Capital optimisation: assets versus liabilities

Even if returns on insurers' traditional investments are lower now than they were 10 years ago, the insurance companies profitability is driven by investments. However that is not always integrated in the firms' business model, as participants discuss in part two of this roundtable from Insurance Asset Risk and Aon.

Vincent Huck: What new assets are you looking to invest in?

Guillermo Donadini: Today, we are very active in commercial mortgage loans and mid-market loans. We are evaluating other assets that might be too long in duration for us, like equity release or infrastructure. However, there are a lot of new asset classes which are great for life insurers, but for P&C where we are much shorter on the curve, there is not really that much. 

Gerard-Jan Van Berckel: The thing is, with alternative asset classes, yes, there is a range of assets available, but finding the right asset is the difficulty – finding an asset that is unique and gives you the additional yield that you are looking for. If you look at infrastructure, is it really so interesting, still? 

Guillermo Donadini: The other thing is sourcing those asset classes, particularly the illiquid ones. Most of our investments are done with in-house asset managers, so we have very honest conversations about how much we really can ramp up our exposures on mid-market loans, on direct lending, collateralised loan obligations or collateralised mortgage loans.   

However, what I am hearing from the market is that it is very hard when you go to a third-party asset manager, as they might promise you a certain level of exposure to a particular asset class, and a year later you only have one third of what they promised, because there was not enough sourcing.  

You may have the best SAA in the world, but to execute on it is hard. You might start thinking about building your own capabilities if you are big enough to do it. At the same time, you are not going to do that unless you need those asset classes for the next decade or so.

Sometimes the asset managers are more excited about making you commit capital into something, but not really about delivering. There is going to be a tension there for quite a long time.

Gerard-Jan Van Berckel: That is where skill comes in. If you have large teams that can source these specific deals, or certain managers with certain capabilities then you are able to access these types of deals.

However, in your case, it is one thing to select the manager, but you also need to understand actually what you are buying.

Guillermo Donadini: Absolutely. Even if you go to an external asset manager, you need to have people who can check what the manager is doing and evaluate if it is done according to the mandate specification.

That is why this problem of low interest rates actually triggers so many operational challenges, from including asset classes into your model, understanding them, how they look in terms of capital optimisation and then execution and making sure that you can evaluate what the asset manager is doing. It is a massive change in the way we have been doing business, in an industry that has been making a lot of money by just buying government bonds 20 years ago.

Gerard-Jan Van Berckel: We agree that there needs to be more focus on the investment piece versus the insurance activity, and more coordination between the liability and the asset sides.

Christian Bird: How do we get the chief executive at the top and the analysts who both comes from an underwriting background to be comfortable with that? When they see a company moves 20% into equities they are going to be nervous.

Guillermo Donadini: Have you ever asked the CEOs of the industry what they think about the investment function role in their business model?

Christian Bird: There are more who are realising that it can make a difference, particularly when underwriting margins are so tight. But again, it is the analysts who might take a concerned view, especially if you get that quarter where you make a loss on equities.

Vincent Huck: Can applying a holistic approach to capital optimisation create some tensions between the actuaries on one side and the investment team on the other side?

Christian Bird: I would not say it’s ‘tension’, I’d say ‘nervousness’. Underwriters and especially long-tail underwriters, would love it if you could get more return, because then they wouldn’t have so much pressure on their rates.

I just think people are nervous; they saw what happened in 2008 and they do not understand it, whereas they can understand catastrophe risk. But they do not really understand that whole investment side of the balance sheet.

Gerard-Jan Van Berckel: Although the underwriting part of the business is being commercially incentivised by the management team as this is the business plan, when underwriting is at a loss, then the investment side is asked to make it good.

Peter Helt: It is going back to the resource allocation. You have, maybe, a ratio of 50 people on the underwriting side to three on the investment side. When you say there is ‘nervousness’, you do not hear the story about the stock market ticking over. All they hear is the big news story, that equities crashed. That is where it comes from, and you do not have 20 experts saying ‘Oh, actually, no, that would not have affected us because we would have done x, y and z,’.

Emily Penn: I am speaking from a slightly different perspective,  because I am more from a life background, but what we have done, in terms of our governance over the last few years is gradually to bring the capital and investment pieces much closer together. We now have a chief capital investment officer (CCIO) rather than just a CIO. Under the CCIO we have the capital methodology and capital management piece, the investment piece, and the ALM piece.

We have done this to ensure everyone is joined up given the strong links between capital and investment. It avoids issues such as  an investment strategy change causing an unexpected blow out on capital’. We are trying to iron out all of those wrinkles much earlier on in the process.

Also, from the capital side, if we do a larger insurance transaction it is completely changing the profile of our liabilities, so our asset portfolio needs to be rebalanced in line with that transaction so that we are not running a load of investment risk for a period after that transaction.

Eric Paire: It is probably more logical for a life company to think about it this way, because you think ‘matching‘. But this may happen pretty well in the P&C environment as well.

Guillermo Donadini: In life insurance, CEOs of life firms understand investments, it is part of the business process. But we have a new environment now, and if other industry players do not adapt, it will be hard for them.

Christian Bird: There were signs of people adapting with the advent of Bermuda’s total return reinsurers. The business model was that at any time you would deploy your capital towards seeking underwriting or investment returns, depending on what looked most attractive at the time, potentially shifting if things change. A few companies are doing that, but the idea doesn’t appear to have really taken off.

Guillermo Donadini: But they are non-public companies. It is much harder for big companies which are public, because it is going to be very hard for them to convince the market a given course of action is the right thing to do from the long-term perspective.

But not adapting is like having a Starbucks, where you sell coffee but you do not sell cheesecake - it is an incomplete business model.

When you have conversations with analysts they focus on certain metrics like accounting figures or combined ratios, and they make recommendations on those metrics, which are basically losing sight of the economic value of the business.

Martin Pfutzner: It is easier to express things in an RoE metric than by a combined ratio because the RoE metric unifies the investments and the liabilities.

You can work out the time horizon, the capital charges and the profit implication for every line of business that you write, for every big reinsurance contract that you buy, for every asset class you go into. From that, you can work on an RoE and every time we make a decision, you check if the RoE is close to your target or not. That lets you combine the whole thing into one, but it is a journey to get there and you have to get people on board.

Christian Bird: I agree that it should be a ‘holistic RoE’, but for investor analysts it is all about the combined ratio.

Peter Helt: Going back to the Starbucks analogy. They are a coffee expert, they have got 20 baristas, that is their business. You do not see them have 20 cheesecake staff; they are not building that up. Until you slowly start to build up two expertises...

Guillermo Donadini: But they make money with it, and when you do not make money any more with coffee, you need to ‘find the cheesecake’.

In the future, you may find an insurer that will sell insurance in a completely different way to the model we have now. Maybe tomorrow Google will start underwriting commercial P&C insurance with better algorithms and all the information that is required, and maybe in a way that doesn’t require an investment department. Then maybe you can say it is ‘pure insurance risk’. But today, both insurance and investment risk come together.

Emily Penn: Is there not an education piece that is needed? I agree, investors invest in insurers because they want to take insurance risk, but what they are not realising is that the other half of the balance sheet is assets. 

Vincent Huck: One of the things that IFRS 17 will do on a very high level, is to show what the drivers of profitability are. It will clearly identify whether the profits of an insurer come from the investment or the underwriting side. So could that have the impact?

Guillermo Donadini: So let me ask you one question, as everyone here is more actuarial than me who is pure investments: did the industry ever made money in the past without investments?

Christian Bird: In the hard market times after 9-11 and hurricanes 2005, yes, combined ratios below 100.

Eric Paire: Can I just qualify that, depends what you mean by ‘the industry.’  The reinsurance industry, maybe, because it is more reactive to pricing. The P&C industry, looking only at the US, they always struggled to cover the cost of capital for decades without the investment income.

Lloyds has never produced a pure underwriting profit for years, until the past, probably, ten years.

So the answer is probably no overall but it confirmes the fact that investment is inherently part of the insurance product – and the separation is partly an artificial one.

Guillermo Donadini: So is it possible to make money without the investments then, bearing in mind it never happened?

Christian Bird: If it is the same for everyone, it is competition isn’t it.

Eric Paire: Exactly. Then you would pay more for your car insurance.

Guillermo Donadini: So why, if, historically, we have been making money from the asset side, now we are denying that possibility of doing more.

Christian Bird: I do not think the strategies are any different; people have always been conservative on the asset side. You could make 6-8% on just treasuries in years gone past, whereas nowadays you cannot. So I do not think people have got less risky, it is just yields are so low that you do not automatically make money on the investment side now.

Guillermo Donadini: If you look at banks they do a lot of things that provides a lot of return. Things that we do not because we didn’t have to. But now, why we do not see more speed in terms of doing more on the asset side if the business, at the end of the day, will always need that asset side, unless Google tomorrow comes up with an algorithm.

Christian Bird: That does create risk though.

Peter Helt: I think that goes back to the point that there is no drive from the public investor to do both. I agree, from the insurance perspective, it is wasted money sitting there.

Interest rates rising

Vincent Huck: Expectation is that in the next five years interest rates will go up, so what happens then?

Guillermo Donadini: If we got real interest rate of 4%, as we had in the 1990s, we will go back to the bad habits, if that is possible, I do not think so.

Christian Bird: If nominal rates get back up to where they were then we would go back to a world where insurance pricing is tighter, and you just rely on your 5% investment income from your treasury portfolio.

Guillermo Donadini: And if inflation is 6%?

Christian Bird: That is the question. But can the world go back to 6% inflation and high interest rates in an attempt to control it? It would be a crash!

Guillermo Donadini: The world is at very high debt levels. We need to decrease that level of debt and it could take 30 years. Maybe we are not going to have 6% inflation, but we may have a level of inflation that gives a negative 1% per year on real terms, and this is going to be painful.

Atanas Christev: It would have to change the mandates in the central banks. The way they are now, there will be a conflict.

Guillermo Donadini: Actually, some banks analysts have started to question the independence of central banks. And also some politicians asked the question why central banks have so much power when nobody elects them.

Martin Pfutzner: Central bank independence has always been a myth, and in good times that was not really an issue but in a rising interest rate environment this is likely to be tested...

Atanas Christev: Or what could probably start getting challenged is not so much the independence itself, but just the nature of the mandate of the central bank. Should their mandate be only about price stability or the stability of long-term rates?  Maybe the mandates could evolve further in the direction of social goals?