Insurance Investor: As new technologies emerge and regulations evolve, how can insurers manage liquidity within their portfolios?
Ed Palmer: The key factors when you are looking at any individual portfolio is to understand the objectives you are seeking to meet, the constraints within which you need to operate and the individual needs of that portfolio.
Hypothetically, if you were only dealing with one portfolio this would be relatively straightforward but in most cases there are multiple portfolios, which means a lot of data to manage and the more complex your investment strategy, the more moving parts there are to handle.
Framing it in the context of portfolio objectives and priorities will give a better feel for how much liquidity you will need at any point in time.
It is better to avoid being a forced seller if you need to raise liquidity but also preferable to avoid sitting on excess cash which you could potentially invest to achieve higher returns.
II: How can portfolio diversification optimise risk-adjusted returns?
Ed:There may be advantages that can be gained from capturing a spread premium by diversifying into private markets if the proportion of illiquid assets in the portfolio can be increased. This may be appropriate if the liability profile is less liquid.
Enhanced risk adjusted returns may also be possible for illiquid assets and in some areas such as infrastructure, favourable capital treatment for qualifying assets. However, achieving the optimal outcome is not always straightforward.
"You may gain access to a more diverse issuer base that you might not see in the public market"
That said, there are still other reasons why you might want to diversify into illiquid assets as you may for instance, gain access to a more diverse issuer base that you might not see in the public market.
You may get security and financial covenants, be able to tailor a structure that suits your own particular portfolio needs, either fixed or floating and a particular currency or specific duration. There are reasons to do it even outside of the established regulatory constructs.
II: How can an insurer build a diversified portfolio? What factors need to be considered?
Ed: Many insurers would observe the market and consider private assets that have a certain set of characteristics but the difficulty that is often encountered is sourcing the kinds of assets that meet
the objectives in sufficient volume.
One of the main themes that is in markets at the moment is competition for assets and this move into private assets and the demand from insurers to diversify their portfolios means that there are
more players looking for the same assets.
"The more sophisticated your investment strategy is, the more moving parts that you need to take into account"
Given that the nature of insurance portfolios is somewhat specific in that for each individual set of liabilities you might have a specific set of objectives and constraints that you need to operate within, what might work for one portfolio may not work for another.
It is not as easy as it looks and the more portfolios you have as well as the more sophisticated your investment strategy is, the more moving parts that you need to take into account.
II: Does asset correlation matter? If so, why?
Ed: There is some correlation but there tends to be a lag in the spread moves that are seen in the public market compared with the private market. The private market tends to react slower to developments so whist there is a correlation there is a bit of a time lag.
Also, historically, the recovery rates that you see on the likes of infrastructure assets and so on are higher than you would see in the public market typically.
II: Wouldn't this be an advantage for insurers since insurers are long-term investors?
Ed: It is an advantage in being able to identify and source private assets at wider spreads with security, financial covenants and potentially higher recoveries so you can see why it is potentially a very attractive asset class. However, it just doesn’t react as quickly as the public market.
II: What trends do you see developing in the next 12-18 months around portfolio diversification for insurers?
Ed: The key themes are going to be growing competition for assets and this is one that has been running for a while now but I don’t see it changing in the current low rate environment and I feel that there will be increasing interest in all kinds of private credit.
The recent reversal in rates is going to be a big driver as well as we have gone in a matter of months from a story of rates heading steadily upwards to now where we have had a very significant reversal of rates.
"We are seeing some signs that the credit cycle may be turning"
Some investors may have been waiting for rates to rise before doing some repositioning within their portfolios and this now seems unlikely so asset allocation may need to be adjusted to position for a lower rate environment over the longer term.
We are also seeing some signs that the credit cycle may be turning and, if this is the case and we are going to see a weaker economic environment , then this will cause insurers to be thinking about positioning themselves more defensively so that their portfolios are better positioned in that scenario.
Ed Palmer, EMEA Chief Investment Officer at Metlife, will be speaking at the Insurance Asset Management Summit in November. You can find out more about the event and book your place to attend here.