@Aviva.
With falling rates and persistent inflation, insurers face growing pressure to optimise their cash holdings.
After the rate hikes of early 2021, yields on cash and money-market instruments reached multi-year highs, allowing insurers to benefit from putting money in bank deposits and money markets.
Today, however, as rates continue to decline, relying solely on money markets is becoming less compelling. Cash yields have fallen, raising the question: where should insurers invest their liquidity now?
At Aviva Investors, we believe insurers should strategically re-evaluate their balance-sheet liquidity. The solution is not to abandon cash, but to adopt a disciplined approach where high-quality, short-dated bond funds serve as a necessary complement to core cash holdings. They can offer a premium above cash, while maintaining liquidity and capital efficiency requirements under solvency capital standards.
The necessity for insurers to maintain robust liquidity buffers is undeniable. These are critical to meet regulatory requirements, ensure timely payment of claims and cover operational expenses.
Traditionally, this liquidity has been treated as a static reserve, a safety net rather than a source of value. But in today’s market environment, that approach is increasingly outdated.
Interest rates are falling, forcing the need to think carefully about how to retain returns on cash without compromising security or solvency. For insurers, this calls for a mindset shift: viewing cash not as a cost centre, but as a driver of performance. Yet many firms still leave this potential value untapped, parking liquidity in instruments that offer negligible yields.
In this new environment, where most central banks have begun and are expected to continue cutting base interest rates, insurers’ default strategy of holding large cash reserves incurs a “cash drag” on their overall portfolio, leading to lower returns.
A blunt solution is to minimise cash holdings. A more refined one is to reconsider how that cash – or more broadly defined, “liquidity” – is allocated. The simple fact is that most insurers do not need all their liquidity same day. Change that constraint, and a world of opportunity opens.
An allocation to short-term bond funds (typically defined as those with maturities between one and five years offers a compelling solution to insurers looking to strategically allocate their liquidity portfolio. Their high liquidity and low volatility make them an attractive option to enhance cash returns while taking on little additional risk. However, not all short-term bond funds are equal. A look under their bonnet reveals important distinctions.
At one level, the low duration of short-term bond funds affords a strong capital benefit in the UK’s regulatory environment, specifically with Solvency II requirements and the PRA’s supervisory expectations.[i],[ii]
Under Solvency II, capital charges depend on holdings’ duration and credit quality. At shorter duration and higher credit quality, capital charges are lower. But we see further potential. By allocating to selected asset classes, such as covered bonds and sovereigns, insurers can lower capital charges further. And they can reduce them even more by hedging out duration risk altogether.
Most short-term bond funds will have a duration of around three years, and a meaningful allocation to BBB-rated issuers. All else being equal, that implies a spread capital ratio of 4.20 per cent (assuming a generous A-rated average portfolio credit quality). This corporate credit exposure can bring volatility, not to mention the capital consumption it implies.
We think insurers can take better approaches. They can meaningfully enhance yields on liquidity while seeking to retain its core qualities – stability of capital, low volatility of returns and high liquidity. Adding smart portfolio allocation choices can then lead to lower capital charges.
To put this into perspective, insurers could halve their spread capital charge compared to short-dated credit, to around two per cent, while still aiming to target cash benchmark returns of 75 basis points.
This advantage is not trivial. It can allow insurers to enhance returns on their liquidity buffers while maintaining robust solvency ratios.
It optimises the risk-return trade-off: Lower capital charges mean insurers can deploy liquidity into assets that generate incremental yield without disproportionately increasing solvency capital requirements.
It gives insurers strategic flexibility: In a world of tightening spreads and volatile rates, capital-efficient instruments provide a cushion for insurers to navigate market cycles.
Aligning investments with Solvency II doesn’t just ensure compliance. It unlocks performance, helping insurers stay competitive.
As regulatory frameworks evolve, capital efficiency will remain a cornerstone of insurers’ portfolio strategy. Those who leverage a dynamic that prioritises short-duration, high-quality assets can position themselves to deliver stable and enhanced return profiles. By embracing short-term, high-quality bond strategies, they can transform what was once a performance drag into a capital-efficient source of value creation.
[i] Policy statement 10/24, “Review of Solvency II: Reform of the Matching Adjustment”, Bank of England, June 6, 2024.
[ii] Supervisory Statement, “Liquidity risk management for insurers”, Prudential Regulation Authority, November 2024.
Key Risks
Investment risk and currency risk
The value of an investment and any income from it can go down as well as up and can fluctuate in response to changes in currency and exchange rates. Investors may not get back the original amount invested.
Credit and interest rate risk Bond values are affected by changes in interest rates and the bond issuer's creditworthiness. Bonds that offer the potential for a higher income typically have a greater risk of default.
Illiquid securities risk
Some investments could be hard to value or to sell at a desired time, or at a price considered to be fair (especially in large quantities). As a result their prices can be volatile.
Important information
THIS IS A MARKETING COMMUNICATION
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This material is not a recommendation to sell or purchase any investment.
The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.
In Europe this document is issued by Aviva Investors Luxembourg, with its registered office located 2 rue du Fort Bourbon, L-1249 Luxembourg, Grand Duchy of Luxembourg. Aviva Investors Luxembourg is supervised by the Commission de Surveillance du Secteur Financier, R.C.S Luxembourg B25708. In the UK this document is issued by Aviva Investors Global Services Limited, registered in England and Wales No. 1151805, with its registered office located at 80 Fenchurch Street, London, EC3M 4AE. Aviva Investors Global Services Limited is authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.
