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Multi-strategy fixed income – considerations for insurers

Source: Asia Insurance Review | Nov 2018

Capital preservation, predictable returns and diversification benefits have traditionally kept fixed income front of mind for insurers. Now, the unwinding of a decade of experimental monetary policy means the risks attached to traditional fixed income are rising, say Aviva Investors' Iain Forrester.
The changing investment environment explains why multi-strategy fixed income products are gaining attention. The fact that they draw on a wide range of sources of return and are less dependent on the directionality of bond markets makes for a compelling proposition when you consider what might lie ahead for inflation and interest rates in the years to come. Specifically, in a rising rate environment where the probability of political surprises and policy U-turns has risen, a multi-strategy fixed income allocation could be helpful. 
The impact of the evolving regulatory landscape 
Insurers’ investment strategies are governed by regulation. Historically such regulation has focused on quantitative assessments of risk, increasingly through the development and introduction of risk-based capital (RBC) regimes. 
More recently, however, regulation tends to encourage insurers to make more qualitative assessments of the risks arising from their investment strategy. This is true within Asian insurance markets, as well as in Europe. For example, the Common Framework for the Supervision of Internationally Active Insurance Groups, which builds on the International Association of Insurance Supervisors’ high-level guidance for over 190 jurisdictions around the world, states that the regulator would expect an insurer “to invest only in assets whose risks it can properly assess and manage.” Similarly, under the European Solvency II regime, the Prudent Person Principle requires insurers to only invest in assets “whose risks the undertaking concerned can properly identify, measure, monitor, manage, control and report.”
Below we set out the key areas insurers must consider when carrying out a qualitative assessment of the risks arising from an absolute return fixed income strategy, including: 
  • Risk identification – Transparency of risk exposures.
  • Risk management – Integrating risk into portfolio construction.
  • Risk measurement – Including considerations around risk-based capital requirements. 
Risk identification – transparency of risk exposures 
Transparency is key. For insurers, the need for transparency goes beyond asset data reporting – it is about having complete visibility of the investment process and portfolio. This transparency is critical in relation to allocations to more sophisticated investment strategies where an investment manager has the scope to generate returns from a broad universe. 
Aviva Investors Multi-Strategy (AIMS) Fixed Income combines strategies designed to give protection in times of stress, exploit market mispricing and benefit from themes expected to perform in rising markets. In practical terms, this means positions in around twenty-five to thirty different strategies. 
Monitoring risk exposures by theme
Risk management – integrating risk into portfolio construction 
Risk management is a key consideration for insurers. In addition to risks within their asset portfolio, insurers must also consider the risks and constraints from their liabilities (“asset-liability management”), accounting balance sheet, regulatory balance sheets, or other constraints (such as rating agency requirements). 
As a result, portfolio construction for insurers can be influenced more by risk, rather than return, considerations. This focus mirrors the typical approaches within multi-strategy fixed income strategies – risk management plays an essential role for AIMS Fixed Income. 
In-house and third-party tools are used to structure the AIMS Fixed Income strategy and model the impact of new investment decisions. This includes assessing Value at Risk (VaR), volatility and correlation, as well as stress and scenario testing. 
The strategy’s risk exposures are constantly monitored. One key measure is the allocation of risk per theme (i.e. spread, duration, curve, currency, inflation and volatility); illustrated above in the AIMS Fixed Income strategy since December 2016.
Risk measurement – calculating solvency capital requirements
The regulatory capital regime has a material impact on insurers’ investment strategies. Globally, insurance regulation has become significantly more risk sensitive with the introduction of risk-based capital regimes.
Under these, the capital arising from an insurers’ investments will be calculated using:
  • A standardised approach prescribed by the regulator (such as proposed for the Risk-based Global Insurance Capital Standard Version 2.0); or
  • An insurer-specific approach (internal model), where the insurer determines its own capital changes subject to regulatory approval. This is only available in certain regimes.
The standardised approach will necessarily be broad brush, focusing on the key sources of potential investment risk. It won’t necessarily reflect the underlying risk profiles of more sophisticated investment strategies, notably for non-directional strategies (such as relative value strategies across or within fixed income markets). 
As a result, the capital requirements arising from an investment in a multi-strategy fixed income strategy may, depending on the regulatory regime, appear high relative to the level of risk within the strategy. In this case, insurers may be able to develop an internal model approach or explore other potential solutions. 
Strategy contribution to portfolio risk and diversification benefit
Bringing it all together 
The universe of multi-strategy fixed income funds, supported by risk-based portfolio construction aligned with the qualitative risk-assessment requirements of insurers, can be helpful for insurers who are seeking to diversify their investment portfolios. The processes established to manage the complexities of multi-strategy fixed income strategies, like AIMS Fixed Income, are well aligned with the qualitative risk assessment requirements of insurers. A 
Absolute return multi-strategy fixed income
Managers of traditional fixed income products try to beat a specific benchmark, but absolute return managers aim to deliver positive returns above cash whatever the market conditions.
To do this, they access a variety of return sources. These include long positions in government, corporate and emerging market debt, which enable the manager to take on duration and credit risk. Managers also have flexibility to avoid traditional sources of risk when prospective returns look unattractive. For instance, absolute return funds can implement strategies designed to profit from changes in the level of market volatility, inflation expectations, the shape of the yield curve and changing dynamics in foreign exchange markets. Crucially, they can also profit from falling prices, by taking short positions.
The ability to invest in directional and non-directional strategies means absolute return funds can generate positive returns in a wide range of environments. Funds normally target a return in the range of 2% to 4% above cash, while attempting to limit the risk of drawdowns.
Tom Clapham
Head of Institutional, Asia
Iain Forrester 
Head of Insurance Investment Strategy
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