“The only constant is change”
Despite the recovery we’ve seen investment markets into 2023, it’s been a highly volatile period for investments.
Combine this with one of the hardest reinsurance markets in years where it’s become more expensive to transfer risk off the balance sheet, and you have the perfect storm. Insurers are consequently managing more insurance risk on their balance sheets in an environment where they’re facing more volatility on their investment assets.
What is reinsurance?
Reinsurance is insurance that an insurance company purchases from another insurance company to insulate itself from the risk of a major claims event. With reinsurance, the company passes on some part of its own insurance liabilities to the other insurance company.
While reinsurance is a form of risk transfer it is also a form of capital transfer, both regulatory and economic. When used effectively, it can change the profile of cash flows, increase risk capacity and manage liquidity risk for example.
In an environment of increasing inflation, increasing claims, reduced profitability and price corrections, limiting insurers’ ability to transfer risk to the reinsurance market, insurers can consider two options:
- Holding additional insurance risk on their balance sheet
- Consider alternative forms of risk transfer (e.g. through the insurance linked securities market).
While Option Two is becoming more mainstream, these may be beyond the reach of some insurers given the more complex arrangements required to put this in place. Going with Option One puts more pressure on the investment portfolio to perform well and carry the additional liabilities. But there are ways to make this work.
Alternatives have become a vital part of insurance companies' investment strategies, providing them with a different source of capital.
For the buyer of insurance, it’s an alternative way to transfer risk, potentially helping to manage the price increases and offering a more strategic way of buying reinsurance.
As the investor or fund manager, seeking portfolio diversification, it offers uncorrelated returns to other financial risks.
- Traditional and alternative reinsurance capital continue to complement each other in the market.
- Insurance-linked securities (ILS) have their value linked to insurance-related, non-financial risks such as natural disasters, other insurable specialty risks and life and health insurance risks, including mortality or longevity.
- Alternative capital is available in a more liquid product form (e.g. catastrophe bonds).
Fluctuating interest rates, volatile market returns, and rising inflation are some of the challenges impacting insurers’ investment portfolios. That’s why many insurers are looking at ways to re-optimise their asset allocation to increase income, contribute to a growing surplus and appropriately align its investments with the enterprise’s overall risk appetite.
Boards are therefore questioning their willingness and capacity to take on additional investment risk, and if that risk profile will give them the return outcome they need to meet their liabilities.
These are difficult questions to answer because the optimal portfolio is unique for each insurer, based on constraints like liquidity and income, the balance sheet and capital.
We propose three strategies to optimise returns while managing market risk and balance sheet volatility.
Given the improvement in the outlook for fixed interest caused by the shift in yields, it’s an opportune time for insurers to evaluate their fixed income portfolios and optimal level of liability matching.
In the past there was a worthwhile trade-off to take a mismatched position to liabilities in the search for yield, but the case for mismatching is now lower and worth revisiting. Expected returns for sovereign bonds have improved significantly from their negative levels in 2020, while its higher starting yields can withstand more mark to market adjustments if yields rose further.
And it’s not just sovereign bonds. Inflation-linked bonds are offering positive real returns for the first time in a decade, while investment grade credit is particularly attractive at the short end of the curve, where rates and spread duration are lower. Even cash offers good returns.
A future filled with opportunity
Insurer investment portfolios have undoubtedly become more complex. Not only are market conditions challenging, but insurers want to generate more value and alignment between their investment portfolio and the broader objective of growing their enterprise value.
While the increase in yields means insurers may not need to take the same level of risk to generate a reasonable level of return as they would have in the past, the uncertain economic environment complicates things.
We believe there are opportunities to improve portfolio outcomes by creating a more flexible approach that leverages a company’s collective expertise and skills along with that of its advisers.
- Take a holistic approach that defines risk appetite at an enterprise level and balances investment and insurance risk.
- Review risk exposures and risk frameworks to ensure the contribution of investment risk and insurance risk is aligned with the company’s overall risk appetite.
- Review market dynamics and ensure the company can tap into evolving themes and solutions within the reinsurance and investment markets.
Our role is to work with our clients to customise investment solutions and derive greater value through insurance-specific investment ideas, improved implementation, operational support, and portfolio alignment with their specific geographic, regulatory, rating agency, liability and liquidity requirements.
If you’d like to learn more about how insurers can manage volatility, please reach out to us.
This content on this website is provided for informational purposes only and should not be taken as advice or recommendation to buy or sell any specific investment product or services, including Mercer’s investment management services, or to enter into any portfolio management mandate with Mercer.
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