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Five diversification approaches for Asian life insurers seeking to mitigate interest-rate risk

With Asia’s life insurers facing heightened sensitivity to interest rates, exacerbated by regulatory changes with the introduction of risk-based capital (RBC) regimes and the new IFRS 9 and 17 accounting standards, a considered approach to diversification across fixed income, equities, derivatives and alternative assets may offer a more efficient means to address the duration gap between assets and liabilities, say Max Davies, CFA, CAIA (Insurance Strategist) and Francisco Sebastian, FIA (ALM & Regulatory Capital Strategist) at Wellington Management.
Five diversification approaches for Asian life insurers seeking to mitigate interest-rate risk
Key points:
  • The duration gap between Asian life insurers’ assets and liabilities is a critical issue that needs addressing given the higher capital charges resulting from new risk-based capital (RBC) regimes across Asia, potentially higher volatility arising from the new accounting rules in IFRS 9 and 17 and the practical challenge of a lack of long-duration instruments in local fixed income markets.
  • A carefully constructed and diversified blend of domestic and global fixed income, derivatives, alternatives and long-duration equities may help insurers reduce the interest-rate sensitivity of their assets within these new RBC and accounting regimes.
One of the few constants in Asia’s diverse and dynamic life insurance landscape is the search for long-duration investments that hedge liabilities.
This relentless effort is set to continue. By nature, the industry generates liabilities that tend to have a longer duration than the assets on life insurers’ balance sheets. The resulting duration gap exposes insurers to changes in interest rates that — to add to the challenge — will soon incur higher capital charges due to the new risk-based capital (RBC) regimes being introduced across Asia, and to potentially increased volatility due to the new accounting standards in IFRS 9 and 17 that come into effect on January 1, 2023.
Further, insurers in Asia face the practical challenge of the shorter-duration and smaller nature of local fixed income markets, which provides limited domestic tools to match the large proportion of long-duration liabilities generated from the region’s popular guaranteed life insurance products — the lack of supply of domestic fixed income assets is particularly pronounced in the corporate bond market. This problem is most prominent in some of the more mature Asian life insurance markets, notably Japan, Hong Kong, Taiwan and South Korea.
Estimates for the average duration gap among Asian life insurers

Source: Estimates, including data from Moody’s, IMF and Wellington Management

Addressing the risks that interest rates pose for insurers is easier said than done. The problem goes beyond merely meeting the demand for duration as the relationship between yield and duration varies depending on the specific asset class and the prevailing market backdrop. As such, insurers should consider a variety of approaches to manage their interest-rate exposure more efficiently.

A toolkit for efficient asset/liability management (ALM)

In our view, diversifying across the following five asset classes may help to manage the interest-rate sensitivity of life insurers’ assets versus their liabilities:

1. Domestic fixed income: Domestic fixed income assets are the most obvious ALM tool because of the predictable nature of the cash flows and their likely alignment with the principal currency of the liability exposures. However, the lack of depth and maturity in many Asian markets means that the supply of domestic fixed income assets fails to meet the demand from domestic life insurance companies.

Insurers must also contend with the limited availability of long-dated bonds in local currency, which is particularly true of the corporate sector. This dearth of long-dated corporate bonds restricts insurers’ ability to develop products with a long horizon, entrenches their over-reliance on government bonds with less attractive yields than credit, and necessitates taking concentrated exposures in the few domestic corporate issuers with long-dated maturities.

2. Global fixed income: Given the domestic supply constraints, exposure to non-domestic corporate bond markets is a necessity for many insurers in Asia. Non-domestic markets can offer duration extension, yield opportunities and potential diversification benefits, both from the domestic credit cycle and through broader sector coverage. However, such exposure will often have to be accompanied by an appropriate currency hedging programme.

Historically, the US credit market has been the most fertile hunting ground for non-domestic opportunities in the corporate bond market, and insurers in some of the most mature Asian markets are now meaningful owners of US-dollar credit, with data from the IMF suggesting that Asian insurers own as much as 11% of US credit markets[1]. The US-dollar credit market also offers more duration than many domestic Asian corporate bond markets, a wide range of sectors and significant depth.

Taxable municipal bonds are one segment of the US credit market that we view as potentially attractive for insurers in Asia given these bonds’ naturally long duration and high quality, as well as the potential for a yield pick-up relative to corporates, their diversifying features and the potential for qualifying as infrastructure, which may help to reduce capital charges in the region’s new RBC regimes over time.

3. Derivatives: Keeping underlying asset portfolios intact while helping to mitigate interest-rate risk, derivatives are becoming an increasingly important component of ALM for insurers in Asia, particularly given the constraints on the availability of suitable assets in the domestic market.

We are seeing the growing use of interest-rate swaps and bond forwards to gain duration and reduce the balance-sheet volatility arising from interest-rate risk. This type of approach enables capital to be deployed towards credit, equity or other risks that may offer a more compelling reward profile.

4. Alternatives: Alternatives are a broad and rapidly expanding asset class and have been a popular antidote to the recent low-yield environment for insurance companies globally. While yields in public fixed income markets are now rising, alternatives should remain an important part of the asset allocation toolkit for insurers, given their structural benefits beyond additional yield, in terms of duration, diversification and potential for ESG integration. The US investment-grade private placement market and infrastructure debt markets are already popular allocations for US and European life insurers and could become equally attractive for insurers in Asia.

5. Long-duration equities: Although equities are often disregarded when it comes to designing an ALM strategy, we think that focusing on equity sectors that correlate favourably with liabilities could help insurers achieve their return and risk-management goals.

For large periods of history, equity prices have exhibited a positive correlation with interest rates and, therefore, a negative correlation with insurance liabilities. However, based on our analysis, equities from some growth sectors show a near-zero, or even slightly positive, correlation with insurance liabilities. By region, emerging markets equities have a risk profile that is more favourable than that of developed market equities for insurers whose liabilities are more sensitive to interest-rate moves.

Towards a more diversified approach

To achieve resilient and more balanced returns, diversifying across a thoughtfully constructed mix of investment options is becoming increasingly important for Asia’s life insurers as they confront the new accounting and capital regimes across the region as well as an increasingly uncertain market backdrop. Implemented thoughtfully, with the attendant currency hedging and collateral management, the diversification approaches outlined above may go some way to addressing the challenges that the continent’s life insurers face.

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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional or accredited investors only.

[1] Source: IMF Global Financial Stability Report: Lower for Longer (October 2019)

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