PPOs (Periodic Payment Orders) are changing the way UK auto insurers invest to meet their liabilities. They are a series of regular insurance payments for the most serious claims, rather than a distribution of funds via a single lump sum. Craig Turnbull, Investment Director, Global Insurance Specialists, reviews the issues and highlights four potential investment strategies.
Periodic Payment Orders, or PPOs, have emerged as a significant component of UK motor insurers’ liability reserves. Recent studies suggest that, in aggregate, they account for some 15 per cent of total reserves.
PPOs are a series of regular compensation payments for the most serious insurance claims, rather than a distribution of funds via a single lump sum.
This means auto insurers and reinsurers need to invest for a liability profile with characteristics very different from the typical motor insurance liability.
The key differences are:
- Long duration – motor insurers have found themselves with a significant book of liabilities that has a duration of some 20 to 30 years, rather than two or three years.
- Inflation-linked – PPOs have an explicit, formal link to a specific and rather obscure inflation index, the ASHE 6115 index. This is an Office for National Statistics benchmark which measures wage inflation in the care worker sector.
- Illiquidity – the very long-term nature of PPOs and the absence of any policyholder surrender option, mean these liabilities have an illiquid characteristic that is unusual in the UK general insurance business.
These requirements have forced motor insurers and reinsurers to consider distinct investment strategies to acquire the sort of assets that will cover PPO liabilities. These investment strategies share some common themes:
PPO liabilities are a UK phenomenon and hence denominated in sterling. This does not preclude the use of overseas assets. But, in the absence of very strong currency views, it is likely that most of the returns will need to be currency hedged if overseas assets are used.
Long and real duration
PPO liabilities are clearly long duration. Long-term inflation over the lifetime of the liability is a key determinant of investment return requirements. While the ASHE 6115 index and the UK Retail Price Index (RPI) are closely correlated, they are not perfectly aligned. Insurers will need to reflect this in their asset strategy.
Appetite for illiquid assets
Settled PPOs have a predictable long-term payment profile. Annuity-style payments mean there may be an opportunity to invest in some illiquid assets. These offer an illiquidity premium relative to risk-equivalent liquid assets.
Investment risk appetite and solvency capital efficiency
Motor insurers, like most other forms of insurance business, typically have a low investment risk appetite and are capital-constrained. That’s why the solvency capital efficiency of investment strategies will be an important consideration.
Based on these PPO-specific requirements, here’s a list of typical investment targets:
- Real assets with overall duration of some 20 to 25 years and denominated in sterling
- For settled PPOs, an appetite to invest a portion (perhaps one-third) in illiquid assets
- Expected return of 100 to 200 basis points in excess of the long-term real risk-free rate
- Market and credit risk solvency capital requirement (SCR) charge of 10 to 20 per cent.
Here are four investment strategies often considered by UK motor insurers and reinsurers to meet PPO liabilities. They’re ranked by risk, starting with the least risky:
Long-term index-linked gilts
Some UK motor insurers, whose investment risk appetite is limited, may consider investing most of their assets backing PPOs in long-term index-linked gilts.
Clearly, inflation-tracking UK government bonds will not achieve the target return of 100 to 200 basis points in excess of the long-term real risk-free rate. But they may serve as a useful benchmark for more ambitious allocations.
One concern is that, by historical standards, this asset class is exceptionally expensive (yields are negative). The following chart (see Chart 1) shows how the real yield on the inflation-linked gilt, due 2055, has fallen over the past decade.
Chart 1: Real yield on the 2055 inflation-linked gilt
Source: Bloomberg, 25 Mar 19. For illustrative purposes only. No assumptions regarding future performance should be made.
There may well be perfectly sound economic reasons for a long-term real yield below minus 1.5 per cent. Some economists have argued that changing demographics and declines in expected long-term productivity growth have contributed to this striking fall in yield.
But insurance investors may also have concerns that quasi-temporary factors such as quantitative easing programmes by the Bank of England are to blame. The robust demand for long-duration index-linked gilts from some institutional investors may also be a culprit.
Finally, while these bonds are assumed to have negligible credit default risk, it is worth re-emphasising the issue of index tracking error. That’s because PPO liabilities with a linkage to the ASHE 6115 index are not perfectly aligned with UK RPI.
Long-term index-linked investment-grade corporate bonds
We can, of course, enhance the bond yield and the expected asset return by finding long-term index-linked bonds that are issued by companies, rather than the UK government.
For example, the yields of sterling-denominated, long-dated, RPI-linked, A-rated corporate bonds trade at some 120 basis points higher than those of long-dated index-linked gilts. An A-rated 20-year corporate bond has a standard formula credit SCR charge of 15.5 per cent.
There is, however, one important catch. The corporate issuers of such bonds tend to be clustered within a single sector – utilities. This creates concentration risk. Chart 2 shows the composition of an index-linked corporate bond fund managed by Aberdeen Standard Investments.
Chart 2: Sector breakdown of ASI index-linked corporate bond portfolio
Source: Aberdeen Standard Investments, UBS Delta, UBS, CoB, 25 Mar 19
However, for those institutions prepared to use derivatives in portfolio construction, it may be possible to synthetically recreate a diversified bond portfolio with investment-grade credit risk and long-term real duration.
Options include: long-term index-linked gilts with a sterling credit index credit default swap; long-term sterling investment-grade (nominal) corporate bonds with an inflation swap; or US dollar investment-grade (nominal) corporate bonds with a cross-currency swap and a sterling inflation swap.
The final choice will be determined by relative market pricing, liquidity requirements and appetite for complexity.
Protected equity strategies
An exposure to equity markets is another solution, although high equity volatility does mean higher risk. An investment strategy that incorporates equities will therefore be more capital intensive in order to meet regulatory requirements.
Developed equity markets typically offer a risk premium of some 400 to 500 basis points. The standard formula SCR for equity risk is 39 per cent (plus or minus the equity dampener feature).
Higher risk will put off many risk-averse UK motor insurers. However, volatility, and hence risk, can be dampened in a couple of ways.
As a particularly long-term form of liability, a small allocation to equities, say 10 per cent, may be suitable for some PPO books.
Meanwhile, UK motor insurers can also use derivatives to manage risk. For example, collar strategies involve the buying of put options to limit potential losses, while selling call options to help pay for the cost of the puts and to cap gains.
These derivatives strategies can be tailored to meet individual requirements. The following chart shows how the equity SCR charge can be impacted by implementing a suitable collar strategy, using as an example a collar designed to target an SCR of 20 per cent (see Chart 3).
Chart 3: Collar strategy impact on equity SCR
Source: Bloomberg, JPMorgan Securities. Data refers to the period from Jan 2008 to Dec 2018. Performances are net of rebalancing costs and gross of index fees. The figures above refer to simulated past performance for the Systematic Daily Rolling Collar Target SCR 20%. Past performance is not a reliable indicator of future performance.
Accessing the illiquidity premium
Illiquid assets can be useful here in two ways. First of all, they can boost investment returns because these assets pay an illiquidity premium.
Meanwhile, European-style regulatory regimes also allow insurers to take credit for the illiquidity premium if they cash flow match their assets and liabilities. This means beneficial treatment when valuing liabilities that can lead to less capital being tied up.
Examples of long duration illiquid assets that can yield a credit spread of some 50 to 100 basis points in excess of risk-comparable bonds, include student accommodation loans and renewable energy infrastructure loans.
PPO books typically make smaller allocations (less than £100 million) in private markets, depending on the size of their book of settled PPOs and their illiquidity appetite.
In such cases, an investment in a private credit pooled fund would be most appropriate. However, the drawback is that a pooled fund is likely to pursue a set of investment objectives that are designed to meet the needs of a range of investors. It would not be tailored to PPO requirements.
PPO liabilities are very different to the standard liabilities of motor insurers and reinsurers. As such, a dedicated PPO asset strategy will also look very different.
There is a wide range of asset classes that can play a role in meeting the investment objectives and criteria of PPO investors. We have outlined a few of them above, but this list is far from exhaustive.
There is no one-size-fits-all ‘optimal’ solution. Return objectives; appetite for risk, capital, complexity, illiquidity; and asset allocation size, all play a role in determining strategy.
That’s why a consultative approach between insurance client and insurance asset manager is essential for success.