Strategic asset allocation: assessing the benefits
28 Mar 2018 - Estimated reading time: 5 minutes
The current low interest rate environment and introduction of Solvency II have been significant drivers for insurers to consider whether their asset allocations remain appropriate. Strategic asset allocation (SAA) offers a powerful tool to assist insurers in this process.
So, what does SAA involve? In simple terms, it is a review that insurers carry out in order to assess if their asset strategy provides a suitable balance of risk and reward, when considered in the context of their risk appetite and policyholder expectations.
This is a particularly hot topic for with-profits funds and the chart below shows the asset allocations for a range of UK with-profits funds. This information has been built up from a combination of Solvency and Financial Condition Reports and fund fact sheets.
The chart shows that there is a wide range of equity backing ratios (EBRs) - the ratio of assets invested in ‘growth’ assets such as equities and property - which is reflective of the varied nature and demographics of with-profits funds in the UK. As expected, one size doesn’t fit all.
While quite a few of the funds have high EBRs (60%-70%), others are dominated by more traditional fixed income type investments.
A SAA review exercise typically involves projecting the insurer’s balance sheet under a range of investment strategies and economic conditions. For these projections, insurers often consider a range of risk metrics to suit the specific investment questions they are hoping to address including:
- Volatility of assets, Own Funds and Solvency II surplus
- Level of Solvency II capital; and
- IFRS volatility
Following the introduction of Solvency II – and with the impending introduction of IFRS 17 – the metrics insurers are having to consider are becoming increasingly complex with more sophisticated modelling needed to take into account the movements of different parts of the balance sheet.
Using efficient frontier analysis helps with-profits investment committees understand how close their current investment strategy is to ‘optimal’ strategies taking into account the range of assets they are considering investing in.
An illustrative example of efficient frontier analysis is shown in the chart below.
Other constraining factors, such as investment horizon and solvency coverage targets, can also be considered in the optimisation exercise.
Below we consider below some different reasons why an insurer would consider a SAA review.
As with many decisions insurers are grappling with, one of the key drivers continues to be the economic environment. Many of the most commonly used fixed income investments, such as gilts now generate low to negative real returns. This has forced insurers to look into alternative asset classes in order to deliver the yields they require. Coupled with being in a relatively low volatility environment and equity markets being at all-time highs, these are all factors that can drive the importance of a SAA review.
New asset classes
Linked to the changing economic environment is the opportunity posed by new, alternative asset classes. With insurers exploring beyond traditional asset classes to enhance yield, the ability to model the impact of these new assets on the balance sheet is crucial. The use of Economic Scenario Generators means that asset return assumptions can be calibrated to monthly market prices, giving realistic projections of price movements over the short and long term.
Regulatory and accounting environment
Another key driver is the regulatory and accounting environment. Solvency II has changed the way in which insurers’ balance sheets move and many firms are still coming to terms with the new, and often competing, metrics which have a newfound importance. As such, Solvency II balance sheet management can be challenging to say the least.
With all the above in mind, and an increased focus on investment governance by boards and investment committees, there are many benefits SAA can bring to enhance the investment decision making process. At Hymans Robertson, we have our own in house Economic Scenario Service model and SAA tools, and would be happy to share our thoughts with you in more detail. If you are interested, please contact a member of the Life & Financial Services team.