Taking Stock and Planning Ahead
“Team Permanent” are several points ahead of “Team Temporary” now in the inflation forecasting game… except it’s not a game. The real-world impact is creating a cost-of-living crisis in the Developed world and possibly worse elsewhere. Games also have rules, umpires and are finite. Markets do not have an ending, hopefully – they roll on. The ‘rules’ keep changing. Economic historians, listening for distant echoes to inform the future, are increasingly in vogue.
Central banks, whose primary objective is to maintain price stability, are scrambling to retain credibility in the face of continuing high consumer price prints. Central bank actions should act as a dampener to (Soros’) reflexivity, or feedback loop of market participants. There is certainly a risk now though that a blinkered view on fighting supply-side inflation by dampening demand-side (with higher rates) will lead to significant recession, and potentially even a collapse in prices. The economic historians meanwhile tend to be more focused on the 1970s and warn of continuing ripples of inflation without Jerome Powell et al channelling Volker-like discipline.
What we do know is that the cost of capital is going up and its availability is going down. Volatility is likely to stay with us for some time, and long-term investors (and hence risk assets) do not like a lack of predictability.
It’s been an extraordinarily difficult period for insurance companies to model and price their liabilities, manage assets versus those liabilities, steer accounting outcomes, protect capital and liquidity all whilst forward planning from both an economic and regulatory perspective.
What are some of the related key questions, stresses, and strains that we are seeing on the asset-side in insurance client portfolios and our thoughts?
Countercyclicality versus procyclicality
Ideally investment decisions such as asset allocation are countercyclical – buy when cheap, sell when expensive. However, insurance constraints are often procyclical, with risk capital weight increasing as assets cheapen (thereby reducing their attractiveness to the insurance balance sheet). GAAP also plays its part, with gain/loss steering lowering insurers’ flexibility to react to more significant market opportunities.
A simple way to address this issue is to sweep cash from all portfolios (dividends, coupons, maturities etc.) into a central account, rather than re-investing into the ‘home’ portfolio. This cash (alongside any new premium income) then allows for a level of opportunistic reallocation without requiring security sales.
Using downside protection, particularly to risky asset portfolios, can provide structural resilience. Whilst the protection carries an ongoing cost (option premium) the strategy offsets drawdown and increased capital consumption, increasing allocation flexibility when valuations are at more attractive levels.
Basis Risks
Extreme market conditions have exposed many previously (relatively) stable relationships that underpinned proxy decision making. For example, even at the headline level Consumer Prices Indices within Euro area economies have varied significantly1. These basis risks support the approach of diversifying when selecting real assets versus real liabilities when no true like-for-like hedge is available, incorporating, for example, equity and property alongside index-linked bonds.
Swap and bond rates have disconnected, with swaps underperforming high quality bonds, causing significant performance differences for proxy bond benchmarks to swap discounted liabilities. This has also resulted in investment opportunities; with issuers whose prices tend to align with swaps cheapening inline. Low risk, low capital, assets like covered bonds are offering their best outright and relative (versus government) yields for years.
Regulatory change
Using mutual funds for opportunistic and satellite allocations is less attractive under the updated IFRS (International Financial Reporting Standard) classification. Larger accounts and more complex account aggregation methods are needed to maintain amortised cost accounting benefits. IFRS9 may therefore hamper insurers’ appetite to allocate to higher risk asset classes if costeffective implementation is difficult.
ESG
Recent events have underscored global connectivity. Whilst generally recognising man-made climate change, there remain significant differences of opinion between countries on how they are best addressed and on what timeline. 2021 was the 16th consecutive year of decline in global freedom2 which reflects that countries’ policy decisions are often made for the benefit of the few versus the many – locally and globally. Fragmented regulatory approaches, conflict, opportunistic profiteering from (typically private) enterprise have all contributed to, recently, derailed attempts at addressing global challenges, including decarbonisation. Related impacts on energy markets have helped roil financial markets. To manage risks and assess opportunities, over the long-term horizons needed for our insurance clients’ portfolios, portfolio managers and their decision support tools need to be supported by appropriate sustainability data, research and stewardship advice.
How are AllianzGI positioned to support insurers with these types of challenges?
Our vast experience of insurers, hardwired via our parent company, ensures the knowledge and flexibility to assist. This may be through something as relatively straightforward as an agreed Key Performance Indicators (KPI) assessment process, which formalises flexibility to respond to clients’ holistic requirements (e.g., P&L steering versus a pure relative performance focus alongside incorporating decarbonisation targets). Elsewhere it may incorporate solvency-capital adjusted optimisation to asset allocation coordinated with downside P&L and capital protection (risk-controlled strategies). We would welcome a conversation on how our global teams can assist with your insurance asset management challenges.
1) French YOY CPI 6.1% as at August 2022 versus Germany at 7.5%, Spain 10.8%, Italy 7.9% and euro area average of 8.9%
2) https://freedomhouse.org/explore-the-map?type=fiw&year=2022
