The new paradigm in Asian insurance
My most important decisions are always made with instinct, intuition, taste, heart – not analysis.
Jeff Bezos, CEO and Founder, Amazon
For insurance investors, all important decisions are made by analysis – and the analysis required is getting more complicated. In Asia, insurance investment is entering into a long-term “paradigm shift.” This structural change is not just shaped by the pandemic and recent volatility in equity and bond yields, but also by many structural factors, such as the continued low interest rate environment, the adoption of new risk-based capital (RBC) regimes and IFRS 9/17 accounting rules, and the intense product competition in the region.
In this new paradigm, where the rules and objectives are changing, insurance investors need to be prepared in three ways before entering the new arena: a new mindset for the game, new weapons to attack and a strong shield for defense.
1. A new mindset for the game
A strategic asset allocation (SAA) is of paramount importance to guide insurers through regulatory changes and market uncertainties to come. The new paradigm for insurance investment requires fundamental changes to a company’s SAA model, starting with the input. Insurers need better and broader asset assumptions to define the full investment universe – both locally and on a global scale. Limiting options to existing asset classes or one region often results in sub-optimal long-term investment results and an inefficient use of capital.
The next step is to feed the new assumptions into a powerful SAA engine. Insurers need to expand the simple return/volatility model into a multi-dimensional SAA model that can incorporate most of the new risk, capital and accounting metrics.
2. New weapons to attack
Asia CIOs need a new set of tools to search for yield in a low-yield environment and volatile market. Our 2021 Long-Term Capital Market Assumptions (LTCMAs) highlight that while we are optimistic about the new business cycle post-Covid, we believe traditional balanced portfolios, e.g. with a 60% equity/40% fixed income allocation will be challenged over the next decades. To generate returns, investors will need to seek out new strategies and new asset classes. For Asian insurers, these new investments can range from non-core fixed income to the entire spectrum of alternative assets.
More insurers are sourcing assets outside of their home market for income, alpha and diversification. We are in the view that the greater use of active management will continue to be a common approach in Asia for dealing with low bond yields. Within fixed income, Asian insurers are actively searching for yield in emerging market debt and selective high-yield U.S. and Asian credits. Outside of fixed income, alternative assets are transitioning from optional to essential for insurance companies in Asia. We believe Asia’s total asset allocation to alternatives will increase from today’s low single digit level to 10-15% of portfolios in the next five years.
3. A strong shield for defense
Searching for yield in today’s market may come with higher risks. Before using the new set of tools, insurance investors need to build a strong shield to protect the portfolio from unwanted risk such as accounting/solvency volatility, prohibitive risk capital, asset-liability mismatch and concertation risk.
While there is no one-size-fits-all solution to eliminate all these risks, at J.P. Morgan Asset Management, we have helped insurers across the globe build fortresses with their balance sheets and capital positions under different RBC regimes and accounting and tax rules. Instead of a SAA overhaul, innovative and effective RBC solutions are expected to help insurers build strong defensive shields to save risk capital, lower accounting volatility and reduce economic losses.
From European Solvency II to Asia RBCs, we have identified the following solutions generally to be effective and relevant in many Asian markets:
- Capital-efficient fixed income portfolio construction could decrease the spread risk charge on fixed income portfolios.
- Matching adjustment (MA) portfolios could significantly reduce policy liability, eliminate MA portfolio solvency volatility and increase the product pricing interest rate.
- Equity hedging strategies with derivatives, if implemented in a systematic and structural way, could significantly reduce the equity risk charge, protect from downside risk and improve both risk-adjusted and capital-adjusted returns.
- Currency hedging solutions allow investors to invest in overseas assets without incurring a foreign currency risk charge.
- Construction of optimal and diversified alternative portfolios could achieve capital efficiency, income, alpha and downside protection. This could be accomplished by optimally allocating to core strategies for stable cash yields and diversification, and to opportunistic strategies for higher returns. Instead of only seeking alpha, Asian insurers are increasingly focusing on capital efficiency, income, asset liability management and diversification in their alternative allocation decisions.
Structural paradigm shift – from persistent low interest rates to risk-based capital regimes and new accounting rules – have changed the game plan for Asian insurers. Insurers need to update their thinking on strategic asset allocations and upgrade their toolbox to achieve higher yields, while continuing to build strong defense and protect portfolios from unwanted risks.