The Cost of Coverage

Risk On… Reluctantly

How the low-yield / rising-interest rate tug-of-war is impacting global insurers

by Michael Siegel

Mr. Siegel is the global head of the Insurance Asset Management business within Goldman Sachs Asset Management. The business is responsible for providing solutions to insurance companies seeking to outsource the management of balance sheet assets, including traditional and alternative asset classes. Mike is responsible for the management and oversight of the dedicated insurance fixed income, relationship management, strategy and accounting teams. Connect with him by e-mail:

In an investment environment characterized by strong global liquidity, insurers continue to battle the low yield environment while preparing for rising interest rates and greater market volatility.

In early 2014, Goldman Sachs Asset Management (GSAM) Insurance conducted the third annual survey, “Risk on….Reluctantly” representing insurers with more than $6 trillion in global balance sheet assets. This article highlights the insights provided by the Survey regarding the macroeconomic environment, investment returns, asset allocation and portfolio construction.

According to the Survey results, chief investment officers are most concerned about the potential for greater credit and equity market volatility, accelerated monetary tightening, slower than expected U.S. growth as well as economic shock in the emerging markets and China. CIOs are tentative about investment opportunities as many view investment grade and high yield as overvalued. Insurers recognize the need to enhance portfolio returns and they are increasingly looking to allocate to nontraditional asset classes such as equities and alternatives.

Inflation of moderate concern

Insurers broadly agree that inflation is a medium-term concern. Nearly 80% of CIOs believe inflation will be a risk in the next two to five years. Despite these concerns, insurers expect only a modest rise in the 10-year US treasury by year end and predict the S&P 500 will post another positive year, although they anticipate more modest returns than the year prior.

Generally, insurers believe equity assets will outperform credit assets. This year, insurers expect private equity followed by U.S. equities, European equities and emerging market equities will be amongst the highest returning asset classes. Strong capitalization levels give insurers the flexibility to invest in alternatives and equities, assets that offer an illiquidity premium as well as inflation protection.

According to the Survey, this year, life insurers intend to increase allocations to infrastructure debt, private equity, commercial mortgage loans and real estate equity. Life insurers’ intended allocation changes highlight their view that the best near-term strategy for enhancing portfolio yields is to allocate to alternatives and equities and to capture sources of illiquidity rather than increasing credit risk or duration. Health insurers intend to increase allocations to government and agency debt, US investment grade corporates, private equity, commercial mortgage loans, high yield and emerging market corporate debt. Given continued uncertainty about the impact of the Affordable Care Act, health insurers may be increasing allocations to liquid, high grade assets to cushion against unanticipated regulatory expenses.

Portfolio Construction

The low yield environment is viewed as the most significant near-term portfolio risk, but insurers are preparing investment portfolios for a reduction in monetary stimulus and the eventual rise in interest rates. Nearly half of all CIOs surveyed cited low yields as the greatest risk to portfolios, while a quarter selected rising rates as the greatest risk. Health insurers are as equally concerned about equity market volatility as they are concerned about low yields.

Given credit assets are generally viewed as expensive, insurers are looking to increase allocations to alternatives including private equity, hedge funds and real estate assets

We asked insurers to identify the strategies and investments they find most effective for managing risk in a rising interest rate environment. More than one-quarter of CIOs surveyed believe shortening duration is the best strategy, followed by allocating to floating rate assets and utilizing interest rate derivatives. Health companies, in particular, favor shortening the duration of fixed income portfolios.
With regard to portfolio construction, 35% of all insurers are willing to increase their overall level of portfolio risk in search of return, while only a small fraction of insurers plan on decreasing risk. Health companies demonstrated the least risk appetite, as 90% said they will maintain overall portfolio risk, and none said they will increase risk.

Insurers are also seeking to capture return by “selling” liquidity. More than a third of all insurers responded that they intend to decrease the liquidity of their investment portfolios while less than 10% intend to increase liquidity from current levels. While inflation is not a near-term concern, many insurers are considering allocations to inflation-sensitive assets. More than half of insurers believe real estate offers the greatest inflation protection, followed by commodities and infrastructure assets. Half of health insurance companies surveyed believe commodities offer the greatest inflation protection.

Increasingly Role of Alternative Assets

Given credit assets are generally viewed as expensive, insurers are looking to increase allocations to alternatives including private equity, hedge funds and real estate assets. Forty percent of all insurers surveyed believe private equity will be one of the highest returning asset classes this year, and approximately 20% believe hedge funds and real estate equity will be among the highest performing asset classes. Life insurers believe that the most effective way to increase portfolio returns is to increase allocations to less liquid asset classes as well as equities and alternatives. Sixty percent of health insurers believe allocating to equities and alternatives is the best way to enhance portfolio returns.

We asked insurers how they determine the appropriate size of their allocation to alternatives. More than half of insurers responded that they size their alternative portfolios in the context of a broader strategic asset allocation process while approximately one-third determine the percentage of their surplus portfolio that should be allocated to alternatives, and periodically adjust allocations based on surplus levels. Seventy percent of health insurers determine their alternatives allocation through a formal strategic asset allocation.

Many insurers believe private equity offers the best compensation for the illiquidity risk inherent in the asset class in the current market environment. The majority of insurers surveyed said they intend to make allocations to private equity this year and most intend to do so via direct primary investments. One-third are most likely to invest via fund-of-funds, while only a small fraction intend to invest in the secondary private equity market in the near term.

More than one-third of all insurers said they will invest in hedge funds. Insurers globally are predominantly looking to allocate to relative value and macro/tactical trading strategies this year. Nearly 40% of Life companies that are considering hedge funds intend to allocate to equity long/short funds.
Insurers are increasingly looking to partner with third-party asset managers for niche assets classes such as alternatives or for strategies for which they may not have in-house capabilities. This year, insurers demonstrated the most interest in outsourcing private equity and hedge funds.