Insurance Insights Q3 2022: Regular review of Strategic Asset Allocations

In prior editions of our newsletter and in discussions with insurers, we have often reiterated the need to constantly review the Strategic Asset Allocation (SAA). Capital markets, to be sure, are constantly in a state of flux and evolving, but so too, for the most part, is the liability profile and business mix. Therefore, to ensure the portfolio is able to meet requirements (whether expected returns/yields or capital efficiencies, or other ALM parameters), one needs to incorporate updates on a regular basis. One of the critical inputs into this process are capital market assumptions. At Invesco, we generate a wide set of such assumptions (CMAs) which are updated on a quarterly basis and incorporate the latest market developments. These, of course, are of relevance to insurers looking at setting, updating, or reviewing their long-term allocations. Other than a pure expected return/yield consideration, insurers are increasingly monitoring other aspects of the portfolio including capital considerations of asset classes and the overall asset-liability matching profile. As a quick reference, we have illustrated, in the charts below, how insurers can assess the attractiveness of particular asset classes at a point in time (Figure 1) and how this stacks up on an expected return-to-capital charge perspective (Figure 2) as well. Combining these two elements can help narrow down the initial list of asset types to consider. 

Please note that for purposes of this illustration, we have used the Solvency II Solvency Capital Required (SCR) standard formula for relevant risk charges as a proxy for more general risk-based capital (RBC) regimes; this can obviously be tailored to other RBC regimes across the region. While the specific charges may differ based on jurisdictions, we feel the trend or direction of risk charge changes based on allocations would still be meaningful and of relevance. It remains important to continually assess portfolios across several dimensions to ensure that its premise remains valid and achievable.

Updating Strategic Asset Allocations – Incorporating New Asset Classes

We have shown earlier how the introduction of some representative alternative asset classes (such as private equity, real estate, infrastructure, private credit, etc.) can help improve the efficiency of insurance portfolios.

To recap, let’s see what happens to a hypothetical portfolio if we were to consider adding private equity (as an example of an alternative asset class) to it below - how could we assess the impact?

Using our in-house portfolio management decision support system – called Invesco Vision¹ – we are able to compare different asset allocations to see which ones may be more efficient than others – and also to look for ways in which we may be able to enhance existing portfolios.  

The charts below (Figure 3 and 4) compare the risk-return profiles of the two portfolios above – to see what impact, if any, the addition of a private equity asset class has - the aim is to assess how the risk-return profile changes as a result of adding new asset classes.

Figure 3 (left) shows the portfolio characteristics on an economic basis and Figure 4 (right) shows the characteristics on a Solvency II SCR basis. The light blue line represents the frontier without private equity and the dark blue line represents the frontier with a single private equity strategy (while the light blue and dark blue single points represent the respective portfolio asset allocations).

The aim is to move our portfolio up and to the left (or at least not excessively to the right!). And, indeed, we can see that by selectively adding a generic private equity allocation, we can improve the overall risk-return profile of the portfolios – the green frontier is higher (than the purple) and the portfolio with private equity represented by the green single point shows a move upwards and appears to offer a better profile (obviously, the allocation change is fairly small and so the corresponding portfolio change would be correspondingly small). We have re-allocated away from listed equities into private equity – therefore, while the expected return is higher, the capital charge on a diversified basis is almost the same. This is a simple example of how selection of specific asset classes can help enhance portfolios.

The effects of adding diversified alternatives (multi-alternatives) exposure to a portfolio

Our next step is to assess if we can diversify any alternatives exposure – instead of just a standalone private equity allocation, what if we were to construct a sub-portfolio of different alternatives strategies – for example, spanning different types of private equity, combining this with some real estate exposure, and also incorporating private credit strategies. We believe such a diversified exposure to “multi-alternatives” has the potential to offer enhanced and more resilient portfolios.

In the revised portfolio below, we have replaced the earlier private equity exposure with a multi-alternatives growth strategy, and we have also taken the opportunity to slightly reduce emerging market debt exposure and allocated this to a multi-alternatives income strategy.

Again, we have the ability visually or graphically to see what impact such an updated allocation may have on our portfolio from a risk-return perspective.

In this updated portfolio above, we have replaced our single private equity exposure (and some of the emerging market debt exposure) with allocations to several different strategies - ranging from private equity buyout, growth, venture capital, to opportunistic and value-added real estate exposure, as well as private credit. The allocations here are meant to be for illustrative purposes only. Multi-alternatives portfolios can be constructed by taking into consideration desired risk-reward profiles with correspondingly appropriate allocations – these are highly customizable (dependent on certain minimum allocation amounts).

The charts below (Figure 5 and 6) compare the risk-return profiles of the two portfolios above – to see what impact the addition of a diversified multi-alternatives exposure has - the aim is to assess how the risk-return profile changes as a result of adding a diversified range of asset classes.

Figure 5 (left) shows the portfolio characteristics on an economic basis and Figure 6 (right) shows the characteristics on a Solvency II SCR basis. The light blue line represents the frontier with just a single private equity strategy and the dark blue line represents the frontier with the diversified multi-alternatives strategies (while the light blue and dark blue single points represent the respective portfolio asset allocations).

We observe that by incorporating a diversified multi-alternatives exposure within our portfolio, we have been able to further enhance the efficiency of the overall portfolio – by further moving our portfolio slightly up and to the left.

The charts below magnify the comparison of a single private equity strategy and emerging market debt with the diversified multi-alternatives strategy to illustrate the potential enhanced profile.

Here (Figure 7) we can more clearly see the enhanced profile of the diversified multi-alternatives strategies compared to the asset classes they are replacing (on a Solvency II SCR basis). This assessment takes into consideration aspects of expected returns and standard solvency risk charges for the indicated asset classes (to note that how the underlying assets/representative indices are modeled would impact the overall profile of the portfolio). We believe this is an example of the types of analyses that are very appropriate and, indeed, should be part of any standard operating procedure in managing insurance portfolios.

Potential operating model

We feel that operationalizing any such program in an effective manner is almost equally important for insurers. Implementing such a program can be challenging and complex.

We feel optimal outcomes of any such program depend on close interaction between investors and asset managers within the set-up of a multi-stage alternative investment framework. The end-result is to deliver a portfolio over time that fully meets investors’ requirements

Finally, we feel it remains vital to maintain oversight over several activities associated with this asset class and investors can look at an effective combination of external and internal monitoring in order to achieve the optimal process.

The pragmatic process outlined we feel can meet these requirements – this is meant to be a very collaborative approach and can lead to more robust outcomes for insurers’ portfolios.

Key takeaways

We hope the approach and examples above of enhancing insurance portfolios has been helpful. We have built upon our earlier higher-level analysis and supplemented it here by delving more deeply into specific asset classes – the ultimate aim always being to enhance the risk-return profile and make portfolios more efficient.

Our view is that the insurance asset management side will continue to progress, evolve if you will, over the next several years in this manner – looking to enhance investment portfolios in a capital-efficient manner, through various market environments and ensure they are able to withstand volatile conditions.

Alternatives, illiquids, or private markets can play an important role within such constructs – from both efficiency and diversification perspectives - and lend themselves well to a typical life insurer’s portfolios – but it remains extremely important to assess the specific types of sub-asset classes, understand the sources of return and risk, including operational, accounting, tax considerations, and then, last but not least, be able to manage and/or have sufficient oversight of such programs.

As always, please do not hesitate to reach out to us – your thoughts on such topics are always much appreciated.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Diversification and asset allocation do not guarantee a profit or eliminate the risk of loss.

Invesco Investment Solutions (IIS) develops Capital Market Assumptions (CMAs) that provide long-term estimates for the behavior of major asset classes globally. The team is dedicated to designing outcome-oriented, multi-asset portfolios that meet the specific goals of investors. The assumptions, which are based on 5- and 10-year investment time horizon, are intended to guide these strategic asset class allocations. For each selected asset class, IIS develop assumptions for estimated return, estimated standard deviation of return (volatility), and estimated correlation with other asset classes. Estimated returns are subject to uncertainty and error and can be conditional on economic scenarios.  In the event a particular scenario comes to pass, actual returns could be significantly higher or lower than these estimates.