18 January 2017
Investment constraints and capital and liquidity requirements are converging to challenge the strongest Chief Investment Officers in the European Life Insurance Industry. One year on from the implementation of Solvency 2, the range of deliverables required by the industry’s senior investing officers is wider and more complex to execute than ever before.
What are the latest investing challenges for the industry and how are these impacting the shape of the industry itself? What skills will the next generation of CIO’s need to acquire and which behaviours will they need to develop in order to meet these challenges?
In addition to the new prudential regulations under which they operate, insurers across Europe are spending an increasing amount of time and resources addressing liquidity based concerns. The European Market Infrastructure Regulation (EMIR) requires that participants must clear their derivatives portfolios, or fully collateralise them. Despite their exemption, annuity writers and pension funds have been impacted nonetheless.
EMIR stipulates a progressive timeline under which insurers (via brokers) must put in place arrangements for clearing house access, so that they can implement pooled, standardised and fungible counterparty management. This necessitates posting cash as collateral. However the impact on portfolio construction goes much further than the resultant loss of return, because of the interaction of the ‘new’ fair value figure with already complex funding, capital and ALM/duration matching calculations. EMIR affects an insurer’s ability to pool and net naturally offsetting risks against one another and the portfolio is subject to repeated impact, because any changing metric in a derivative contract will entail the new process. If all of that that were not complicated enough, problems with the valuation of some derivatives mean that they will, for the time being, sit outside of the new clearing process – thus the portfolio becomes part-collateralised under the old CSA regime and part-cleared under the new one.
To rub salt, full collateralisation might historically have been achieved by Repo trades with wholesale or investment banks; however the Basel III Directive has made such trades more capital consumptive for banks, which are obliged to maintain more cautious Net Stable Funding and Liquidity Coverage ratios.
Faced with a profusion of rules, each bringing with them new balance sheet intricacies, one market source suggests that insurers might just prefer to invest in gilts/index-linked gilts or other forms of sovereign debt. Such an approach provides for adequate duration, reasonable levels of credit risk and a source of funding. In doing so, one negates the need for LDI/derivative transactions which require collateralisation. Additionally, the bonds could be used to meet initial and variation margin requirements within a portfolio. For UK insurers at least, the gap between these two classes of investment may have narrowed.
The trouble is that Credit remains in short supply and for those that choose to incur the capital cost of a cross-currency hedge and invest in overseas assets, due to EMIR there is now an additional liquidity requirement which may be incurred over ten or more years. UK or Spanish firms with Matching Adjustment admissible portfolios face additional stress testing requirements for hedging. Although UK insurers might, on the face of it, be most exposed to increased hedging expenditure as a consequence of EMIR, Continentals who have backed their guarantee-based portfolios with callable bonds also face a predicament over whether they need to/should hedge over the callable period or for the underlying bond’s full tenor. Historically speaking, collateral efficiency has not been an area of expertise for life companies.
The difficulty for our intrepid CIO is that the regulation adds a new metric to an already hard-to-achieve set of performance criteria and collateral management tends to become more of an issue in the context of other market risks. A holistic approach to portfolio management will embrace (among other things) a fully maintained asset allocation model, derivatives usage, capital optimisation and liquidity/peak collateral data. Faced with ever more ‘dials in the cockpit’, achieving an attractive risk-return profile invokes a range of potential outcomes which can all too easily become a ‘Pandora’s box’.
...If they could only find and secure the correct type of credit assets with which new transactions can be backed, those insurers which have chosen to embrace a capital intensive path can expect an excellent 2017… That is the view of Willis Towers Watson, which has recently issued a bullish report on the sector.
Last year buy-outs fell back a touch, due to political and regulatory uncertainty, but the UK’s June Brexit vote triggered at least one opportune bulk purchase annuity transaction, when the ICI Pension Fund agreed to insure a £750m tranche of its liabilities through a ‘buy-in’ arrangement with Legal & General. The deal was signed just eight days after the UK voted Leave and advisor Lane Clark & Peacock estimated that the fall in sterling led to a saving of £10m.
The ICI scheme has now entered into no less than nine de-risking transactions, insuring c. £7bn in liabilities across its £11bn fund. The L&G deal was the fund’s third buy-in of 2016. Not content with this, it then completed another two in September with L&G and Scottish Widows, insuring a total of £2.5bn in liabilities over the year. LCP estimated that savings made as a consequence of the ‘umbrella’ arrangement were £100m. Such transactions went some way to demonstrating both the value of umbrella contracts and also just how far ‘flightpath’ strategies have progressed.
There is certainly no shortage of demand. In the UK, Defined Benefit scheme deficits peaked immediately after the Brexit vote and finished 2016 £90bn higher than the start of 2016 (according to figures from PwC), with a combined deficit value of £560bn. When the Bank of England cut rates on 4th August, the ensuing market rally led to an increase in scheme assets of £60bn; however, due to rates discounting, the funding gap itself increased by £130bn. WTW predicted that the total volume of buy-ins, buyouts and longevity swaps in the UK would hit a record £30bn in 2017. LCP noted that, at £70bn to date, UK company schemes have still transferred just 5% of total DB assets.
The 2016 deal backlog was caused by a mixture of political, regulatory and economic uncertainty – not least of which was the delayed impact of the new regulations, which led to periods of first introspection, then abeyance by providers. This temporarily restricted capacity as CIO’s wrestled with how best to respond to challenges like EMIR. Faced with policy acquisitions which can transform their balance sheets, CIO’s are more challenged than ever to put into place solutions which are realistic and achievable - before market movements move the opportunity away again.
On the personal annuities side of the market, whilst there have been signs of a ‘bottoming out’ in the precipitous fall in sales since the annuities reform in the UK was announced three years ago, life offices continue to modify and adapt their product portfolios as the UK reform looks set to be replicated elsewhere and the insurer-as-savings provider, capital-light model becomes established. In November, LV= announced that it had begun a process which could result in such a refocus and this was followed shortly after by AXA, which withdrew its capital guaranteed Secure Advantage products in the UK and France, citing a combination of increased regulation in the capital protected side of the unit-linked investments market, combined with prevailing rates. In their place, savings/drawdown based products, where capital and/or income guarantees can be bolted on are on trend.
As the European industry splits between capital-light and capital-heavy models, one organisation which, I think, sits somewhere between the two extremes is the Prudential. In October, the Pru launched its single retirement account for savings and income, which includes a pension savings and income account, allowing for withdrawals from the age of 55, with scalable capital and minimum income guarantees which can be bought at inception. The Pru’s giant, successful W-P fund provides for a broad church of investors and consequently utilises a wide range of capital and investing expertise, but the firm notably scaled back its bulk purchase annuities business in the UK last year, which will no longer be open to new business. CFO Nic Nicandrou justified the decision: “It’s a lot of work when we can deploy that capital elsewhere”.
Others firms have left little doubt as to which of the prevailing strategies they have chosen: One of these (in the UK at least) is AEGON, which in August 2016 'relieved' L&G (an insurer which is most definitely committed to a more capital intensive path) of its Cofunds platform business for £140m. In doing so, AEGON became the biggest platform provider in the UK, with assets under administration of £85bn and 800,000 investors. Early in 2016, AEGON UK sold its entire annuities book to Rothesay Life and L&G - in doing so placing itself firmly in the 'Capital Light' category. Capital pressure continues to drive consolidation and back-book sales, adding to the moving parts faced by today’s CIO.
For the European life industry, it seems that the challenges faced by CIO's are more intimidating than ever, representing as they do a 'perfect storm' of macro-economics, ever growing regulation and capital and consolidaton pressures, combined with the difficulties involved in properly assessing and validating new investment classes in a rapidly changing world.
The success of today’s CIO depends upon their ability to maintain a course, yet negotiate divergent and often contradictory forces. The role is increasingly characterised by a need to manage and execute vastly complex and ever more intricate balance sheet initiatives, some of which can be transformational, others just plain data heavy. In order to complete these, today’s CIO must demonstrate capabilities and aptitudes in categories previously reserved for other Executive members: senior finance officer, chief actuary, treasurer, 'banker' and corporate strategist.
In addition to the growing range of non-investing technical skillsets required, leadership competency is more important than ever. Today’s CIO must visualise and sympathetically chart a course through the many differing signals and ingredients which intertwine to form a successful investing recipe. Whichever investing model is used, the search for yield calls for a broad, flexible approach towards deploying resources, whilst maintaining the healthy circumspection which has always characterised this group of practitioners. In an ever more fragmented distribution network, today’s CIO will need to be well placed to spot potential ‘disruptors’ and innovators, who might successfully challenge widely held notions and accepted wisdoms.
It is very important to hold and maintain a balanced view of the regulatory landscape: To understand both the intentional spirit of regulatory development and its detailed application. Latitude is required to understand the full, secondary impact of changes to the rulebook, combined with strong powers of interpretation and an empathic approach. The CIO must be friend, confidant, advisor and skilled negotiator with external officers and regulatory bodies. Internally, the ability to understand and manage the often complex relationships found among senior stakeholders in the life industry remains a key requirement of the job.
Insurance European industry CIO’s now manage assets of €9.8tn and growing. Only those who demonstrate all of these behaviours, and more, are likely to reach the very top.
With sincere thanks to Erik Vynckier, of InsurTech Venture Partners and Christian Bragazzi, of SwissRe