Mr Fred Ngan of EY Hong Kong explains how life insurers in Asia Pacific can optimise their strategic asset allocation as the investment, regulatory and market landscapes continue to evolve.
Many life insurers that pursued de-risking activities after the financial crisis are revisiting their strategic asset allocation (SAA) and exploring investment into higher-yielding assets. Conventional bond strategy is becoming relatively less attractive due to pressure from low yields and increased credit volatility.
As the regulatory environment changes and insurance market competition intensifies across the Asia-Pacific region, risk and capital profiles continue to evolve. These factors will likely have investment implications on the cost of capital and pricing competitiveness.
On the supply side, it is encouraging to see that alternative investment markets such as property, credit lending and infrastructure have opened up for insurers. However, without a sound asset liability management (ALM) strategy, insurers chasing high yields and short-term tactical gains could put their earnings and solvency position at risk. As a result, we believe that insurers should look to optimise their risk-adjusted return via the use of a redefined efficient frontier.
In our latest publication “Strategic asset allocation for Asia-Pacific life insurers”, we explore a new efficient frontier that is customised based on a life insurance company’s key performance indicators (KPIs), risk appetite limits and capital constraints.
This approach integrates investment, risk and capital management into one powerful framework. We also provide a glimpse into an EY proprietary SAA database that allows asset allocation and assumptions to be compared with industry practices.
Why optimise your Strategic Asset Allocation?
In Asia-Pacific markets, we found that most life insurers’ SAAs can be further optimised. This can be explained by local regulatory constraints and capital charges, limited financial instruments in domestic markets, and complexity in managing the risk and return trade-off from the various perspectives of shareholders, policyholders, regulators and rating agencies.
ALM is not a new concept: the approach to SAA optimisation is still evolving. The traditional “asset-only” investment model does not work well for insurers that intend to focus on long-term insurance liability characteristics, capital and liquidity implications. Often, they need to manage multiple performance and capital metrics that are measured under fundamentally different frameworks. Here are some rationales for optimising your asset portfolio:
• Increase embedded value, IFRS profits and long-term investment returns through yield enhancement, alternative and offshore investments.
• Improve capital efficiency by optimising shareholder returns at a given level of risk and practical constraints, allowing full rewards for the risks that are taken.
• Enhance product competitiveness by offering better yields to policyholders and improving the likelihood of meeting illustrated bonuses,
• Unlock free surplus by diversifying into alternative and offshore asset classes that have a low (or even negative) correlation with existing core assets.
• Better manage risk vulnerability and surplus volatility by selecting a portfolio that minimises risk exposure, such as interest rate duration and convexity mismatch between assets and liabilities.
Refining efficient frontier for life insurers
The exhibit below illustrates conceptually how an optimised SAA can be achieved using ALM techniques.
The “efficient frontier” represents all possible combinations of SAAs that offer the highest return at a given level of risk and constraint. By testing different combinations of asset allocations and asset strategies (eg duration-matching, illiquid assets, global diversification, held-to-maturity treatment), insurers can identify a portfolio that provides the optimised return metrics at a given level of economic capital.
This way of optimising the SAA will ensure a balanced evaluation of investment strategies. Nevertheless, there are factors that are critical to the success of this optimisation. These include: the choice of efficient frontier design, objectives, constraints, investment strategies, level of financial analyses, and – last but not least – asset risk calibration (and its relative position compared to the existing asset classes). Complications emerge in determining the ideal investment strategy when balancing the conflicting views of risk and return trade-off among shareholders, policyholders, regulators and rating agencies.
What EY SAA benchmark offers
Our proprietary EY SAA database provides competitive insights by comparing a portfolio against those of the industry peers across various dimensions, including (but not limited to) by country/region, fund size and product portfolio. (Product portfolio includes par, non-par, universal life and shareholder funds; unit-linked product is excluded as it does not require a corporate SAA. The SAA charts show the weighted-average asset allocation for the life insurance companies, basing the weights on the latest market value available to us).
This benchmark database consists of data from 70 major local and multinational insurers across Asia-Pacific, with a total invested asset value of over US$1 trillion. As indicated, the focus is on market (Exhibit 2) and product (Exhibit 3).
Exhibit 2 summarises the average asset allocation across nine Asian markets from our database. As seen in the chart, high-level asset allocation varies significantly across markets because of local regulations on investment constraints, capital charges, maturity level of the domestic financial markets and asset management expertise.
• The SAAs of insurers operating in less-developed markets such as Thailand and Vietnam tend to be driven primarily by local regulatory regimes that favor domestic sovereign bonds (regardless of the external rating) over riskier and offshore assets.
• Korea and Taiwan have legacy ALM and duration gap issues caused by a combination of high product guarantees and low domestic interest rates in recent years.
• Hong Kong and Singapore insurers enjoy more flexibility in choosing assets to support their liabilities but are subject to higher resilience reserve (in Hong Kong) and certain concentration limits (in Singapore).
• In mainland China, the concentration in domestic bonds and deposits can be explained by the high returns from onshore assets and the relatively local restrictive regulations.
• Similar levels of deviation can be observed between multinationals and locals in most countries.
Insurers are in a risk business offering a wide range of protection and wealth management products. Thus, an SAA benchmark offers much more insight at the product portfolio level given the different natures of liability characteristics, product design and investment mandate.
For instance, a long-term fixed-income strategy with some duration constraint is often used to back non-par products such as universal life to lock in investment yield and target spread. Participating whole life portfolios usually contain a heavier portion of equity investment to boost yield and enhance product competitiveness. Some insurers have an SAA dedicated specifically to shareholder funds, but the underlying asset allocation varies depending on the shareholders’ investment objectives and risk appetite.
Our proprietary benchmark database allows detailed comparisons, given specific asset assumptions, bond composition, credit mix and type of alternative asset. It helps insurers to identify where their portfolio stands in relation to the rest of the industry. The database also enables insurers to benefit from market intelligence and best practices, ensuring that their portfolio is at least as competitive as the others from their peer group.
New environments, new strategies
As regulations and capital regimes continue to evolve in recent years, we believe that insurers need to rethink their asset allocation in today’s new landscape. For instance, the China Insurance Regulatory Commission (CIRC) introduced their second-generation solvency regulation system and relaxed investment restrictions on insurance funds, creating tremendous investment opportunities for yield enhancement.
A number of other Asian countries are also moving toward a risk-based capital regime, which will reset the risk and return trade-off for investment strategies. Conversely, European subsidiaries operating in Asia will need to manage Solvency II requirements as the rule becomes effective in 2016.
In response to the recent monetary tightening, insurers have become more concerned with sharp interest rate hikes, which can potentially force them to sell fixed income assets at a realised loss to cover policy surrender benefits. Tactically, insurers could shorten their asset duration to take advantage of the higher new money rates, but a longer-term bond strategy has yet to be developed.
These initiatives will give rise to a new SAA based on new asset strategies and diversification into alternative and offshore investments. Taking no action could be riskier than rebalancing the asset portfolio. Under the new landscape, insurers must recalibrate their expectation on asset return and volatility to take advantage of the new opportunities that lie ahead.
Mr Fred Ngan is Consulting Actuary, Strategic Asset Allocation Leader at EY Hong Kong.