The North American insurance industry is facing challenges on two fronts: a sustained period of low interest rates and rapid technological change.
Insurance companies are adapting their investment strategies to meet these challenges. Will the successful businesses be those that evolve their existing models? Or will they be those that embrace the revolutions under way: in private markets, in risk management and in technology-driven changes across all facets of the insurance industry?
We commissioned an independent global strategy consultancy to do a study that combines traditional data collection and extensive face-to-face interviews with senior investment professionals.
The majority of the interviewees were either Chief Investment Officers or, for firms where this role does not exist, the senior executive, actuary or risk officer responsible for investment strategy.
The research was conducted with 45 insurers in the three mature markets in North America: Bermuda, Canada and the United States. The combined assets managed by the respondents are around $3.6 trillion, an estimated 30% of the total North American insurance market.
Source: ASI North American Insurance Survey 2018
The North American insurance industry is in good health, with premiums expected to grow across all insurance segments. Insurers have, in general, successfully managed their businesses – and balance sheet risks – through a period of falling bond yields and changing regulations.
Low yields have driven a shift in investment portfolios from public to private market assets in search of higher returns. Changes to solvency and accounting regulations are driving changes in investment strategy for insurers in Bermuda and Canada, but less clearly so in the U.S.
Against this backdrop, the research identified four themes that we believe will shape the industry and influence the way that investments are managed.
Theme 1 Investment returns: when the tide goes out…
77% of insurers surveyed expect to struggle to meet target investment returns
In contrast to the healthy backdrop described above, insurers expect future investment returns to fall short of their internal targets.
As Warren Buffet famously said, “You only find out who is swimming naked when the tide goes out.”
A decline in expected returns is happening just as insurers are becoming more reliant on these returns as a source of differentiation in a highly competitive environment. Insurers are responding to this expected shortfall in returns by actively seeking to further increase allocations to alternative assets to plug the gap (see figure 1). By contrast, there is limited appetite to add to overseas exposures.
A downturn in the credit cycle is seen as the key risk to investment returns.
Figure 1: Yield enhancement is primary driver for asset allocation change
Source: ASI North American Insurance Survey 2018
Theme 2 Optimizing alternative allocations
56% intend to increase alternative credit
As insurers seek to maximize investment returns, they continue to reduce exposure to traditional fixed income assets and increase exposure to alternative assets (see figure 2). Corporate loans, real estate loans and private equity were the most cited asset classes within alternatives for additional investment. However, our interviews revealed that insurers are struggling to reach target allocations.
Accessing these assets is challenging. There are inevitable time lags between committing capital and gaining exposure. Demand exceeds supply for the specific assets that meet the needs of insurers.
Figure 2: Expected asset allocation change (net) over next 3 years
Source: ASI North American Insurance Survey 2018
Theme 3 The value of outsourcing: beyond alpha
76% expect the trend to increase alternative assets to drive greater use of external managers
The ongoing shift from public to private markets will necessarily drive outsourcing to external managers. Many insurers have strong in-house investment capabilities and primarily look to external managers for specific asset class expertise.
However, the delivery of investment returns from harder-to-access asset classes is, while necessary, not sufficient to meet insurers’ needs.
Investment experts within insurance companies need to collaborate with external asset managers to manage the additional complexities and risks of these investments. In addition, they value a dialogue with their peers at external managers on investment strategy. External managers are mostly seen to be delivering on essentials but sometimes need to do more to understand the specific needs of their insurance clients.
“We are increasingly relying on our external asset managers to run risk scenarios.” -Mid-sized U.S. Health Insurer
“Our modeling capabilities will never be on par with those of a global asset manager.” -Medium-sized U.S. P&C Insurer
Theme 4 The technology tipping point?
86% agree that the insurance industry is on the verge of a seismic tech-driven shift
Only one respondent sees technological change having a major impact on investment strategy and management approach.
The industry is in the process of being reshaped by the advances in technology. These changes are expected to largely affect the operational facets and distribution routes of the industry, with limited concerns about increasing competition – in part because competition is already intense.
Despite this period of rapid change, insurers do not expect to have to currently adapt their investment approach.
“We can always be improving our TAA.” -Large U.S. Life Insurer
“Insurance is a very old industry and the principles have not really changed. The shift to computers and the internet was profound, but did not have a significant impact on our investment strategy.” -Large Canada P&C Insurer
These are some of the findings from the survey. What are our views? We sound an amber warning on four areas. We highlight two areas where there is scope for a global asset manager to add value.
Understanding the fundamental risks of private markets
How should insurers think about the strong consensus view driving the shift from public to private assets? After all, betting with the consensus is rarely the path to strong returns. Yet this shift reflects a fundamental change in the way that business is financed.
But history might teach us a thing or two about this shift. We evaluated the history of British asset allocation over 200 years, and there were lessons to be learned that have global inferences.
A shift can last for years. An influential actuarial paper made the case for embracing illiquid assets in 1862. By 1890, fully 80% of life office assets were invested in non-exchange traded assets.
Eventually investors became complacent and misjudged risk. Insurers suffered losses when falls in agricultural land prices led to defaults. Sometimes, what looks like an illiquidity premium turns out to be credit risk. It can be difficult to separate the two forms of risk.
Assistance on asset allocation: expertise and structure
Half of large insurers cited tactical asset allocation as an area for improvement for their in-house investment capabilities, compared to just 18% of smaller insurers and 20% of mid-sized firms. This pattern is true of strategic asset allocation too, albeit the differences are less marked (27% for small firms, 30% medium, 39% large).
This does raise the question of whether some smaller firms are unaware of their lack of expertise relative to their larger peers, who generally have more resources dedicated to these areas.
Getting asset allocation decisions right is not enough. Assets have to be held in the right structures, tailored to the individual needs of the insurance company.
The risks and uncertainties of rapid technological change
Insurers are alert to the known risks and opportunities of rapid technological change, but exposed to the many unknowns that accompany these changes.
Insurers are focused on the opportunities that technology brings, through operational improvements. But they may be playing down the threat of new competitors – as well as the threat from existing competitors that successfully embrace new approaches. A McKinsey study (Notes from the AI frontier: applications and value of deep learning, McKinsey Global Institute) estimated a range of the impact of artificial intelligence across 19 sectors. The maximum impact on the insurance sector was estimated at 7.1% of revenues, making it the third-most affected sector after travel and high tech.
Technology is already changing investment on many fronts: from the isolation of risk premiums in smart beta applications; to high-frequency trading; to nowcasting of economic data; to machine learning applications in investment decision making.
Yet the fundamental nature of insurance investment has changed little over the last two centuries. Investment strategy is largely buy-and-hold, matching the duration of assets and liabilities. The long-dated nature of the liabilities allows for a significant exposure to more illiquid assets. Advanced computing makes actuarial calculations significantly easier to carry out, but does not change the underlying math.
Nor does artificial intelligence remove the need for human judgment. Effective risk management requires a codification of this judgment alongside quantitative modeling.
Complacency on ESG risks?
U.S. insurance investors lead the global pack in terms of the shift from public to private markets, and from active to passive. But they appear to lag when it comes to prioritizing the integration of ESG analysis into their process. Only one respondent cited ESG expertise as a key factor during external manager selection.
Yet in our opinion ESG analysis is not simply driven by the desire to do the right thing. There is well-documented academic evidence of a link between good management of ESG risk and good management of the financial risks that determine the creditworthiness of a company.
Alternatives to alternatives
Investors are struggling to reach target weightings in private markets. Secondary markets in private assets provide one possible avenue to accelerate additions to private markets, but liquidity in secondary markets is even lower than the primary market.
Insurers can consider alternative strategies in public markets for sources of higher return and increased diversification.
A deeper understanding of risk
The increasing shift into more complex private markets is likely to put a premium on those managers able to offer advice across a broad range of assets and strategies. These asset managers can triangulate: specific expertise in alternative asset classes; an understanding of the regulatory implications of investing in those asset classes; and the specific needs of the client.
Investors need to understand the real dimensions of risk. Backward-looking measures of risk are not enough.
Incorporating human judgment into forward-looking scenario analysis leads to better-informed decision making. But investors also need to understand the limits of risk models.