Seeking returns: insurance companies and the low yield dilemma

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11 Dec 2012

When pension trustees get frustrated by the difficulties posed by today’s low yield environment, they should spare a thought for those managing investment portfolios at insurance companies. Not only do insurers have to cope with difficult financial markets but they also have Solvency II looming, ogre-like, over their shoulders.

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When pension trustees get frustrated by the difficulties posed by today’s low yield environment, they should spare a thought for those managing investment portfolios at insurance companies. Not only do insurers have to cope with difficult financial markets but they also have Solvency II looming, ogre-like, over their shoulders.

When pension trustees get frustrated by the difficulties posed by today’s low yield environment, they should spare a thought for those managing investment portfolios at insurance companies. Not only do insurers have to cope with difficult financial markets but they also have Solvency II looming, ogre-like, over their shoulders.

The business of managing an investment portfolio at an insurance company is a subtly different to the same job at a defined benefit pension fund. An insurance company has much more specific obligations to its customers, whether that is stumping up compensation for a written-off car or paying out on a life insurance policy.

For this reason, the insurance industry has been matching assets to liabilities long before this concept became trendy in the pension industry. This, in combination with regulatory requirements, meant the insurance industry has always been a big fan of fixed income products such as sovereign and corporate bonds as they provided dependable cashflows over long time frames. But as yields on these products have dwindled to nothing the insurance industry has been forced, like the pension industry, to look for alternative forms of return.

Different beasts

The insurance industry is not homogenous. A general insurance company providing household and car cover is a very different beast to an annuity provision or a life insurer. They have very different constraints and objectives. For an annuity fund or a life insurer, a close matching of long-term cash flows is important because the insurance company knows what it will have to pay out and so will invest a high concentration in fixed income products with a long duration.

At one end of the spectrum is the general insurer, which must keep a large proportion of its funds in cash so that it can pay out on claims. The investments that it can make must have short-term goals. Bernard Abrahamsen, head of institutional sales and distribution at M&G Investments, says: “General insurance companies have to be able to pay out swiftly if someone crashes their car or their house burns down.”

They also need to keep promises. “An insurance company cannot say it will only pay £5,000 on a written-off car worth £10,000 because they’ve had a bad time in the market,” adds Abrahamsen. With-profits funds may seem anachronistic, but even though these products have largely fallen out of favour and are mostly a legacy issue for many insurance companies, many of the world’s largest still have big books as large as £50bn.

John Roe, head of strategic and investment risk management at Legal & General Investment Management, says: “That’s a lot of money that has to be invested somewhere.” Those with-profits funds can be sub-divided into strong and weak funds. “Strong withprofit funds will have spare capital that can be invested in a range of asset classes while weak with-profit funds are more constrained and need to invest in a similar manner to an annuity fund,” adds Roe. Given the very different nature of these types of insurance business, there is no one-size- fits-all when it comes to looking for alternatives to more traditional fixed income classes. Abrahamsen says: “The challenge for insurance companies is to find an investment to provide extra return for the portfolio without compromising on its ability to honour its promises.”

This is the most challenging for general insurers because they have to have a high degree of liquidity and their investment horizon is so short term.

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