Will CAR leave LDI behind?

Investment returns have become a thorny issue for general insurers of late.

When several major firms announced mark-to-market losses in 2008, the industry declared it was time to go back to basics and focus on underwriting. Yet it was canny investment strategies that allowed insurers and reinsurers to record excellent results as the clouds of the financial crisis began to clear in 2009.

As such, insurance CEO s might feel like they are walking a tightrope—on one hand, they must make the most of their capital but avoid taking too many risks.

The tightrope is expected to become more difficult in the next 12 months, as investment returns are not expected to be as favourable as in 2009 and overall underwriting profitability is set to dip as prices continue to soften. What’s more, insurers’ choices will be constrained by new regulation such as Solvency II , potentially forcing insurers to place more capital against their risks and prove they are limiting financial risks for shareholders and policyholders alike.

The industry’s finance officers would be forgiven for thinking that the only option is an ultra-cautious investment strategy.

So how do insurance companies choose an investment strategy in such a restrictive landscape?

Aviva Investors has developed an investment framework that is designed to maximise return on shareholders’ capital under regulatory, accounting and risk constraints.

The message is simple: return on capital is the only meaningful measure of profitability for a firm. Investments play an important role in generating value for the company. Insurers should not resign themselves to over-cautious or buy-to-hold strategies since market risk can be properly managed and diversified. However, as insurers are regulated institutions, investments consume capital and the effectiveness of any investment strategy should be measured against its capital consumption.

Designed by Aviva Investors’ Liability-Driven Investments team (LDI), the framework has been named Constrained Absolute Return (CAR).

Corrado Pistarino, who leads the Insurance LDI team at Aviva Investors says CAR represents a new style of asset management for insurance. “When our team was created in 2009, we thought about how shareholders’ and policyholders’ funds should be managed. Because of the different set of constraints, managing shareholders’ and policyholders’ funds commands different investment disciplines. For shareholders’ funds, maximising return on capital is the key objective.”

The asset management company has put together a framework that looks at investment risk within the wider enterprise risk. “Capital is amorphous. CAR is also designed to allow the insurers flexibility in deploying capital where and when it is needed, increasing the underwriting capacity when profitable or shrinking the amount of new business when underwriting looks poor, while reaping the benefits of larger investment returns. It is ultimately a commercial decision. This is a challenge and an opportunity for the insurance world.”

Pistarino believes Aviva’s presence in the insurance world gave his team an advantage in finding a common language between insurers and investment managers, he adds.

As such, Aviva Investors was conscious of the insurers’ specific needs (e.g. impact of liquidity stresses), as well as the interaction between underwriting and investment risks.

“Because of the short-term nature of general insurance liabilities, achieving good results with CAR means being dynamic and sensitive to changes in market conditions.”

Insurance bosses have always been preoccupied by capital, but it now looks like being a more tangible limitation to the risks they adopt. The issue is not just restricted to Europe and Solvency II. Regulatory capital constraints are growing in the US and Asia too. “Regulatory constraints on insurers are dependent on local jurisdictions,” Pistarino adds. “We are currently developing a client base in Asia, the geographical breadth means we have to fine-tune the CAR framework according to different constraints.”

Pistarino believes attitudes in the industry are changing in light of the increasingly challenging landscape in regulatory capital and underwriting.

“There is a growing perception that investments have to be approached in a new way,” he says.

“P&C insurance tends to be a cyclical business, and this should have an impact on the way the company’s balance sheet is managed, switching between investments or underwriting whenever it is needed. Insurers are aware of this dynamic and are beginning to consider the opportunities that their investment portfolios may offer in terms of extra returns, especially when underwriting returns are poor.

“Therefore, a company’s investments—you can call it ‘market risk’— should be seen as an opportunity to level up underwriting returns. Insurers understand the need to be more flexible, that’s where their profitability comes from. Also, Solvency II will force the industry to a major recalibration. It will be a driver for innovation, efficiency and improved risk management. Despite some people’s concerns, a real blessing.”

Flexibility helps satisfy regulatory requirements too. “This is a highly regulated business so when it comes to shareholders’ funds, the regulator dictates the amount of capital against any risk,” he says.

Flexibility is fine in principle, but some insurers in the past have been limited by their own resources and lack of investment market knowledge. Even the language of the investment community is very different to the lexicon of insurance.

Because of their complexity, investments require expertise that is not always present in an actuarial team. Equally, experience of insurance is not always present among investment managers.

Aviva Investors aims to bridge the gap. “The language of actuaries is completely different, but at Aviva Investors, we are lucky to have such close ties to insurance. An investment manager should be able to sit in front of insurance CEOs and give them confidence that their funds are being managed in a way that is in tune with their business. That has not always been the case.”

Can companies gain a taste of CAR by allocating a small portion of their investments at first? “CAR is a holistic investment strategy that considers the entirety of an insurer’s balance sheet,” Pistarino states. “It is difficult to slice the balance sheet.

"However, we recognise that an insurer may be willing to apply this concept to a particular set of liabilities to gain comfort with our approach. In this case, we would treat it as a mini balance sheet and optimise return on capital for that portion of the business. Within those boundaries, we still take a holistic view, looking at the aggregate risk of assets and liabilities.”

As a result, CAR always requires a bespoke analysis. It also demands an investment discipline based on greater intimacy between assets and liabilities. This is a discipline rarely seen within investment management firms or within the asset and liability management (ALM) teams at the insurance companies.

“This fresh approach would also call for changes to the organisation and governance over all risks. The need for a chief investment officer (CIO), or broadening the role of an existing CIO, should also to be considered,” Pistarino explains.

Pistarino expects momentum gathering behind the message of CAR throughout 2010 and into 2011 as underwriting profit is predicted to be further squeezed across the general insurance industry. His team is currently working on extending the framework so that it can be offered to smaller insurance companies, in a cost effective way. It is due for release in Q4 2010.

If the industry listens to the messages of Constrained Absolute Return, then insurance bosses might just find the tightrope of investments far less daunting.

The opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors).They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested. Past performance is not a guide to the future.

Aviva Investors Global Services Limited, registered in England No. 1151805. Registered Office: No. 1 Poultry, London EC2R 8EJ. Authorised and regulated in the UK by the Financial Services Authority and a member of the Investment Management Association.

Contact us at Aviva Investors Global Services Limited, No. 1 Poultry, London EC2R 8EJ.