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Christopher Wright: From a markets perspective, we’re continuing to see high rates and rates volatility driven by the prolonged inflationary backdrop, but with surprisingly sanguine risk markets and tighter spreads. It's quite a distinctive market environment, with many knock-on effects in areas that are relevant to the sector either directly or indirectly.
Higher rates have reduced funding deficits for pension schemes and materially improved solvency ratios among life insurers. This puts positive pressure on the pension risk transfer (PRT) pipeline and brings new opportunities and challenges.
"Asset allocations themselves naturally respond to the market conditions, with gilts looking relatively attractive within the context of tight credit spreads."
For example, many schemes are reaching maturity earlier than expected, with strategic asset allocations (SAAs) that are not necessarily fully ready for buy out; this presents opportunities for insurers to step in and help with that transition.
Asset allocations themselves naturally respond to the market conditions, with gilts looking relatively attractive within the context of tight credit spreads, and certain real assets not re-pricing as quickly in response to higher rates.
These dynamics are also taking place within the context of various regulatory reforms. We've seen much of the Solvency UK reform come through, with changes already in place, such as to risk margin, and the PRA more recently confirming policy with respect to the Matching Adjustment. Insurers are working through how best to adapt to these changes.
The sector has also been managing the transition to IFRS17 and IFRS9, which is ultimately an uneconomic reporting change. However, what it does present, from a hedging perspective, are opportunities around how insurers can better manage hedging across different bases, and in particular increase the focus on hedging for the most economically and capital efficient outcomes.
Chris: Interest rates at current levels are of course not new historically, but the recent experience is new for many currently working in the market and happening at a particular point with respect to pension scheme maturity. Furthermore, the size and speed of the recent rates increase, after a decades long bull market for fixed income, was very significant.
"From an insurer’s perspective, it pays to in any case to always think about higher rates scenarios' as part of broader risk management."
Schemes that were expecting to reach maturity over a number of years but weren’t fully hedging the value of their liabilities with respect to interest rates have approached the buy-out stage much more quickly. This brings challenges for the Schemes, which insurers can help support.
From an insurer’s perspective, it pays to in any case to always think about higher rates scenarios' as part of broader risk management. Nonetheless, as the fiscal and monetary response to the pandemic played out and the inflationary pressures became more apparent, thinking was more focused across the industry on what higher rates would mean, and ensuring the right preparations were in place to manage and perform well within that scenario.
However, as the paradigm shift has been rapid, and it’s fair to say that the market as a whole is still adapting to it, this is one reason that despite the larger PRT pipeline, transactions are being managed prudently.
Chris: We’ve now seen much of the Solvency UK reform come through and so the impact of risk margin reform is already known. More recently we’ve had the PRA confirm their policy with respect to the Matching Adjustment.
The principles have now been clarified, which has been welcomed, but insurers will still be working through the implications for existing and new asset classes. I expect the impacts will therefore resemble more evolution than revolution.
Nonetheless, there’s a definite enthusiasm across the industry for opening up new capital and investment opportunities, which can benefit policyholders and improve the flow of capital across the UK economy.
Chris: From a balance sheet perspective, we’re seeing many across the industry considering their hedging strategy in response to the significant increase in interest rates, with some choosing to increase hedging and ‘lock in’ some of the solvency benefit. There are a number of different schools of thought here and it depends in part on broader strategy and balance sheet conditions.
From an SAA perspective, spreads remain tight, and there has been less incentive to issuers to raise longer-dated debt with yields as high as they are.
"Efficient cash management is also increasingly important given the short,
dated yields now available."
In contrast, treasuries and supranationals naturally look more attractive in this environment than pre pandemic, particularly on a risk adjusted basis, and investors are reconsidering the role these assets play in their SAA as a result. Efficient cash management is also increasingly important given the short, dated yields now available.
It’s always important to be prepared for a range of macroeconomic outcomes rather than predict a single base case. That said, whilst the increase in rates has been beneficial for insurers and pension schemes, If we do see rates somewhat fall from here, I don’t expect this to materially change the industry wide picture, given solvency and funding levels are generally very robust, and risk asset markets would generally welcome an easing in rates.
There are of course a number of known geopolitical risks including across the Middle East, Ukraine, and Taiwan. There are also a significant number of upcoming elections throughout 2024 – notably for me the US, UK and France. Amongst much else, these factors can play a meaningful part in the inflation and therefore rates picture.
Looking at the UK specifically, given the fiscal constraints, I’d expect any government to support private sector investment.
Chris: The use of algorithmic approaches to optimise balance sheets has been around for some time and is now quite prevalent across the industry; this is certainly something we’ve found relevant. I wouldn’t typically classify these approaches as ‘AI’, but they can nonetheless add material insight and value. In particular, these tools help identify opportunities and solutions more quickly than a human, and in effect shine a torch to illuminate potential avenues, even if a human then takes that insight and develops it into a full solution.
"We can build clever optimisers, but they need sufficiently accurate and quick underlying models and data to work on."
The ability to sufficiently and quickly model a balance sheet under a range of ‘what if’ scenarios is key to placing these ‘smart’ tools on top, which can then help rapidly explore risks and opportunities. This is somewhat analogous to the problem of needing data to feed AI – we can build clever optimisers, but they need sufficiently accurate and quick underlying models and data to work on.
