AIG is developing a new asset allocation framework to address what it sees as a fundamental shift in the market environment that could last another generation. 

That was the stark message from the US insurance group's London-based chief investment officer for international (non-US) markets, Guillermo Donadini, speaking at an industry conference last week.

“[We] must change the way we manage our assets,” Donadini said, as he warned of the potential for real interest rates to remain negative for another 20 years in developed markets.

Simply relying on government bonds to compensate for one's liabilities is no longer feasible, he noted.

“The challenges these days are that we need to compensate with risk premia what we used to get from real interest rates," Donadini said. "For a long time just buying long-term fixed income was enough, but that is not the case any more."

To achieve its former level of return, AIG has been venturing into new asset classes such as high-yield bonds, private markets and structured finance and has developed a more sophisticated asset-allocation framework, he said on a panel at an FT forum in London, Managing Assets for Insurers, on Wednesday (April 18).

The property-and-casualty (P&C) insurer is also studying the use of smart beta strategies for equities, added Donadini, whose investment remit includes the Asia Pacific region. Smart beta strategies employ alternative and/or dynamic index weightings or 'factors' with a view to generating excess return over traditional market-capitalisation benchmarks.

"My particular view – not AIG’s – on hedge funds is that they are expensive for the value they provide, so we are trying to find different ways to capture risk factors, and I think smart beta could be one method to use,” said Donadini.

MULTIPLE CHALLENGES

Other challenges highlighted by Donadini, aside from negative real interest rates, included stretched asset valuations, the more demanding regulatory environment as a result of Solvency II, and high levels of global debt, a concern also flagged by the International Monetary Fund last week.

Dealing effectively with the latter may conceivably require a pickup in inflation. “The amount of debt globally is as high as it was after World War II [which ended in 1945],” he said, “so we should expect that it would be diluted now in real terms, as was the case before [in the years following the war].”

The creeping inflation risk is something insurers ought to consider addressing, said Heneg Parthenay, London-based head of insurance at Insight Investment, an affiliate fund manager of the BNY Mellon group.

“For insurers concerned about a potential spike in inflation, it is time to consider allocating a part of their government bond assets to inflation-linked bonds or alternative asset classes with implicit inflation protection, such as real estate or all forms of real assets,” Parthenay said in the same panel discussion.

INFLATION HEDGES AND VOLATILITY

However, while pension funds can gain some inflation protection by hedging against a country's prevailing consumer price index, P&C insurers must hedge against claims inflation, said Jayne Styles, CIO at MS Amlin, a London-based P&C and reinsurance firm.

"The way we approach it is that we factor in the pricing of the insurance product," she noted during the same panel discussion. "So certainly we’ll be exposed to index-linked bonds from time to time when the view is that the market is under-pricing inflation, which has been the case recently."

Styles said MS Amlin had not changed its broad investment strategy in response to the prevailing low interest rate environment, but had reduced its portfolio duration and become a little more tactical.

“Interest rates are not at levels where they are providing a cushion,” she said, suggesting that long/short and relative-value strategies were more beneficial in the current market.

Styles, who runs a £6 billion ($8.4 billion) multi-manager portfolio, said MS Amlin has also been reducing its corporate bond allocation “for quite some time” as credit spreads have narrowed.

Another concern for investors globally is the widespread expectation that equity market volatility is back to stay and the question of how they deal with it.

Donadini said AIG does not hedge downside volatility risk, unless it’s very cheap to do so, as it was last year.“It’s more about having an asset allocation that we know can absorb a lot of volatility under very stressful scenarios, given our capital buffers. And it’s about us having as much diversification as possible.”