The interface between insurance companies and the capital markets with regards to capital optimisation is typically characterised by observers as having three distinct parts.
Firstly, and most simply, raising capital. In the debt capital markets this means subordinated, or more specifically today, hybrid capital issuance. Of course, insurance companies continue to issue or buyback shares depending on their capital needs and the mix with hybrid capital they are seeking.
Secondly, how insurance companies can minimise the capital required for their current book of business. This was the area that insurance companies, particularly in the UK, addressed in the wake of the low solvency ratios and asset/liability mismatches they found themselves in at the beginning of this decade. The need to work on this became even more imperative when insurance regulators such as the Financial Services Authority introduced realistic balance sheet regulations that highlighted such problems.
These first two parts of capital management have become prevalent in the insurance industry, certainly in the UK and increasingly across continental Europe. Insurers approach to hybrid capital is characterised as "mature" by many DCM bankers covering the sector, even if enthusiasm for the product has ensured that it has remained a prominent feature of insurance companies activities in the capital markets.
Insurers were also quick to address the second issue after suffering problems in the early years of the decade. Life insurance companies in particular were forced to immunise themselves against the movements in interest rates that had thrown their asset/liability matching out of whack.
"Life insurers wrote a lot of options and guarantees in the 70s, 80s and 90s, and those guarantees came back to bite them as interest rates and equity markets fell," says John Roe, insurance ALM advisory at the Royal Bank of Scotland in London. "That was therefore the first area of significant insurance ALM, when they started moving away from just cash investments and began looking at hedging the risks, realising that they had too much risk in their funds.
"They reduced the equity exposure and hedged what I would call unrewarded risks, such as the interest rate guarantees. There was therefore a period when reducing capital requirements was key for a lot of insurers."
From interest rate to credit issues
Having neutralised unrewarded risks on their balance sheets, and seen equity markets recover from the lows that followed the bursting of the dotcom bubble, insurers have become less reactive to events and more pro-active, entering a third aspect of capital management.
"They are asking how they can get a better return on the capital than they have, which is a more aggressive spin on the same actions they were taking while reacting to the problems they had," says one insurance DCM banker. "And then there is the issue of actually removing insurance-type risks from their balance sheets and transferring them into the capital markets."The latter part of this is most clearly in evidence in the market for insurance-linked securities, for the most part through catastrophe bonds for non-life companies (see chapter on insurance-linked securities starting on page 37 for further details) but also by life insurance securitisations (see chapter starting on page 27). Life insurance companies would also like to rid themselves of longevity risk, of which more below.
But having learned how better to understand and model the risks that hurt them in the early years of the decade, insurance companies have equipped themselves well to achieve a better return on capital by being more selective about the risks they wanted to take with the capital they had.
"With the recovery in the equity markets over the last couple of years, there has been some re-risking of funds," says Roe at RBS, "particularly the closed funds, with some of the funds at Resolution and Pearl being examples of this with some of their funds. They have sought to increase the equity proportion of their holdings again."
He says that having achieved some of the "easy wins" within their portfolios, such as neutralising guaranteed annuity options, insurance companies are now turning to areas such as their credit portfolios.
"They are asking how they can maximise the returns on the capital they are investing in their credit portfolio," says Roe. "For example, whereas the fixed interest strategy used to be cashflow matching using bonds for a large portion of the portfolio, increasingly they are realising that they should actually be incorporating derivatives in order to be more capital efficient in the credits they are invested in."
The best of both worlds
Some insurance companies are more advanced in this area than others, being able to combine a flexibility that allows them to take advantage of opportunities in the markets without jeopardising their capital unnecessarily.
One UK insurer, for example, took out an unusually large credit hedge just before the turmoil hit the markets, a move that now looks like one of the sharpest calls on the market this year.
"We had been talking for some time about credit markets being extended, spreads being too narrow, and defaults only going one way, and therefore trying to improve the overall credit rating of the with-profits funds fixed income portfolio," says a portfolio manager at the insurance company in London. The insurer therefore positioned itself accordingly.
"We were expecting to hold this position for the next couple of years while spreads widened gradually," he adds. "Instead, we were wondering whether we should take it off within a few weeks because everything went pear-shaped very, very quickly."
The credit hedge was one of the tactical asset allocations decisions that the companys portfolio management group takes on short term views on the market, but the team combines this with longer term strategic asset allocation. The latter features input from the companys capital management team, which provides insight into the optimal asset allocation for the companys with-profits and annuity funds, taking into account the constraints posed by the nature of liabilities and capital regulations.
"As most companies now do, we distinguish between strategic asset allocation and tactical asset allocation, although sometimes they get blurred," says the portfolio manager. "Strategic asset allocation is about meeting policyholder or client objectives for an efficient level of capital such that our expected return on capital is optimised.
"The capital implications, and accounting implications, of the different investment strategies we undertake are therefore key inputs into the strategic asset allocations that we set ourselves for the different internal funds."
Where the insurer is considered ahead of the game is in combining this strategic asset allocation with a nimble tactical approach.
"Once we have set the strategic asset allocation and that has been agreed by the internal statutory board, then we have a certain amount of flexibility to shift that asset allocation around within given parameters to take advantage of what we see as mispricings in the different securities markets," says the official. "And although the leeway we have relative to our strategic benchmark might seem small in theory, it is quite a lot in practice because it is a such a large fund that we are managing.
"We realised many years ago that having to go often to an asset allocation committee just hindered us, but now we can put on positions relative to our strategic benchmark and the board knows that it is in line with risk appetite and that there is no threat to capital. And we have generated a very good performance within the flexibility we have."The longevity risk conundrumOne risk that life insurance companies have so far had no choice about taking is longevity risk. "There are two key influences on pensions liabilities: investment returns and longevity," said Watson Wyatt in a report, "Sharing longevity risk", in April. "In the last 10 years these have combined to create a perfect storm for defined benefit schemes, with a reduction in real investment returns coupled with a dramatic increase in life expectancy.
"Longevity increases have a severe gearing effect on pensions liabilities."
The pensions consultant gives the example of an increase in life expectancy from 80 to 84 for a person with a pension payable from retirement at 65. This would result in the pension being paid for 19 years rather than 15 years, an increase of 27%.
"As a result, without a radical re-think, current and future pensioners will receive their pensions for far longer than their predecessors, when the cost of providing pensions has already increased substantially."
The key issue, as the title of Watson Wyatts report suggests, is who pension funds and insurance companies can persuade to share some of the risk. Should someone be able to find out who this is, and package it in an appropriate manner, the market has huge potential.
"Its the kind of thing that if it cracked, creates the opportunity for growth several orders of magnitude larger than the entire insurance-linked securities space," says Eugene Dimitriou, head of alternative risk transfer at RBS in London. "There are also myriad ramifications in terms of how pension funds and insurance companies manage their risks."
But cracking the market will not be easy. "The problem with longevity risk is that its not an event," says Olivier Heyraud, managing director, financial institutions debt capital markets, at Royal Bank of Scotland in London. "Its a trend. To hedge a trend you need to be able to find investors on the other side."
While reinsurers have absorbed some of the risks, they have taken on only a very small proportion of the huge amounts sitting on pension funds and insurers books.
Hedge funds have often been cited as potential repositories of longevity risk, but there has been little hard evidence of this so far. Insurers also doubt whether hedge funds, given their short return horizons, will do anything other than take over the risk for a short term, and the question will then be who it will be passed on to afterwards.
"Eighteen months ago investment banks were all saying they could do something in this field and claimed to have a number of funds who were keen to diversify into this uncorrelated risk," says a treasurer at one insurance company. "The also said that somehow they could dress it up to give hedge funds the right kind of maturity that they were looking for.
"But while were keen to help developments in that area and are talking to a number of investment banks to see what can be developed, weve yet to see anything concrete emerge."
Some observers have called on governments to provide a solution to the problem, but the UK Debt Management Office, for example, has pointed out that governments will be unwilling to take on more of a risk they are already exposed to through state pensions, health costs and other extra expenses they themselves face as people live longer.
However, bankers and even some life insurers are confident the problem of longevity risk can be addressed.
"Its inevitable that the market cracks in some way, in the sense that it cannot be healthy for pension funds and insurance companies to be the exclusive repository of all this risk," says Dimitriou at RBS. "The capital markets are 100 times as large and can take diversified positions."Its got to crack. Its just a question of when."