RETHINKING RISK: A NEW APPROACH TO UNDERSTANDING RISK IN PORTFOLIOS

02.09.2018
BY KATE MILLER

Risk management is a core focus for insurers and nowhere is this more important than with the assets in their investment portfolios. Following a decade of low bond yields and muted market volatility, many insurers’ portfolios have gradually taken on more risk than they would have considered in the past. As yields on lower-risk assets such as government bonds plummeted, insurers moved their investment portfolios further up the risk scale to achieve meaningful returns.

Such moves would not usually be considered under normal market conditions. But the years following the 2008 financial crisis were extraordinary. Central bank stimulus caused asset prices to climb steadily, and market volatility was virtually non-existent. To match their liabilities with asset duration, or simply to keep generating a sufficient level of investment returns, many insurers had no choice but to add more risk to their asset allocation.

But as we are approaching the end of the current economic cycle, insurers may now find themselves in a position where their portfolios are ill-equipped to withstand a downturn. After a prolonged bull run, we believe there is more downside risk than potential for upside in markets right now, especially with geopolitical risks adding to the uncertainty. Global Central Banks appear to have realised this with most of them recently pivoting their monetary policy stance from a tightening bias to on-hold with growing probability of loosening policy in the near future. This is evidenced by inversion, in parts, of the US Treasury curve in 1H 2019. As economic momentum has slowed, global growth appears to have peaked at the same time that geopolitical risks have risen. As a result we expect that volatility will resurface as Central Banks attempt to engineer a “soft landing” with unconventional tools as interest rates remain historically low. Overall, investors must be more selective, cautious and alert than they have been in the decade since the Great Financial Crisis.

So what does this mean for insurers? At the very least, it should serve as a reminder to boards of directors and investment committees that now is the time to review their portfolios and develop a comprehensive understanding of the risk they are carrying. Under Solvency II regulations introduced in 2016, boards of directors must be able to demonstrate that they have a detailed understanding of the risks embedded in their portfolios. Other regulators are also becoming more demanding of boards to demonstrate a good understanding of the decisions they have made and the associated risks. In addition to being given greater responsibilities around governance and risk management, Solvency II’s prudent person principle requires insurers to manage portfolios so that all assets can be properly identified, measured and monitored.

Whether asset allocation decisions are taken by the insurer’s own investment committee or determined entirely by an outsourced investment manager, it is the board’s job to ensure that the investment portfolio is adapting to market conditions and rising risks. It may have made sense to invest in riskier assets during a period of low volatility and rising markets, but potential financial loss caused by a reversal of fortunes could make it more difficult for an insurer or any institution to meet its liabilities.

This is why it is more important than ever for insurers to understand the risks of what they’re invested in, reassess their risk budgets on a forward-looking basis, and adjust their asset allocation to suit. Risk budgets should not be derived by simply looking at the past three years of market data. The lack of volatility and upward momentum of asset prices in recent years is giving a skewed picture of potential risk. Instead, insurers must base their risk appetites on their capacity for loss while also looking forward (and further back) into market data and the behaviour of risk assets in different market conditions.

By having a thorough understanding of the current risks in their portfolios, insurers will not only be satisfying Solvency regulations, but they will also gain greater insight into how they are matching their liabilities with asset duration. Given the uncertain outlook for financial markets and the global economy, now is the time to consider the virtues of dialling back some of the risk in portfolios and repositioning them to weather a potential downturn.

 

To speak to Kate Miller or the rest of the Institutional Team, please give us a call on +44 (0) 207 396 3388 or alternatively email invest@londonandcapital.com


 

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