These are the findings of the survey. What are our views? We sound an amber warning on four areas. And we highlight two areas where there is scope for a global asset manager to add value.
Understanding the fundamental risks of private markets
How should insurers think about the strong consensus view driving the shift from public to private assets? After all, betting with the consensus is rarely the path to superior returns. Yet this shift reflects a fundamental change in the way that business is financed. Demand and supply are rising in tandem. We carried out a study of the history of asset allocation over 200 years – the history is British but the inferences are global – and two lessons stand out.
First, this shift can last for years. An influential actuarial paper made the case for embracing illiquid assets in 1862. By 1890, fully 80% of life office assets were invested in non-exchange traded assets.
But eventually investors became complacent and misjudged risk. Insurers suffered losses when falls in agricultural land prices led to defaults. Sometimes, what looks like an illiquidity premium turns out to be credit risk. It can be difficult to separate the two forms of risk. The lesson is that understanding the underlying fundamentals is key.
Assistance on asset allocation: expertise and structure
50% of large insurers cited tactical asset allocation as an area for improvement for their in-house investment capabilities, compared to just 18% of smaller insurers and 20% of mid-sized firms. This pattern is true of strategic asset allocation too, albeit the differences are less marked (27% for small firms, 30% medium, 39% large). This does raise the question of whether some smaller firms are unaware of their lack of expertise relative to their larger peers, who generally have more resources dedicated to these areas. But it also reflects the fact that other smaller firms do recognise this as an area of weakness, which they have already solved through outsourcing to external experts.
Getting asset allocation decisions right is not enough. Assets have to be held in the right structures, tailored to the individual needs of the insurance company. The right structure can enhance capital efficiency, reduce balance sheet volatility and prevent the swings on income statements created by mark-to-market pricing of risk.
The risks and uncertainties of rapid technological change
Insurers are alert to the known risks and opportunities of rapid technological change, but exposed to the many unknowns that accompany these changes.
Insurers are focused on the opportunities that technology brings, through operational improvements. But they may be playing down the threat of new competitors – as well as the threat from existing competitors that successfully embrace new approaches. The impact of technological change is primarily on the liabilities side: such as increased efficiency in managing claims and payments, and improved pricing of risks. But changes in liabilities could eventually lead to changes in the way that assets are managed too.
A McKinsey study (Notes from the AI frontier: applications and value of deep learning, McKinsey Global Institute) estimated a range of the impact of artificial intelligence across 19 sectors. The maximum impact on the insurance sector was estimated at 7.1% of revenues, making it the third-most affected sector after travel and high tech.
Technology is already changing investment on many fronts: from the isolation of risk premiums in smart beta applications; to high frequency trading; to nowcasting of economic data; to machine learning applications in investment decision-making.
Yet the fundamental nature of insurance investment has changed little over the last two centuries. Investment strategy is largely buy-and-hold, matching the duration of assets and liabilities. The long-dated nature of the liabilities allows for a significant exposure to more illiquid assets. Advanced computing makes actuarial calculations significantly easier to carry out, but does not change the underlying maths.
Nor does artificial intelligence remove the need for human judgement. Effective risk management requires a codification of this judgement alongside quantitative modelling. Technology provides tools to more effectively manage the many complexities of investment, but does not provide complete solutions.
It is clear that the successful firms of the future will have embraced technological change. But managing exposures to more exotic asset classes requires expertise that is difficult for, say, a robo-insurer to replicate. The ability to combine technological expertise with investment expertise will be an increasingly important differentiator.
Complacency on ESG risks?
US insurance investors lead the global pack in terms of the shift from public to private markets, and from active to passive. But they appear to lag when it comes to prioritising the integration of ESG analysis into their process. Only one respondent cited ESG expertise as a key factor during external manager selection.
Yet in our opinion ESG analysis is not simply driven by the desire to do the right thing. There is well-documented academic evidence of a link between good management of ESG risk and good management of the financial risks that determine the creditworthiness of a company. Investors who do not incorporate ESG analysis in their process are putting themselves at an information disadvantage.
Alternatives to alternatives
Investors are struggling to reach target weightings in private markets. Secondary markets in private assets provide one possible avenue to accelerate additions to private markets, but liquidity in secondary markets is even lower than the primary market. Insurers can consider alternative strategies in public markets for sources of higher return and increased diversification. Outcome-oriented multi-asset strategies, US dollar-denominated emerging market debt and systematic alternative risk premium strategies are all examples that have the potential to offer appropriate risk-return characteristics for North American insurance investors.
A deeper understanding of risk
Insurers look to external asset managers for their expertise in risk management. The increasing shift into more complex private markets is likely to put a premium on those managers able to offer advice across a broad range of assets and strategies. These asset managers can triangulate: specific expertise in alternative asset classes; an understanding of the regulatory implications of investing in those asset classes; and the specific needs of the client.
Investors need to understand the real dimensions of risk. Backward looking measures of risk are not enough. Incorporating human judgement into forward-looking scenario analysis leads to better-informed decision making. But investors also need to understand the limits of risk models. A fundamental understanding of investments is also key. Best practice combines sophisticated modelling of these fundamentals with a realistic appreciation of the ability of those models to manage the unknowable.