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How insurers are using stress tests in their investment portfolios

Insurance Consulting and Technology|Investments
Insurer Solutions

By Ash Belur | December 2, 2020

Ash Belur talks to Insurance Asset Risk about insurers' usage of stress tests in their investment portfolios and how 2020 might have thrown many of the scenario assumptions out of the window.

Q. No insurer probably had a COVID-19 type pandemic scenario at the start of the year, but were there any stress tests and models that helped insurers in their investments in March/April? Do you think that the shock changed their approach to testing their investment portfolios?

On the asset side of the balance sheet insurers were not directly modelling this kind of event, although clearly life insurers have pandemic stresses for their mortality books. Nobody had a pandemic scenario, maybe the only exception being on the life modelling side, but there was none on the asset side. If you look at what happened in H1 – a combination of lower equity, lower rates and higher spreads, it's similar to what happened in the 2008 crisis. So, insurers had some stress tests that helped them in this crisis.

Will it change the stress tests going forward? Yes and it's natural, because the CFO or CRO will ask for it. It is natural that investors will have a pandemic scenario on the asset side by year end or by the start of next year because of governance. And rightly so, but I don't think they should overfocus on that one. You have to be careful you are not just addressing the fire that just happened. You have to think to the future and that is hard.

Q. So what should they think about?

A general insurer's typical portfolio will be 5% cash, 20 to 30% government bonds, 40% to 50% investment grades corporates, 10% equities and 10% alternatives. So what are the common tangible factors affecting the risk on my assets and/or my asset and liability framework?

Even if it is a short duration portfolio, top of the list will likely be credit risk – and the mismatches between assets and liabilities. Then comes interest rate risk, inflation risk and equity risk. In this particular stress event, the impact has been on sectors driven by large scale movement of people – hospitality, airlines, and cruise lines.

You want to think about what might happen in a modestly severe and a really severe scenario – and there are at least two ways of doing that. You could look at volatilities to imply what risk could be or you could look at the historical extreme events and think about the qualitative and the quantitative aspects of what happened to your portfolio. It may also be useful, given the lack of recent experience, to create bespoke scenarios.

I think you should look at both the market pricing of risk right now and what actually happened historically in terms of risk. When you generate a stress test, you can't just say IG corporate spreads widen from 80bps to 200bps – you also have got to play out the scenario based on your views, correlation or some methodology to figure out what the secondary risks are in other parts of the portfolio.

Q. Stress tests are a risk mitigation tool, how do you balance that with the need to find returns?

This is the really hard part. Because whether you like it or not, if you are in the investment seat at a general insurer, you are measured on what your assets return, not what your assets return less the cost of liabilities.

In the current environment with rates down to very low levels, if even positive, CEOs and CFOs might ask the CIO "what have you done for me this year". It's a problem, because sitting on the sidelines right now by just running a portfolio of cash and government bonds to match your liabilities in euros, you are going to make a negative return.

The investment team will always be staffed with people who want to take risk, whereas the risk team will be driven by "what happens if". So the right balance needs to be struck here. People have been chasing risk for a while in the belief that governments and central banks are going to back them up. And in the UK, at least, there are effectively two camps.

One camp thinks that government and treasury actions, like the furlough schemes, will create massive inflation. These investors are buying real assets, ground rents, equities, credit and they think it is going to go up because they think it is going to be an economy fuelled by an increase in the money supply.

The other camp is saying the UK, the US and Europe are dead cats with economies that cannot be moved. Japan is the usual example for this argument. So, they think the FTSE is going to sit there and we will have no inflation combined with a wave of unemployment and it's going to be tough. These investors, are saying "we want to earn between 0% and 0.5% annually for the next three to four years, this is going to be a tough environment and it is not going to change anytime soon". And it is too soon to know who is right at the moment.

This article was originally published by Insurance Asset Risk, 25 November 2020

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Director, Insurance Investment Team

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