by Wellington Management
Tim Antonelli, CFA, FRM, Multi-Asset Strategist
Tim Antonelli is responsible for identifying, sharing, and acting on major business trends affecting insurers globally and their investments across asset classes. He interacts regularly with a range of insurance industry regulatory bodies, rating agencies, and trade organizations around the world.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice.
Individual portfolio management teams may hold different views and may make different investment decisions for different clients.
Over the past year, I had the privilege of meeting with more than 100 global insurance companies, with total assets of around US$12 trillion on their balance sheets. While each insurer has its own particular risk tolerance, distribution strategy, regulatory issues, and accounting regime, they all shared many similar core concerns about what lies ahead. These challenges represent a unique intersection of industry regulation, financial positioning, and macroeconomic conditions.
So, as a new decade begins, there are three key themes that we believe insurers must navigate in order to be successful in 2020 and beyond:
1) Downside risk mitigation
2) Climate change
3) BBB credit exposure
FIGURE 1: Derisking Too Early Could Prove to be a Costly Mistake
Missing the S&P 500’s best days, 20 years ended 31 December 2018 (annualized returns, %)
Sources: S&P, FactSet. For illustrative purposes only.
THEME 1: DOWNSIDE RISK MITIGATION
A dominant theme across continents in 2019 was the renewed focus on downside risk mitigation. A number of factors make this an even more critical issue for insurers in 2020:
• A desire to protect gains accrued from the strong run in capital markets over the past decade;
• Migration of accounting standards to reflect more ”mark-to-market” investment results (e.g., the negative earnings impacts from the fourth quarter of 2018 are still fresh in many insurers’ minds); and
• Select regulatory risk-capital calculations allowing for a reduction in capital charges if certain criteria are met.
We have been in a “late-cycle” environment for years, but eventually it will have to turn. However, the danger of derisking too early should be a very real concern for insurers (FIGURE 1). In an environment where every basis point of investment return matters, a better strategy may be to maintain risk assets with an eye on loss prevention.
Target asymmetrical returns
There are a variety of ways for insurers to implement this type of approach. One such option is to invest equity assets with a focus on asymmetrical return profiles. Insurers are typically loss-sensitive and willing to sacrifice some upside potential in order to avoid drawdowns, so achieving 105% of the benchmark return on the upside, while only participating in 85% of the downside, can be a favorable tradeoff. Institutional investors have long assessed this upside/downside capture ratio on an ex-post basis. However, certain equity investment approaches, combined with manager skill, may be able to achieve asymmetrical return profiles that are consistent and repeatable over time. Thus, moving from pure equity market beta, which has been a winning trade over the past decade, to approaches that have the potential to both outperform in an up market and (more importantly) limit losses in a down market, should be a continued focus for insurers in 2020.
Be dynamic with a multi-strategy equity solution
Another option is to have a single manager handle the tactical and strategic asset allocation decisions across equity exposures. Timing the market is difficult enough; allocating to the right segment of the market is even more so. Between getting those two factors correct, and then sourcing internal approvals to implement, an opportunity to enact a risk-on or risk-off trade could pass an investor by. With that in mind, building a bespoke offering that can access a broad investable universe, while achieving a desired return and volatility profile, is becoming an increasingly popular approach. The ability to be dynamic and react swiftly to an ever-changing market landscape should serve insurers well as we near the end of a bull market.
Be selective in private markets
Of course, I’d be remiss if I didn’t also discuss the significant flow of insurer assets into private markets in recent years. In essence, this has been the “perfect trade,” capturing market returns plus an illiquidity premium – in most cases, risk-charged in line with public-market equivalents across regulatory regimes and with muted accounting statement volatility. However, with some parts of the private markets (particularly direct lending) continuing to see sharp inflows, the importance of being selective as yields compress and underwriting deteriorates becomes all the more important.
Don’t overlook late-stage private equity
Despite the frothy conditions on the credit side of the private market, we continue to see interest from global insurers in late-stage private equity. This asset class lends itself to being “insurer-friendly” for several reasons:
• First, the path to liquidity events is much quicker than its early-stage cousins, typically one to three years.
• Second, the portfolio companies tend to be fundamentally sound with strong management teams, thereby reducing substantial downside risk found in early-stage funds.
• Finally, in the mark-to-market world of insurance accounting (GAAP & IFRS1), the reduced financial statement volatility from this asset class is considerable.
We believe this type of fund can demonstrate accounting statement volatility in the high-single- or low-double-digit range over the course of the fund’s life. This would position the strategy’s volatility substantially lower than the average venture capital private equity fund, while still targeting a strong internal rate of return (FIGURE 2).
FIGURE 2: Late-Stage Private Equity Offers an Attractive Risk/Return Profile
Private equity: Risk/return by fund type (vintages 2005-2016)2
1 GAAP = Generally Accepted Accounting Principles; IFRS = International Financial Reporting Standards
2 The size of each circle represents the capitalization of funds used in this analysis.
3 Excludes early stage
Source: Preqin Pro. Chart data as of 31 December 2016 (most recent available)
Finally, if regulations permit, using derivatives for financial risk mitigation is another way to structure risk assets with an eye toward limiting tail risks. While downside hedges on their own can be cost-prohibitive, these approaches can be structured in more cost-effective ways, such as with collars or put spreads. Depending on how the hedges are implemented (think systematically over discretionary), an insurer can receive meaningful capital relief in risk capital regimes, such as Solvency II. At Wellington, we can partner with clients to tailor this type of exposure to each client’s risk appetite and cost sensitivity.
THEME 2: CLIMATE CHANGE
“No doubt some of these expenses are “unreasonable.” Like renting a white Cadillac convertible and then soaking it with the hard-crusted, sun-baked scum of 100 grapefruits and 2 dozen coconuts and 26 pounds of catsup and French fry residue…and a goodly number of bad dings, dents, and scrapes that were covered, … by an extra $2 a day for total insurance. The car was not a happy looking machine when I turned it in, but they gritted their teeth and took it. This is/was the insurance side of the American Dream, the terrifying underbelly of actuarial tables.” – Hunter S. Thompson
Hunter S. Thompson’s quote above highlights the seemingly perpetual safety net provided by insurance. Even in jest, Thompson observes that maximum losses (while not enjoyed) are still assessed as tail risks by actuaries and will ultimately make the buyer whole. However, as financial losses from climate change move from tail events into the realm of “likely” outcomes, one has to question how long insurers can afford to underwrite coverage for those risks and (just as important) how insurance buyers could afford the inevitable resulting premium increases. Perhaps the most pronounced theme echoed by insurers across the globe in 2019 was growing interest in the financial risks posed to their business models by climate change. While regions such as Northern Europe have been at the forefront of thinking about these risks, the interest from Asia and the US was much more significant than even just a year prior. It’s not completely surprising when you consider the trajectory of total climate-related losses in recent years (Figure 3).
FIGURE 3: Climate-Related Losses Have Been Substantial in Recent Years
Uninsured and total losses from natural catastrophes worldwide: 1980-2018 (US$bn)
Inflation-adjusted via country-specific consumer price index and consideration of exchange-rate fluctuations between local currency and US$. Source: Munich RE, ©Münchener. Rückversicherungs-Gesellschaft, NatCatSERVICE. Data as of 31 October 2019.
Regulatory bodies are taking notice
Insurers themselves aren’t the only industry players taking note of this phenomenon. Regulatory bodies have also been getting involved in a major way:
UK – Prudential Regulatory Authority:
– Requires that a senior stakeholder be identified at each insurer to be accountable for financial risks from climate change
– Has created mandatory stress tests for insurers to complete
– Has established more robust disclosure frameworks around risk appetite statements and plans to mitigate such risks moving forward
France – Prudential Supervision and Resolution Authority:
– Has required climate-risk-related disclosures since 2016
– Will create mandatory climate change stress tests for 2020
Singapore – Monetary Authority of Singapore:
– Will include stress tests related to climate risk in annual industry review
– Is partnering with research institutes to integrate long-term climate risk into risk models
– Has created a sustainable bond grant that subsidizes the issuance of green, social, and sustainable bonds in Singapore
US – National Association of Insurance Commissioners:
– Has implemented a climate risk disclosure survey (but only select states are participating: CA, CT, MN, NM, NY, WA)
– Has made climate risk the top strategic focus of 2020
– California has requested divestment from thermal coal
Hong Kong – Stock Exchange of Hong Kong:
– Will require listed companies to disclose significant climate-related issues
Australia – Australian Prudential Regulation Authority:
– Will require climate-related stress tests for all insurers, banks, and pensions in 2020
Industry still has a long way to go
However, it is important to note that even the most forward-looking insurers are still in the early days of formally integrating climate risk management into their underwriting and investing processes. The most advanced of the insurers I spoke to included one Nordic company that was aggregating both transition risk and physical risk metrics across its invested assets and presenting an annual risk assessment to its board. Meanwhile, a UK-based entity was using physical risk projections on its real estate exposure to begin retrofitting the properties for the rising probability of flooding in the area. These were the outliers. In contrast, the average insurer seemed very willing to identify and assess climate-related risks, but lacked the data, the scientific knowledge, and the in-house expertise to formally integrate these elements into its core business.
While climate science models often frame the future in terms of decades, there are three important variables that could cause the price impact for the insurance industry to occur well before the manifestation of the physical climate risks themselves:
1) Disclosures: As global investor disclosures become more commonplace (whether mandated by regulators or not) and more robust, the capital markets will likely reward “good corporate citizens” and pull investment dollars away from “bad citizens,” creating pricing pressure.
2) Litigation: Climate-related litigation has been growing at an exponential rate in recent years and shows no signs of slowing (Figure 4). Lawsuits alleging that company directors and officers were negligent by not fully disclosing the climate-related risks faced by the business have the potential to create significant case law. It might only take one guilty verdict, or a substantial settlement, to expedite the mark-down of not only the offender’s assets, but also those of similarly situated peers.
3) Rating agencies: Credit rating agencies have adjusted their ratings for climate-/weather-related events, but typically only on a reactive basis. The city of New Orleans, post-Katrina, was downgraded to B-, while Paradise, California’s pension bond was downgraded to CCC after the state’s devastating wildfires. However, we are starting to see a mindset shift among rating agencies in terms of how to assess physical climate risk exposure. For example, Moody’s has recently moved to acquire a large climate-risk data firm and has laid out a framework for how to assess physical risk within a sovereign context (Figure 5). As these datasets become better understood and accepted, it’s not a stretch to imagine proactive “notching” (both positive and negative) to credits that have demonstrated climate-risk-mitigation techniques (or a lack thereof). This proactive approach should resonate with many insurers, who often wish to avoid downgrade risk in their long-term fixed income portfolios. Having a fixed income manager with the ability to conduct this analysis on a pre-purchase basis will be of utmost importance.
FIGURE 4: Climate Litigation by Applicant Type – US vs Rest of World
Sources: McCormick, Glicksman et al. (2018); Grantham Research Institute (https://climate-laws.org)
FIGURE 5: A Proposed Framework for Assessing Physical Climate Risk
Source: Moody’s Investor Services. For illustrative purposes only.
Start small and build
A problem as large and complex as climate change may feel overwhelming for insurers to tackle. To begin, my recommendation would be to make small changes that can build incrementally over time toward a best-in-class result. For our insurance clients, we bring to bear the academic rigor applied by the Woods Hole Research Center in its physical risk modeling – not only for the portfolios we manage, but also for our clients’ underwriting distribution and their allocations to long-lived (and often illiquid) invested assets. By determining an initial climate risk “footprint,” you can initiate the process of creating a strategic long-term plan for the future. That is considerably more difficult to do if you don’t know how you’re positioned today. Being a resource for our insurance clients across their enterprise will be a major focus of ours in the coming years (Figure 6).
FIGURE 6: Wellington’s Suggested Path to Climate Risk Management
Source: Wellington Management. For illustrative purposes only.
THEME 3: BBB CREDIT EXPOSURE
Insurance companies’ exposure to BBB rated credit has grown substantially in recent years (Figure 7). While this growth has coincided with the rating migration of the bond market broadly (with ~50% of corporate bonds outstanding now rated BBB, vs 35% in 2006), many insurers are beginning to wonder if they should take steps to address the increased credit risk by adjusting their exposure accordingly moving forward.
FIGURE 7: Insurer’s Exposure to BBB Credit Has Grown Substantially in Recent Years
Total US insurance industry exposure to bonds with NAIC 2 designations, 2009-2018
Source: NAIC. As of 31 December 2018
We would caution insurers against simply avoiding BBB credit exposure altogether, particularly in today’s yield-challenged environment. However, we believe it is very important to recognize that all BBBs are not created equal and to therefore place a high premium on fundamental research and credit selection.
We believe most BBB rated issuers have strong incentives to preserve their investment-grade ratings in order to keep borrowing costs low, retain market access to financing, and maintain certain business dealings. Many BBB companies that are unable to meet deleveraging targets organically through realized synergies or free-cash-flow growth could seek to do so through other means, including dividend/share buyback cuts, capital expenditure reductions, and asset sales.
Many BBB rated issuers have considerably higher leverage, which is why credit selection is so critical in this segment of the market. Some such issuers will justify (and keep) their investment-grade ratings, while others will fail to meet deleveraging targets and risk being downgraded to high yield. We have witnessed a number of previously A rated companies leverage up for mergers and acquisitions and get moved into the BBB bucket as a result, making it difficult to express an “up-in-quality” bias toward A rated issuers. BBB rated corporate valuations also appear relatively more attractive overall than A rated corporates, as the yield differential between the two groups recently ranked in the 58th percentile relative to history (Figure 8).
FIGURE 8: Option-Adjusted Spread Differential (BBB Rated Bonds vs A Rated Bonds)
Source: Bloomberg Barclays US Corporate Index. Chart data as of 29 November 2019
While the investment landscape heading into the new decade may look treacherous in some respects, I would argue that being well prepared, strategic, and proactive should provide ample opportunities for insurers willing to be early movers. To that end, we stand ready to continue serving as a front-line defense and trusted thought partner for our insurance clients across the globe.
To learn more about our insurance capabilities,
please visit wellington.com/en/insurers or contact:
Rich Coffman – US | firstname.lastname@example.org | (617) 951-5311
Sarah Marschok – US | email@example.com | (617) 790-7170
Jon Wagenseller, CFA – Bermuda| firstname.lastname@example.org | (617) 289-3805
James Bradbury – EMEA| email@example.com | +442071266464
Bob Sharma, CFA – EMEA| firstname.lastname@example.org | +442071226068