If this global economic expansion was a party, it would be getting late in the night. In 2019, as the global economy transitions away from the environment markets and investors have grown used to over much of the last decade, insurers face a greater risk of downside surprises.
After above-trend global growth in 2018, this cycle’s peak is most likely behind us. Less divergence among countries is likely and the U.S. may not lead the way in growth as the fiscal stimulus boost fades. A Europe and UK caught in the economic and political crossfire will need close watching. And eyes will be on China and the levers (tax cuts, fiscal measures) that could be pulled to offset a growth slowdown, amid escalating tariffs and the deleveraging of the shadow banking sector. We expect 2019 to bring higher bonds yields in the U.S., UK and Europe but lower terminal rates than in previous cycles. Looking out over 2019, we see several political, macro and credit risks that could cause volatility to flare-up, or otherwise have a significant impact on global markets (Exhibit 1).
Facing potential political, macro and credit risks, investors may want to address portfolio resiliency
EXHIBIT 1: RISKS TO MARKETS IN 2019
- Escalation of U.S.-China trade war
- Italian politics
- European recovery momentum stalls with stagnating growth, quantitative tightening
- China growth slowdown below 6%
- Stronger dollar increasing stress on some emerging markets
Corporate credit risks
- Idiosyncratic situations causing rating agency downgrades (i.e., General Electric
- More pronounced deterioration in investiment grade demand/flows further widening spreads
Source: J.P. Morgan Asset Management; forecasts and estimates as of Jan 24, 2019.
Broad investment considerations for insurers
Given the risks summarized in Exhibit 1, insurers may want to consider the following, to potentially improve their investments’ resiliency:
Risk management in portfolios
Insurers need to be certain that they have the right amount of risk in their portfolios. Have they stress tested their portfolios to determine the impact on income and capital of both credit downgrades and market value movements? Have they considered tail risk/downside hedging strategies approaching the latter stages of the credit cycle? Insurers could assess the spread risk in their portfolios in the context of a strategic asset allocation (SAA) that incorporates all stakeholders’ input and consider having dry powder in the case of a sustained widening in fixed income market sectors, such as investment grade, high yield credit and emerging market debt (EMD). It’s also important to assess asset liability management (ALM) risk and see if it is appropriate to close any duration mismatch.
Insurers and their asset management teams should communicate closely so all parties stay updated on market movements and their impact and be nimble in their portfolio positioning. Investment committees should also have the ability to react quickly to changes in the market environment and be able to swiftly dial up or dial down risk.
Mandates are ideally designed with a focus on diversification—the only free lunch in town. Limiting the amount invested in any single issuer, and ensuring a diversified mix of names, is the best protection against event risk. There should also be a focus on working with teams that have a deep bench of experienced research analysts who can identify and weed out challenging candidates. In addition, the accounting treatment and investment strategy of a number of insurance ‘buy and maintain’ portfolios allow them to withstand mark-to-market volatility and take a longer-term view, with their investments primarily driven by a view on fundamentals. Such portfolios could take advantage of any pockets of liquidity or opportunities as they present themselves. Widening spreads on names that asset managers are fundamentally comfortable with will likely lead to adding that exposure, at attractive yields.
Hedging, regulation, Environmental Social and Governance (ESG) —and other tools and approaches hold interest in 2019
A number of other topics are at top of mind for our clients and we believe they will be important in 2019:
Insurers have diversified portfolios into non-base currency assets, especially assets with USD spread risk, such as corporate credit and Emerging Markets Debt (EMD). As hedging costs have increased, insurers have sought the most efficient hedging strategy, in line with their risk appetite and market expectations. Discussions have centred on defining and executing the right strategy. Our research, to cite one example, compared historical three-month rolling FX forwards to three-year and five-year cross currency swaps and found little difference in their realised costs—while FX forwards are much more liquid instruments.
A few insurance companies have adopted this new accounting convention while others have deferred adoption to 2022. Working with clients, we have discussed adapting the investment process and guidelines to incorporate all aspects of IFRS 9—Solely Payments of Principal and Interest (SPPI) cash flow tests; defining an impairment policy to identify non-performing bonds and calibrating probability of default and loss given default for each bond held in the portfolio. IFRS 9 will also impact the accounting treatment of fund vehicles, potentially giving rise to P&L volatility on an insurer’s balance sheet.
Risk, liquidity analysis
Advancing further into late cycle, we continue helping clients calibrate and measure salient risks in their portfolios. We have seen tremendous interest and analysis of decreasing liquidity in the fixed income markets. Our analysis has included bespoke stress tests for key risks in 2018 and exploring ways of measuring and monitoring liquidity risk in portfolios.
Buy and maintain portfolio management
We continue to iterate, and enhance, how we approach and manage buy and maintain portfolios for our insurance clients. Recently, we have worked closely with our insurance strategy and analytics team to improve in-house tools used to construct and manage portfolios optimised for SCR capital while incorporating our investment views; built out a book yield attribution tool that fits into our balanced scorecard approach of measuring performance for insurance clients; and partnered with our fixed income quantitative research team to accurately measure reasons for portfolio turnover and apply that in a scientific way to buy and maintain portfolios.
Environmental, social, governance (ESG)
Our clients are increasingly interested in our approach to ESG, which is to integrate ESG into our existing investment process. Our research analysts and portfolio managers use awareness, monitoring and engagement, and explicitly consider ESG factors when selecting credits. They use ESG reports to review overall portfolio scores, and have generated thought leadership on how successful using ESG factors has been in generating alpha. We also see interest our ability to tailor mandate design to meet clients’ ESG requirements. We can also consider ESG factors as inputs into our optimised credit portfolio offering.
1 Asset and liability management
2 International Financial Reporting Standard