Ruth Farrugia: Insurers should always maintain a balance between underwriting pricing discipline and investment management to ensure that they have consistent and sustainable margins – especially when it comes to the life side – to protect against market fluctuation. This is the key to maintaining a competitive advantage whilst also being able to adapt to market conditions.
When you look at the last couple of years with the cadence and upward momentum of rates, having the flexibility to reprice to ensure that price fluctuation was reflected on both sides of the balance sheet, became extremely important.
Over the last couple of years, there have been two different themes when it came to loss budgeting. One big theme related to rotational opportunities; the industry was starved for yield for over a decade, and there was this momentum around rates where these opportunities became available to focus more on recurring income and harvest returns to bolster long-term margins. However, there were loss implications given dramatic rate movement. So, thinking through balance losses with shoring up income and budgeting across your balance sheet was a challenging dynamic.
Those two dynamics were common themes across both life and P&C – because everyone was looking to extract value irrespective of probabilities a ‘soft’ or ‘hard’ landing were, or somewhere in between. Everyone recognised that this great “all-in yields environment” was going to shore up at some point. This was because the trajectory of a 6-7% yield environment in high-quality fixed income that we saw over the last 18 months was not going to last forever – which meant the discussion would move to “how do I extract value?” and “where do I find the best opportunities?”.
"We have two ongoing wars, so there has been a focus
on first and second order impacts."
The risk/return opportunity set over the last few years was attractive there was no reason to go down in structure to capture good yields, we saw many opportunities in higher-rated structured finance and higher-rated investment grade (IG) corporates across both the public and private markets. It was a good environment to take advantage of great opportunities without going down too much in risk. That extraction of value and income enhancement was a prevalent theme across life and P&C.
The other theme related to risk management and portfolio positioning. We would always advocate sound risk management principles; we have always been “credit fundamentals first” when it comes to areas of vulnerability, so we are very proactive in managing portfolios. Management of earnings can also be a good risk management tool. Discussion around portfolio diversification is a big theme. Over the last couple of years, we’ve seen that idiosyncratic risk presented itself, and unforeseeable events coming from the tail event (the pandemic) with implications such as supply chain disruptions.
There were other components, too. We have two ongoing wars, so there has been a focus on first and second order impacts - trying to anticipate what’s around the corner and the possible long-term implications. There was also a short but sharp banking crisis that we had last year, which brought to the fore the importance of asset and liability management (ALM) – but, importantly, the known adage that banks live and die by confidence. It brought forth risk vulnerabilities and how we think about positioning.
All of this has brought capital market assumptions back to the fore: how do we think about strategic asset allocation (SAA)? How should we think about long-term assumptions when constructing a medium-to-long-term SAA in such volatile markets? A large majority of P&C and life insurers will do ‘soup-to-nuts-style’ SAA, which is either a yearly or ‘every so often’ event. Over the last 16 months or so, we've had the largest demand for SAA conversations and analytical work, where people want to know about capital assumptions when there is so much variability in the market.
Pricing asset allocation and portfolio construction support all this work. Looking at capital market assumptions, but also risk positioning around how they could position their portfolio.
In terms of advice to clients, stress testing of a portfolio is important, as is bringing the assets and the liabilities together. Liquidity stress testing means having to maintain that ALM discipline – which is bare bones –this is an important discipline when it comes to insurance asset management. Given the shape of the curve and the opportunities in the shorter end, there were a lot of conversations around duration and cash flow matching – while still being thoughtful about long-dated liabilities.
Ruth: Firstly, ALM and stress-testing are key. Then, liquidity and how you're positioned from a credit angle is also critical.
It's important, too, to have dialogue with your managers and see what credit analysts bring to the table. Get their views about portfolio positioning and areas where you want to peel off gradually.
We have been thoughtful when it came to certain segments, mezzanine and lower-rated structured finance, there is a lot of noise around some A and BBB-rated CMBS, given disrupted markets and we have been judicious when it comes to below investment grade exposure retaining a strong up in quality bias.
Ruth: It’s a hard dynamic because spreads have come in, especially across public markets. Most of the primary insurers coming in have no issuer concession. If you think about where we are inside the five-to-ten-year averages across most of the asset classes, with rates being where they are, it means the opportunity set has moved.
On the underweight side, we're remaining thoughtful when it comes to the office sub-sector of Commercial Real Estate (CRE), and that's across the board. In terms of CMBS, the newer deals have fared better. That market has benefited from technicals, but newer deals are priced better in terms of overall allocation.
"When it comes to overweights, private corporate credit
is still a strong green."
Collateralised loan obligations (CLOs) have been up in quality and are still biased toward AA/AAA. They've tightened a lot, but the market is very constructive on AAAs, and, with the rest of the capital structure underweight, spreads have come back in. Also, there is a lot of work currently being done on the CLO structure.
Regional banks will be underweight – the smaller ones more than anything else. And, famous last words, but equity more broadly is underweight. There is going to be comeuppance at some point in time, but it's still underweight currently.
When it comes to overweights, private corporate credit is still a strong green. Given our origination capabilities, we're always going to tilt more towards that side – so infrastructure, private corporate, IG, structure and protections, and financial covenants is a good way to be resilient within your portfolio and get spread premium to publics.
Within publics, we've also seen good opportunities on the ABS (Asset Backed Securities) side.
Ruth: We've gone from low inflation to the other end of the spectrum, which has created complex dynamics.
It has also created good opportunities on the portfolio side to upgrade income and focus more on recurring versus variable income. Budgeting for losses is the key theme from a risk management purview, but also from these rotational opportunities that we've seen along the way.
Then, there is the focus on ALM discipline. We would always discuss liabilities first, and our ALM is sacrosanct; maintaining that discipline should be ongoing. What we're seeing in the market now is increased cash reserves and high-quality liquid assets (HQLA) among insurers. That might be due to circumstance; the shorter end of the curve was opportunistic, as I mentioned, and insurers didn't have that much of a negative carry, so it wasn't too hard to stay short in instances and maintain an HQLA or less and cash reserves.
Some of it also relates to liquidity and maintaining the right level because you want to diversify your portfolio. Stress-testing on the liquidity side has been a prevalent theme, too – which means maintaining appropriate liquidity to be able to capture opportunities in the market as they present themselves.
This includes scenario analysis and regular stress testing, as well as the interplay between assets and liabilities when it comes to looking at what is cash flow matching and what liquidity needs you are going to have. That conversation will vary from client to client because it depends on the type of insurer and their allocation.
"From a liquidity view, we need to know what the adequate buffers are,
which in turn points to stress testing around scenario analysis."
It also means looking at specific business objectives and how these tie into capital assumptions. We’ve had conversations around potential downgrades that erode economic value and might impact capital buffers, especially on the life side.
From a liquidity view, we need to know what the adequate buffers are, which in turn points to stress testing around scenario analysis. The answer will differ depending on the type of client, their asset allocation perspective and portfolio positioning, as well as their aims.
Ruth: From a funding perspective, the environment continues to be constructive and positive. Even with upticks in SOFR from the back end of 2023, front-end sponsorship remains strong. It's a continuing theme that you see sponsorship reflected in attractive pricing, but there is still an available balance sheet too.
From the debt landscape, that paradigm remains constructive. When we talk to insurance clients, they're still focused on capturing and extracting value, and they want to know where they should place their money.
However, that balancing act between public and private remains a strong theme – and, on the ALM side, it's top of mind too. Insurers want to know how to secure opportunities whilst still being thoughtful on pricing – for example, new longer-dated business.
There are other areas too. It’s been a golden age for annuities, and we've seen those markets come back with a vengeance. However, maintaining thoughtfulness around ensuring you price adequately on both sides – liabilities and assets – is important.
Ruth: When speaking with insurance clients, the National Association of Insurance Commissioners’ (NAIC) private rating work is top of mind.
Whenever we’ve been involved in structuring our transactions and funds and sizing up the underlying issues, we have been thoughtful to ensure that our structures meet the definition of a true bond, understanding the underlying cash flows as well as -the appropriate risk/return profile.
On a global basis, there is currently a focus on reinsurance, especially with the Bermudian regulator looking at asset allocation within the broader portfolios. In the long term, there are Treasury and repo clearing rules that are coming through, and there is a T+1 settlement that kicks off later this year – which meant there will be new operational considerations.
Ruth: We’ve seen long-term sustainability targets set – which means that transition finance is and will remain a big theme.
There is so much demand on the infrastructure side, and we've been focused on renewables for many years, but the demand for infrastructure continues to increase. It’s not surprising, but the setting of targets and how we get there remains an area of consideration.
"Inflationary pressures and recessionary concerns continue to be agenda items
on the table when we talk to insurance companies."
It’s important to touch on geopolitics, which is skewing inflation risks – especially given that 2024 is such a large election year. We need to be looking at the future implications of outcomes.
Inflationary pressures and recessionary concerns continue to be agenda items on the table when we talk to insurance companies, and the ensuing implications from a long-term allocation perspective must be considered.
