How should insurance investors react to interest rates and inflationary pressures?
Bruno Servant, CEO, Vincent Chaigneau, Head of Research, and Antonio Cavarero, Head of Investments, at Generali Insurance Asset Management, which is part of Generali Investments, give their thoughts on the fiscal and regulatory pressures in 2022.
Andrew Putwainposted on Monday, May 23, 2022
Andrew Putwain: Floated changes to Solvency II have been proposed, which could free up more capital for insurers. Do you see this affecting the investment sphere and what are your thoughts on the possible changes?
Bruno Servant: Potential changes in the volatility adjustment mechanism and the existing regime for long term equity can have an impact on the investment policy. But the main effect in this period is the increase in interest rates which is freeing up capital in life portfolios when liability duration is higher than the one of the assets. This impact can be very significant.
Also, the increase in rates reduces the capital charge linked to guaranteed rates when they exist.
"Inflation has already been there for a while. Real rates were already well negative before 2022 but the pressure coming from inflation was lower"
These changes can permit a review of the investment strategy in life portfolios, while impact on P&C is different.
Andrew: Can you discuss the interest rates and inflationary pressures and how this is affecting investments Liability Driven Investment (LDI) plans?
Antonio Cavarero: Inflation has already been there for a while. Real rates were already well negative before 2022 but the pressure coming from inflation was lower.
The threat posed by inflation must be tackled from an asset allocation perspective, more than simply relying on inflation limited instruments – they can play a role, but they cannot be the only tool.
Investors need to maintain some equity exposure, lower than in a normal environment. but still be part of the portfolio, focusing on the sectors that are in condition to provide the best performance when inflation is rising like financials, energy, and commodities
Credit remains is a big pillar of the asset allocation, centred on those names with good creditworthiness, solid capital balance sheet and a business model that can handle the price pressures coming from higher inflation.
There is a decreasing upside for interest rates. I don't think that the Fed will be able to complete the hiking cycle as it is priced by the market today. They have room to go this year but, at some point, financial conditions will be tight enough to make them stop.
"We know that inflation will be pervasive, but we don't know by how much. Exposure to the war in Ukraine is also an unknown and might cap the capability of tightening financial conditions above a certain level"
ECB is caught between a rock and a hard place. On one side, they have to recognise the super-easy conditions and the negative real yields environment that they have created. However, they also have to recognise the inflation wave that is coming, and we don't know what the secondary effects will be.
We know that inflation will be pervasive, but we don't know by how much. Exposure to the war in Ukraine is also an unknown and might cap the capability of tightening financial conditions above a certain level.
Vincent Chaigneau: We expect bond yields to rise further but self-correcting mechanisms to limit the move.
First, asset valuation globally depends on low long term real interest rates, and those are rising fast. If they continue to rise aggressively then this could be disruptive to financial markets and conditions. That would create some flight to quality that would cap the rise in yields.
"Insurers have also over the past years increased their exposure to real assets, and this is a good thing in a high inflation environment"
Second, the sharp rise and high level of public debt may become unsustainable if real bond yields rise too much. Indeed, debt sustainability largely depends on the differential between real interest rate and growth. Concerns about debt sustainability could quickly cause market disruptions and hurt confidence and growth, capping the rise in risk-free yields in the process. Many insurers have short-duration positions, i.e., assets being shorter than liabilities in duration, and the recent surge is yields is thus supportive for their capital position. Insurers have also over the past years increased their exposure to real assets, and this is a good thing in a high inflation environment.
Andrew: In this period of high inflation and interest rates, what are the growth strategies?
Bruno: There is a strong trend into real assets, which started years ago, and it is still going on. Here, some investors have started earlier with a higher appetite linked to longer liabilities and specific regulation.
Improving solvency ratios can also facilitate a higher allocation to private assets such as private debt going from infrastructure debt, corporate loans.
On the equity side, private equity remains attractive, not only because it is less volatile due to accounting standards, but because private equity captures value at the early stage, and it shows good resilience.
In private debt, private equity, and real estate, we have to see how the market evolves in the new macro environment. So far, we see valuations holding up well.
"How will high inflation impact both P&C and life insurers? In P&C, high inflation implies higher claims, which may threaten profitability unless the company enjoys a strong pricing power"
Global real assets reached $7.4trn in 2020 and they are expected to reach 12.6trn in 2025 (CAGR of 11%) according to Preqin. On our side, we’re also seeing a high potential of growth.
Vincent: How will high inflation impact both P&C and life insurers? In P&C, high inflation implies higher claims, which may threaten profitability unless the company enjoys a strong pricing power. Regarding the Life business, the negative asset performance this year will hurt Assets under Management – for all Asset Management (AM) business, not just Insurance AM. A lot of insurers have tried to move from traditional products towards Unit-Linked products, and the impact of rising yields on the business is not trivial. The risk is that investors take advantage of the higher yields to move into bond funds rather than staying in traditional life insurance where the returns are lower; insurers will need to ensure that any such flow benefits their own Unit-Linked funds, rather than leaking out and undermining the volume of assets under management.
In time, if indeed it is confirmed that we move out of the ‘low yields for longer’ paradigm, life business would likely benefit again.