This article is taken from the roundtable: ‘Fixed income investing in a crowded world – how to build a portfolio of high quality, low risk assets that meet growth and cashflow challenges?’
You can read the full roundtable in the research report Investing In Fixed Income, Europe, 2019 which can be downloaded here.
Ruth Farrugia: I manage life and non-life insurance portfolios across EMEA, so in terms of investment landscape, we have had to deal with historically low yields. As a result, the traditional insurance business model has shifted quite substantially with the redesign or withdrawal of products with guarantees and a shift to unit-linked products.
There has also been the advent of Solvency II, which is a complex capital framework. It’s a mark-to-market framework, which makes balance sheets much more sensitive to mark-to-market volatility.
There has also been a combination of low rates and spread compression, which have been further exacerbated in Europe by the European Central Bank (ECB) purchase program. This has made it quite a challenging environment.
"There has also been a combination of low rates and spread compression, which have been further exacerbated by the European Central Bank purchase program."
With that being said, you do have to put money to work, and if you look at European insurance reporting, what becomes immediately clear is that there are some common trends.
There is for example, an increase in risk appetite on the credit side. We have seen an increase in BBB buckets and high yield, and generally a shift towards semi-traditional asset classes including emerging market (EM) as well as a transition to non-traditional asset classes, such as private assets.
We have also seen a tightening on the Asset Liability Management (ALM) side and a more disciplined ALM philosophy, which the regulations have also pushed us towards. This leads to adding more duration that is targeted at capital efficiency.
Ruth: In terms of portfolio construction, in our world we look at returns over different time horizons. Ultimately, it is important to bear in mind that we are long-term players. We are trying to match different tenures in terms of liabilities, but in life portfolios we do have longer-dated liabilities.
When we look at returns across asset classes, we must define not only what kinds of returns but also risk appetite.
Risk-adjusted returns in terms of asset classes, in particular for Solvency II portfolios and the returns on Solvency II, are an extremely important consideration.
"It is important to bear in mind that we are long-term players."
There is also an element of horses for courses as portfolios are very different.
Some of our portfolios and entities have stability of earnings as an objective, where you need to be a bit more conservative. So, an allocation to core sovereign high-rated will help you.
The returns might not look great from an economic point of view, but will look better on a risk-adjusted basis. It will help the ALM profile and it will provide a nice cushion as well in a downturn.
"When we optimise portfolios, we create an efficient frontier."
We saw this at the end of last year, where the sovereign component came to the rescue and provided a very nice offset.
When we optimise portfolios, we create an efficient frontier, which makes it quite straightforward in terms of coming up with capital efficiency ratios for our asset classes.
This doesn’t necessarily determine reality, but it provides a long-term guidepost. Often, they provide good guidance as to the entry points, when an asset class becomes more attractive.
Ruth: If you were to add capital efficiency to your question, then it would be perfection. We, like many others, have found value in terms of private assets, and by this, I mean private placements, commercial real estate debt and infrastructure.
It is the premium but also the flexibility as they come fixed or floating and can target different tenors in terms of the ALM objectives as well.
Infrastructure deals for instance marry very well into annuities and matching adjustment portfolios in the UK. And generally when the stars are aligned you get quite good spread duration.
"We, like many others, have found value in terms of private assets."
In terms of diversification with private placements, you get access to issuers who might not want to go or who do not go to the public markets and there are also covenants which provide downside protection.
As we hit a downturn, this might become more prominent. I still see value in these asset classes even on a risk-adjusted basis.
Understandably, with these asset classes there has been a bit of an expansion in terms of the investor base and overcrowding, but there is still good relative value.
Ruth: The beauty with Solvency II is that it is still evolving. There was a 2018 review of the standard formula and the 2020 review of the long-term guarantee package, so there are still changes happening along the way.
The biggest challenge has been the complexity of mandating a full balance sheet approach so that you can’t, as an investment person, act in silo.
But this is probably a good thing, when you are forced to interact with the other stakeholders across the balance sheet.
The capital charge regime is also challenging, because of the strict mark-to-market aspect of it.
"The biggest challenge has been the complexity of mandating a
full balance sheet approach."
As we get towards the end of the cycle, we need to factor in what impact credit migration would have in our portfolio and how much capital you can afford with the mark-to-market volatility.
We have seen pockets of this along the way last year, which demonstrated the direct impact on your Solvency ratio. So, these are all considerations that you have to bear in mind, that have come with the new regulation.
