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.
