Suo Wu: There are many aspects to consider in the constrained credit spread environment, one is that when credit spreads are tightening, it would limit the potential yield from credit investments. Additionally, regulatory constraints on the credit quality would further restrict the types of investments insurance companies can make, which vary across different regulatory regimes.
"Liquidity challenges arise in a constrained credit environment. In the insurance
world, there's always the cash flow needed to cover the liabilities."
In addition to these challenges that investment teams at insurers are facing, insurers also have to manage the reinvestment risks. When the initial holdings mature or new business is issued, the insurers get new cash, which needs to be reinvested. In a constrained credit spread environment, it will be an interesting challenge. If insurers reinvest into assets with similar credit quality, then they are sacrificing the earnings that they could potentially get from going elsewhere with higher risk.
On the other hand, liquidity challenges arise in a constrained credit environment. In the insurance world, there's always the cash flow needed to cover the liabilities. Selling those assets to meet liquidity needs could be a challenge in such an environment. In that case, traditional strategic asset allocation (SAA) may not work.
Going forward, investment teams at insurers may need to consider the investment risk, the liquidity needs, and the future stress scenarios, when developing their SAA. That's why under a constrained credit environment those insurers or insurance asset managers should think more strategically about the SAA to adapt to constrained credit spread environments.
Suo: The interest rates have been twisted or inverted, but overall, we see a decreasing trend in rates. Currently, there are opportunities for asset managers, but there are other challenges present too.
"My recommendation for insurance asset managers is to strike
a good balance between the high yield and the high risk."
Some of the portfolio managers did duration mismatch to take advantage of the changing interest rates. However, in a decreasing yield curve environment, normally the default risk and credit risk will increase.
My recommendation for insurance asset managers is to strike a good balance between the high yield and the high risk. They should approach risk management more strategically, consider the diversification benefits, and emphasise a lot of stress testing to make sure that the investments can withstand potential future shocks.
Suo: The barbell approach is tied to various investment concepts. It’s one of the methods those insurance companies can pick, allowing them to invest in both high-risk and low-risk assets in a barbell set-up, as well as the high-tenured assets and low-tenured assets. Recently, we have also seen a barbell shift from liquid public assets to illiquid private assets globally.
The benefit is that high-risk or high-tenure assets can generate good returns, while lower-tenure assets can give a good amount of liquidity. When insurers need cash to cover their liability outflows, they can sell those liquid assets quickly without needing to sell the long-tenure assets. This avoids realising gains or losses, especially in fluctuating interest rate environments and helps mitigate issues like IMR or tax complications.
There are also opportunities for insurers because if they can balance these factors well when developing SAA, they can gain a competitive edge compared to competitors. Traditional SAA tends to optimise for a single period, focusing on asset returns and volatility. However, it’s crucial to also account for future investment strategies and future liquidity needs.
So, the leading future SAA should consider the liability impact over time and account for the insurance dynamics, such as the investment risk and the liquidity needs in the future. Whether it’s a barbell, laddered, or another approach, this type of strategy can help insurers generate a good amount of returns while managing risk effectively.
Suo: The misconception is that people believe the barbell approach can protect them in the downturns or market shocks – assuming that because they have both liquidity and earnings at the same time, they’ll be safe. However, in extreme market conditions, the liquidity could dry up, which means the approach may not work as expected.
"There's a misconception that if people are implementing the right approach,
then they can manage all downside risks effectively."
When thinking about SAA, it’s important to consider the impact of liability. Insurers should run stress tests under different stress scenarios to fully understand the risks embedded in both assets and liability. There's a misconception that if people are implementing the right approach, then they can manage all downside risks effectively, but that’s not always the case in severe conditions.
Suo: SAA is very important for addressing a lot of the challenges that insurers are facing. Traditional SAA Is focused on current conditions – worrying about the yield curve, credit environment, or barbell strategies, etc. But often, this approach focuses too much on the present stage and not enough on the future.
It’s essential to consider a more dynamic method when developing SAA, one that takes into account liabilities and ALM constraints over time. This method can give insurance asset managers more confidence in their investment strategies, as it aligns better with long-term goals and changing market conditions.
