more global in their allocations and to hedge back the currency risk. I also agree with Prasun that for an insurer, active management can really add value at this point in time.


Gerard Moerman: What I see happening in Europe is more of a drive towards rethinking credit risk, complexity risk, illiquidity risk in order at least to have a little higher yield. That compensates the premium that clients need to pay. However from the perspective of a pure life book and matching it with assets, then you can say it is really irrelevant where rates are, because basically, that is your 'ground level'. Your asset allocation will not change that much, as the major reason is matching. It is within the (investment grade) matching portfolio where we witness more diversification and the move towards alternatives and illiquids.

Would you agree with that remark?


Emily Penn: It is a different position between a with-profits book and an annuity book. In the with-profits book we can make changes to the strategic asset allocation, which we review on a regular basis. The annuity book is buy-and-hold and any changes need to satisfy pre-agreed trading guidelines. Diversification is certainly a big theme because of the gradual downgrade of portfolios towards BBB. Annuity firms are diversifying outside of the UK, as well as by looking more at illiquid assets. However, within the with-profits fund we have more flexibility to make more substantial changes at our will, rather than going through all the regulatory barriers and hurdles to get changes done.


Corrado Pistarino: At Foresters we are actively engaged in broadening the investment universe offered to our members. However, there are obvious constraints a small insurer has to face. One example is the constraint around the currency exposure, especially with respect to illiquid assets that are expected to be part of the Society's portfolios over a significant time horizon. Because not only would we be investing in an asset that is expected to be part of our asset allocation for a significant amount of time; if you were to set up a currency hedging programme, we would be committing the Society to an additional operational stream for the lifespan of the investment. For a small company, this extra layer of complexity may not always justify the incremental benefits in terms of return and portfolio diversification.

Corrado Pistarino

We are looking actively at Alternative assets, as everyone else is. However, we recognise that suitability remains a key requirement, especially for a with-profits fund. From the point of view of expected returns, the illiquidity premium usually associated to Alternative assets is very appealing. From a risk management perspective, though, investing in Alternatives increases portfolio opaqueness and requires a thorough due diligence process as well as robust monitoring capabilities in line with the Prudent Person Principle.


Russell Baird: The large insurers typically have the resource and capability in-house to implement these operational programmes. For the smaller insurers however it is going to be a bigger challenge. That is where you would see more partnerships with asset managers emerging to help support them. These smaller insurers might look for more commoditised, less bespoke but nonetheless relevant products.


Emily Penn: There is also the difference between firms that have a standard formula and the firms that are on an internal model. We are using the standard formula, and we are very constrained to invest in public rated fixed income instruments.


Mike Ashcroft: There is a cost element as well, for smaller insurers. Given yields are very low, that extra return you get on alternatives is good, but it is not amazing. The question is, is it enough just to cover the costs? There is a barrier to entry into this type of market for smaller insurers, because that market has not really been commoditised into an easy solution yet, one that ticks all the regulatory boxes that a smaller insurer can just buy. Certainly, all the ones I am aware of that can do it are the big players, that go in heavily with lots of internal resource, lots of 'risk people' supporting all the risk understanding and challenge. It does pay off, but it is not a small investment.

Part two is available here and part three is available here.