There can be little doubt that insurers will be looking to review their asset allocation in the coming months. The advent of Solvency II, coupled with opportunities presented by the banking crisis and today’s competitive pressures, mean the type of assets that insurers currently hold may prove less than optimal for the future.
The good news is that the rule changes provide insurers with an opportunity to look at their asset and capital allocation more broadly. In a challenging investment climate, it makes sense to review how capital is used, seek out greater returns on that capital, and hopefully achieve a more optimal investment portfolio.
There are new opportunities emerging. The state-funded banks, for instance, are under pressure to improve their balance sheets and liquidity, and are regularly approaching insurers with potential new investment opportunities. Solvency II facilitates investment in a wider range of asset classes, providing that insurers can demonstrate an understanding of the risks involved and show that they are holding sufficient capital against those risks.
To date, many insurers are adopting a wait-and-see approach given uncertainty around the final rules, and even the timing of when this will come into effect. Some insurers are holding off on major asset decisions until there is further clarity, e.g. delaying property investment decisions due to the perception that it may be less attractive as an asset class under Solvency II.
Nevertheless, some insurers – annuity writers in particular – are likely to be hard hit by Solvency II. Historically, these players have held longer-term corporate bonds, to match their annuity liabilities. This asset class is likely to require increased levels of capital under the new rules, and many annuity writers have started to consider the implications of moving towards assets with a shorter duration.
We have already seen a number of insurers considering liquidity swaps with banks – opportunities for insurers to attain increased yields on their portfolios, in return for the ‘transfer’ of excess liquidity to the banks. The growing interest in such transactions has prompted the UK regulator to launch a consultation process with a view to issuing proposed guidance.
Meanwhile, some insurers are beginning to look at mortgages as an asset class, and considering the merits of purchasing existing mortgage portfolios versus originating mortgages. It seems likely that we will see an increased use of derivative instruments to improve capital efficiency, either by enhancing asset yields and/or reducing volatility.
So there are opportunities to improve the insurers’ capital position via asset allocation, but insurers do need to analyse the possibilities and understand the implications that different asset classes offer.
It’s not just a matter of investing in mortgages or divesting out of long-dated bonds or property portfolios, insurers need to understand the tax, accounting, and regulatory implications in addition to the capital implications, and the data and governance requirements to monitor and manage these asset classes.
Many insurers have built models to understand what their capital position will be under the new rules. Some may find themselves under some capital strain, which may require significant changes in their asset allocation. Others may have sufficient capital, however they could still benefit from changing their asset allocation. Almost all of those assessments will result in some change to investment strategies. And with longer-term investments in particular, the decision process needs to start sooner rather than later.