An increasing number of pension schemes are looking to “invest like an insurer” – be that as they prepare to approach the insurance market or as they think about how to invest their assets for a run-on strategy.
Whilst insurers’ investment strategies vary between them, there are some general principles that hold for all, which is not surprising given the heavily regulated environment in which they operate. These are:
- Low risk – but not no risk – diversified portfolios
- High hedge ratios for interest rates, inflation and longevity
- A focus on sustainability
Let’s look at each of these topics in more detail.
Low risk – but not no risk – portfolios
In the current markets, insurers are typically seeking to generate a return of around Gilts + 1.5% p.a. on their portfolios. You may be thinking that this is a lot higher than they give pension schemes credit for when setting premiums – and you’d be right, but of course they need to deduct from this return the cost of the capital they hold to protect policyholders from risk, their profits, the cost of longevity hedging, an allowance for defaults and also expenses.
Corporate bonds
So how do they generate the Gilts +1.5%? Well historically corporate bonds have formed a major part of insurers’ investment strategies. Typically, these are:
- At the higher end of the credit spectrum than pension schemes would invest in
- Diversified across sectors, with a slant away from more volatile sectors such as travel and retail
- To some extent, diversified across countries, for example investing in US credit when this has a more attractive yield, after allowing for the cost of hedging the currency risk
With credit spreads (the additional yield above risk free achieved by investing in a corporate bond) currently at very low levels, insurers are using corporate bonds less in their portfolios at this time. Instead, some insurers regard investing in gilts as attractive at the moment, given the current spread of gilt yields above swap yields. This approach benefits from a lower capital requirement initially, whilst giving them the flexibility to invest in something more attractive in the future should spreads widen.
Each insurer’s credit portfolio is a work of art, furthermore, for new business the assets an insurer chooses to invest in will constantly vary to reflect changes in investment conditions. This often means that the in-specie transfer of a pension scheme’s assets as part of premium payment can be harder than may be expected, even where the scheme is invested consistently with the principles typically used by insurers.
Illiquids
Investing in illiquids and benefiting from the illiquidity premium makes complete sense for a long-term investor like an insurer, and is another mainstay of return generation for bulk annuity providers. Solvency UK, the insurance regulatory regime, sets high standards if an insurer wishes to include illiquid asset returns in their expected investment returns, requiring them to be Matching Adjustment eligible, with requirements such as the liabilities and assets being very closely matched and the cashflows on the assets needing to be fixed (or “highly predictable” for up to 10% of the portfolio). These requirements mean that typically insurers must invest in higher quality illiquid assets than a pension scheme and that it is generally difficult to transfer illiquids to insurers as part of premium payment.
So what kind of illiquids do insurers invest in? Increasingly over recent years they’ve seen this as a way to also achieve their sustainability goals and invest in “productive finance”. These are typically large-scale infrastructure projects – such as social housing and renewable energy – providing financing to companies across the UK and contributing to future UK economic growth. Below we’ve set out some examples of recent insurer investments.
