The COVID-19 pandemic has solidified the prospect of "lower for even longer" interest rates. Insurers and reinsurers already familiar with the challenges of reduced investment returns, effective asset and liability matching and optimizing capital face more of the same – but with some differences in the economic backdrop.
In the spring of 2020, when vaccines started to offer some light at the end of the long COVID-19 tunnel, attention turned to ensuring economies were able to achieve sustainable and self-reinforcing recoveries. Pre-global financial crisis, the stock response of the previous 40 or so years to any future economic slowdown or shock would have been to cut interest rates significantly. But with interest rates already so low and the effectiveness of central bank quantitative easing policies weakened, the emphasis has been to shift to a longer-term trend of capital investment from governments in, for example, infrastructure, to support economic growth.
What does this potentially mean for insurers’ and reinsurers’ investment and capital management strategies to 2030 and beyond?
Pluses and minuses
From an investment point of view, it’s likely to create a good environment for growth-related assets over the next 12 to 24 months despite returns on government bonds remaining weak.
Longer-term, though, the policy shift may create higher economic volatility. It raises the possibility of higher inflation – a pernicious enemy of P&C insurers, in particular, and something the market has virtually forgotten about. While higher inflation is unlikely to be a big problem for advanced economies, it’s certainly a plausible risk that insurers will need to consider in modeling and stress testing both the resilience of investment portfolios and as a driver of liabilities and asset/liability matching.
Strategic asset allocations that balance resilience and returns are likely to come to the fore; some companies may want to take more risk when credit is cheap.
Indeed, as government spending becomes a more important economic policy tool, there should be good investment opportunities in real assets, including green infrastructure and other areas of innovation. Such opportunities will also play well to (re)insurers’ expanding ESG (environment, social and governance) agendas and potentially add to the ESG credentials that a lot of investors, including those in the insurance-linked securities (ILS) space, are increasingly drawn to.
Of course, changes in governments’ fiscal policies won’t be taking place in isolation. Insurers will also have to contemplate how to allow for and adapt to significant structural economic trends that are likely to characterize the first half of the century and will therefore interact with and influence the policy agenda.
See also: Navigating the Future of Risk Management
Four structural trends that will matter for (re)insurers in the first half of the 21st century:
1. Shifts underway to a lower-carbon economy -- e.g., transition to electric cars from internal combustion engines. The shift will affect how and where insurers and reinsurers invest premium income, both from an ESG and returns perspective, and may have an impact on how they allocate capital to the business lines they write. In aiding and helping to steward climate transition efforts, insurers have an opportunity to be a force for good.
2. Technology – enough said, really. Technology is changing the way we live and work, from where and how work is done and the new investment opportunities it fosters, to the type and scale of risks that insurance is needed to cover. The global pandemic is only likely to accelerate this trend, bringing with it particular issues for insurers around capital efficiency and things such as access to technology and cybersecurity for business and governments collectively.
3. The societal lens — society is increasingly demanding and expecting to see proof of sustainability, inclusiveness and diversity. For (re)insurers, that demand speaks to issues such as reputational risk, the insurance gaps that exist around the world and the potential need for public/private cooperation to fill those gaps.
4. The shift of wealth and capital from West to East — as seen in the rise of China and emerging markets and where the largest opportunities for growth in financial services will exist. Notably, from an investment perspective, while some insurers might have historically placed China government bonds in an emerging market bucket, they are increasingly offering the high quality, policy certainty, low credit risk and higher liquidity attributes that typically appeal.
The changing economic backdrop will inevitably put further onus on strong financial and capital modeling and management.
Insurers weathered the initial COVID-19 capital storm well for the most part, but its legacy is lots of uncertainty. One area of capital management that has already come in for closer scrutiny from regulators, for example (notably as part of the Solvency II review), is recovery and resolution plans.
Another factor in allocating and managing capital longer-term that is firmly on regulators’ and rating agencies’ radars, as well as that of wider stakeholder groups, is climate risk. As climate risks – and opportunities – have become ever more financially material, the need for an enterprise-wide perspective, taking in both the asset and liability sides of the balance sheet, is being further reinforced.
Taking risk and capital management as a whole, the shifts occurring suggest there will be a case for challenging implicit assumptions in models and reassessing mid- and longer-term views of risk and risk appetite. One area we highlighted in a recent article focusing on life companies, for example, is the potential benefit of value of new business (VNB) metrics in helping companies decide where they concentrate business acquisition efforts.
Modeling and capital optimization will be an important part of guiding the efficient use and resilience of capital, taking into account options such as reinsurance structures, business domiciles and mergers, acquisitions and divestments. Appetite and capacity of reinsurance and ILS markets for a broad range of risks remains strong, and better understanding of exposures will lead to better negotiating positions. Equally, there should be continuing opportunities for acquisitions and divestments given the relative cost of capital. These could certainly be routes for companies to focus capital in their core and most profitable business areas, to take advantage of diversification benefits and to maintain a watchful eye on regulatory capital requirements.
With these kinds of goals in mind, there are opportunities for companies to make more use of capital models with customized inputs to really gain insights into their business; to ask the right questions based on the market and economic outlook and their key performance indicators. One area where many companies appear to have struggled to date, and where such analysis would have an application, for example, is to align capital projections with business planning forecasts – as required for the Solvency II ORSA (Own Risk Solvency Assessment).
See also: 7 ‘Laws of Zero’ Will Shape Future
In search of clarity
While there is almost certainly more that companies will be able to do with their existing models over the coming years to adapt and deal with the economic and market changes taking place, what about "the perils of the unmodeled"?
Without taking steps to keep up with the measurement of developing risks, be they pandemic, cyber or climate-related, insurers could have a problem despite all the modeling advances made in the last 10 to 15 years. This potential problem is all the more important when you consider that many insurers will really need to drive combined ratios down into the low 90s to produce an acceptable return on capital in light of the expected level of investment yields. That will need a whole balance sheet approach.
After all, consistent returns underpin why a lot of investors are attracted to insurance stocks and provide their capital in the first place. Often, interest boils down to one thing: dividends. During the pandemic, many regulators put a brake on that investment thesis by basically telling insurers they couldn’t pay dividends, and the situation has been complicated by the uneven playing field created by the different approaches taken by different national regulators. But, as things return to normal, the industry will have to demonstrate that future dividends aren’t at risk.
Investment and capital strategies that balance growth with resilience, recognize structural economic trends and drivers and smooth out potential volatility in the post-COVID economy will play an important part.