Short and Long-term Insurers have proprietary capital that tends to be available for the long term. The challenge is how to invest this capital to take advantage of the risk premium available in the long-run, considering the short-term needs of profit stability and capital resilience. By considering how much additional capital is required to optimise returns, rather than optimising under existing constraints, one can realise the full potential of this opportunity. To execute on this, a framework is required to translate from business needs to the available asset strategies.
Insurance companies tend to consistently have a fair amount of proprietary capital available for investment - from the additional capital held for adverse events in life companies, to assets held as a reserve in a general insurer.
Long-term capital
Much of this can be seen as long-term capital, because it is anticipated to be there over the long-term.
Long-term capital is best put to work by investing in assets which unlock the risk premium. There is volatility in the returns, but over the long term we expect higher value as compared to investing in less risky short-term assets.
The capital has a job to do
Ideally, we'd like to ignore the volatility over the short-term when we put the capital to longer-term use, but cannot do so for two good reasons:
You need capital when an adverse event arises: Prudential authorities require you have enough capital at all times, measured at market value, and so you cannot ignore the risk or short-term fluctuations in the capital value. Accounting regulations require you to show an unbiased accurate representation of whether you have enough assets to meet your liabilities right now. You can't count on the risk premium providing higher long-term returns to make up for any shortfall now.
The nature of persistent capital
The capital has a job to do, and therefore the return on the capital is important in the short-term. To minimise P&L and solvency volatility, the capital needs to be invested in stable (short-term) assets. Thus the nature of the liability that these assets are backing is short-term, even though the assets and those liabilities are there for the long-term.
Where is the opportunity?
The opportunity is that you have the capital for many years. If you can manage the implications of short-term return volatility, you can earn more over the long-term by unlocking the value of the risk premium. The cost of meeting these constraints needs to be less than the additional returns made - an adequate asset strategy is required to ensure this
Invest in your returns
A key aspect of managing short-term volatility is to have enough capital at any point in the short term i.e. you need a buffer. This means you one must contribute some more capital as a buffer, if you want to take on more risk.
Solvency regulations mimic this fundamental economic need, by requiring more capital as you invest in riskier assets. But regardless of the regulations, an insurer would need a buffer to be resilient, and maintain their risk profile (to ensure that the cost of equity doesn’t increase).
By contributing additional capital to a buffer, the entire pool of capital can earn a higher return - this is essentially a leveraged position, which is where the opportunity lies (and is more valuable in certain situations, such as when interest rates are high).
This opportunity is not available to others, and cannot be replicated by a shareholder. Therefore it can only be unlocked in within the company.
Shifting the discussion
To unlock the full potential of the value over the long term, insurers need to shift the discussion to "how much must I invest in a buffer to get the best value" - rather than to look at their position and try to optimise return for the capital that's there already.
To illustrate the point: an insurer that has very limited solvency, and is not willing to invest more capital, will need to invest in cash. Any other strategy would result in inadequate solvency and risk profile. Hence they would decide to stay in cash, rather than ask for capital/retained earnings to build a buffer, to enable higher returns in the future, thereby missing a lucrative opportunity.
Often, the optimisation is positioned as a SII/SAM capital constraint given the existing capital and buffer available, instead of being considered as an opportunity relative to other opportunities for investing capital. In addition, this capital constraint is but one of the actual considerations insurers should consider.
There are other considerations
Insurers have a wide range of issues to manage in the short term - from liquidity management and exposure concentrations, to risk appetites, P&L volatility and solvency management. This complexity means that optimal asset strategies to meet the varied constraints are often not straightforward.
To handle this complexity, insurers need a framework to translate between the appropriate asset strategies and their business requirements. This allows the universe of suitable asset strategies to be accessible to top management, in terms of management’s criteria and strategy.
A simple example
Assume you bought a bond by paying R400 now, and in return will receive R1000 in 10 years time. Between now and 10 years, the value of that bond will change as interest rates change, but in 10 years, you will get R1000. If all you needed was the money in 10 years, all this volatility doesn't matter.
But what if you had to show your wealth to a lay person each year to convince them you can pay then R1000 in 10 years? Or if there was a 5% chance you may need some money earlier, how much would it matter? And if it was a 25% chance?
These are very difficult issues on which to make decisions on - so rather, a framework that could give you the option to pay an extra R10 now, and in return, a maximum of R100 may be required to meet your needs, may be more useful in making a decision. Especially if you had the knowledge you could borrow R100 if you had to.
With a framework that can provide clear communication, backed by an asset strategy to provide levers to control how a fund behaves, one can practically start to manage the trade-offs, and take advantage of the opportunity.
There is judgement
Insurers have different portfolios, profit exposures to market factors, economic outlooks, and risk appetites. The decisions based on these factors are sometimes subjective, and need to be aligned with other management views. The balance of these factors will influence what the final optimal strategy needs to achieve.
Active Management
As a business and the economy evolves, and assumptions unfold, changes will be required, to rebalance the execution of the strategy to the current conditions.
This indicates that active management has a role to play. However, care needs to be taken to ensure short-term decisions do not compromise the long-term goals.
What do these strategies look like?
There is a range of asset strategies, depending on the actual needs: from static portfolio constructions involving select asset classes (mezz, infrastructure, equity, credit, bonds, etc), to using derivatives or dynamic portfolios. Each of these can further be combined with overlays to manage particular issues. Access to various asset classes also impacts the strategies available.
Because the universe of strategies is wide, a framework that clearly lays out the business requirements in suitable terms is required to find a pragmatic strategy that balances the needs of the business.
The bottom line
Once the strategy is in place, it needs to deliver value - both in monetary terms, and business factors, such as resilience and managed profit volatility. Measurement of this can be tricky, as the returns are expected to emerge over the long-term, but one can adjust for that. Nonetheless, if one could add even just 1% net additional return over the long run to the entire capital base (after the cost of any additional capital, and asset strategy costs), it would be significant.
Delivering on the strategy
Regular reporting and engagement with stakeholders is required to ensure the strategy is delivering as promised. A framework that can translate the performance details into deliverable business goals allows for transparent performance management.
Optimal capital allocation
Shifting to a value-based approach, where insurers strategically manage this opportunity, is likely to deliver value. This may require allocating additional capital to this opportunity, rather than managing it within the existing confines.
If you'd like to discuss any of the points raised in this article, or other related topics then please get in touch at michael@workworth.co.za
Disclaimer: This article has been prepared in good faith with sources believed to be reliable. It contains opinions, and in no way is this article to be construed as advice, a professional opinion, or guaranteed for accuracy. No liability accepted for any loss arising from any use hereof.
