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Balancing reward with every type of risk in alternatives

By Zaheer Ismail , Miguel Fonseca Dias da Silva and Punil Chaubal | April 18, 2024

Increased consideration for investment in alternative asset classes, in insurers' strategic asset allocation ("SAA") exercises, should be supported by the Prudent Person Principle ("PPP").
Insurance Consulting and Technology

Increased consideration for investment in alternative asset classes, in insurers' strategic asset allocation ("SAA") exercises, should be supported by the Prudent Person Principle ("PPP").

Insurers confronted by financial and economic turbulence over the past three years have responded by exploring new asset classes and investment strategies. But while strategic asset allocation (“SAA”) exercises have helped them address emerging risks and opportunity, it is vital that the Prudent Person Principle (“PPP”) is a key consideration during such work.

SAA provides a means to optimise risk-adjusted returns through exposures to a range of asset classes combined appropriately for the insurer’s liabilities and investment goals. However, every SAA exercise should include a determined focus on compliance with PPP.

Without that focus, insurers are in danger of taking on undue risk that is not promptly and accurately identified, putting policyholder obligations at risk, and being subject to unwanted regulatory scrutiny.

The rise of alternative assets

Exposure to new and complex risks is a mounting concern as insurers increasingly embrace alternative assets and private investments.

Recent years have seen financial markets rocked by crises including the COVID-19 pandemic, geopolitical conflicts and economic challenges. Conventional asset classes, including equities and fixed-income securities, have struggled. Many insurers have therefore broadened their search for return. Asset classes such as private debt, infrastructure and hedge funds have all attracted significant interest.

SAA exercises have played a key role in this shift, supporting insurers’ efforts to move towards an investment approach better suited to delivering their objectives in these more turbulent times.

However, these exercises can have their limitations when it comes to identifying and quantifying risk, sometimes overlooking other types of risk inherent with complex investment strategies.

That falls short of what is required under the PPP. Insurers must be confident they are only investing in assets and instruments where they can properly identify, measure, monitor, manage, control and report the full range of risks.

New asset classes, new risks

When PPP is considered within SAA exercises, insurers will naturally think about a series of issues that could be relevant to a move into alternatives.

Issues to be accounted for may include complexities in valuing certain asset classes and infrequent valuations leading to reporting difficulties. These assets can also face significant drawdown risk during periods of severe market stress. The illiquid nature of private assets can add portfolio complexity. During periods of liquidity strain for an insurer, such as a large catastrophe or mass policy lapse event, an insurer may not be able to redeem their holdings in a timely manner or at favourable pricing, potentially resulting in the need for cash injections from shareholders.

The PPP is designed to ensure that these risks are considered. A basic risk-return exercise might indicate a high allocation to these complex assets is appropriate.

However, an SAA exercise incorporating the PPP would recognise the additional risks, incorporate an understanding of the insurer’s capabilities, and use that additional information to set appropriate allocations to those asset classes.

Putting the PPP front and centre

None of this is to suggest insurers should steer clear of alternative and private assets. However, they must move forward with the PPP front of mind. Doing so will enable insurers to pursue improved returns while still ensuring that policyholder protections safeguards remain paramount.

The bottom line? New asset classes offer insurers a more sophisticated and nuanced investment strategy that could help them navigate ongoing market turbulence and enhance returns. But the PPP must remain paramount.”

Punil Chaubal | Insurance Investment Advisory Leader

However, insurers may need further expertise to achieve these goals, particularly where they lack experience of these new asset classes. Specialist knowledge may be required to take full account of the different type of risks attached to such investments. Stress tests and scenario analyses, for example, can help insurers assess the potential impacts of exposure to new asset classes on their solvency and their ability to pay policyholders.

The Prudent Person Principle: a recap

The Prudent Person Principle (PPP) came into force as part of Solvency II in 2016, providing insurers with greater investment flexibility compared with the previous UK regime as long as their assets are invested in accordance with the PPP.

In practice, this means insurers should only invest in assets with risks they can identify, measure, monitor, manage, control and report; they must be able to take these risks into account when assessing their investment strategy.

The PPP also introduces specific considerations for assets backing each type of liability, so insurers must think about the placement of assets within their portfolios.

Assets used to back technical provisions must be invested:

  • appropriately for the nature and duration of the insurance and reinsurance liabilities; and
  • in the best interest of policyholders.

Assets backing the insurer’s Solvency Capital Requirement and Minimum Capital Requirement must be invested:

  • to ensure security, quality, liquidity and profitability of the portfolio as a whole and
  • localised in a way that ensures their availability.

Additional considerations under the PPP include the requirement to maintain investments not traded on a regulated market at prudent levels - an important point in the context of insurers’ increased appetite for alternative and private assets.

Finally, the PPP requires insurers to ensure their investment portfolios are properly diversified to avoid too much risk concentration. This includes diversification by asset class, region and issuer.

Regulatory disclaimer:

WTW approved this document for issue to recipients categorised as Professional Clients only.

All investments involve risk including the loss of principal. The information presented is current as of the date of this presentation.

The views and opinions shared are for educational purposes only and are subject to change due to market, regulatory and changes in other conditions.

This material is based on information available to WTW at the date of this material and takes no account of developments after that date.

The material is not intended to provide, and should not be relied on for, compliance, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable, but WTW does not warrant its completeness or accuracy.


Senior Associate, Insurance Consulting and Technology
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Senior Consultant, Insurance Consulting and Technology
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Insurance Investment Advisory Leader, Insurance Consulting and Technology

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