What makes a good investment strategy for a with-profits fund and why do such funds pose particular problems?
With-profits insurers in particular are required to pay attention to policyholders’ reasonable expectations (PRE), so for example although just the basic sum assured is guaranteed at outset, policyholders, depending on the circumstances, might reasonably expect that some of the fund is invested in assets that might give some upside in addition to the strict guarantee.
Non-profit funds are usually managed by buying roughly matching assets so, for example, an insurance company writing annuities would normally buy a collection of bonds and endeavour to have a reasonable congruence between the asset and liability cashflows. Unit-linked products pose less of a problem for the insurance company because the investment risk gets passed onto the end client. With-profits contracts provide the greatest challenge for investment managers because there are guarantees that need to be met but the policyholder is expecting to get some upside in addition due to PRE.
Traditionally, with-profits funds have had asset allocations that include significant contributions from equities, bonds and property without much use of derivatives. However, the environment for with-profits funds has changed significantly in the last five years, resulting in many with-profits funds altering their investment strategies. Whichever strategy they employ, typically it will be guided by the longer term nature of the liabilities. So if a customer wishes to surrender his policy when the markets temporarily are at a low level, the office can have a problem. Life companies will therefore often charge market value adjustors (MVAs), which act to decrease the surrender value paid to such customers.
Insurance companies pay close attention to the excess of assets over liabilities, often termed free assets. When free assets are large then a company can choose to have a relatively laissez faire approach while a company with a lower level will have to be much more disciplined. Over the first few years of the decade, falling equity markets coupled with falling interest rates resulted in a significant reduction in the free assets of most with-profit funds. While the equity market has recovered to a certain extent, with-profits funds have found that because both nominal and real interest rates have remained low, free assets haven’t recovered to the levels at the start of the decade. Lower free assets increases the likelihood of funds going insolvent and this has resulted in funds switching from growth assets (equity and property) into fixed income assets.
While free assets were being eroded by falling assets and rising liabilities, new regulations were introduced covering valuation of these liabilities. The previous regulations led to the value of the liabilities being smoothed over time, but the new regulations require the liabilities to be valued on a market consistent basis increasing the volatility of the free assets and causing funds to focus on how the investment strategy affects this volatility.
Clients holding with-profits policies benefit from both the guarantees and any upside by way of bonuses. Therefore, many clients like to see a high proportion of the assets invested in classes with growth potential rather than those offering fixed returns. To measure this, we define the equity backing ratio (EBR), which is the growth type assets such as property and equity expressed as a proportion of the total assets. Another change that has had an impact on the investment strategy of many funds is the closing of funds to new business. This change has meant that there is not the same competitive pressure on funds to have high EBR and this has contributed to too many funds reducing the proportion of their assets invested in equities.
Just like any other investor, a with-profits fund should seek to maximise returns for a given level of risk. Risk in the context of a with-profits fund relates to the ability of the fund to meet liabilities when they fall due. This ability directly relates to the level of free assets and funds when setting their investment strategy now pay much greater attention to how the value of assets and liabilities move relative to each other.
Holistic approach
A fund’s investment strategy should be set after considering how the value of the fund’s liabilities move. This is commonly referred to as liability-driven investment or LDI for short.
A recent case where this didn’t happen was when life funds devised investment strategies around equity markets rising. This approach failed to recognise that there are many factors that influence a fund’s free assets including nominal and real interest rates.
Over the last few years, equity markets have improved and equities have been sold by many life funds. At the same time, however, falling real and nominal interest rates have meant that free asset ratios haven’t improved as much as life funds would have liked.
A more appropriate strategy for many funds would have been to put in place a programme of selling equities as free assets improved with the estimated free assets taking into account equity values and real and nominal interest rates.
As discussed, with-profits policies typically provide some sort of guarantee while also offering potential upside. For decades with-profits funds have been selling policies with embedded guarantees. When many of these policies were sold, the guarantees were
perceived to have little value and also actuarial modelling technology was less advanced and there was a lot of pressure from marketing departments to offer generous guarantees. Consequently, funds chose not to explicitly value them or recognise the impact they had on the solvency of the fund. However, during the early years of this century, when equity markets were falling and interest rates rising, the values of the guarantees increased significantly.
Most life funds now value all guarantees explicitly and, when setting their investment strategy allow for the sensitivity of the values of the guarantees to changing circumstances.
Many funds either partially or fully hedge guarantees embedded in policies. Sum assured guarantees are often hedged with put options covering the equity exposure. Guaranteed annuity options (GAOs) are typically hedged with swaptions (a contract giving the option of entering into a swap at some latter date).
There are numerous ways in which a with-profits fund can allow for the combined affect interest rates, inflation and equities can have on their solvency position. For instance, an insurer using predominantly equities to back fixed income type liabilities can protect the level of free assets to a large extent by using options that have a payoff linked to the difference in the return of a portfolio of bonds that resembles the liabilities and equities.
The guarantees embedded in life insurance policies are often quite complex and therefore difficult to perfectly hedge. A guarantee to pay out a sum insured at maturity may seem simple at first, however, it doesn’t necessarily take into account the impact of market value adjustors (MVAs) and discretionary bonuses that can add to the guarantee.
In the UK, many with-profits funds are required to calculate the value of their liabilities on two different bases: the regulatory peak (where companies have to value according to a closely defined set of rules) and the realistic peak (where the approach is more market consistent). The company then has to hold the greater of these two values in reserve (the twin peaks approach). Over time, a company can be in a situation where the liabilities change from having one peak bite to another. This can have an impact on what the most appropriate investment strategy is.
Even given some of the complexities referred to above, most guarantees can be hedged effectively using relatively simple derivative instruments or dynamic asset allocation strategies in a similar way to the dynamic hedging assumed in the Black Scholes option valuation methodology.
Increased diversification
One of the oldest investment rules is that investors should look to diversify their assets. Diversification should take place across different asset classes and geographical regions.
There are numerous ways in which life funds in the UK could improve the diversification of their investments including increasing the allocation to international equity and credit.
Life funds could, by expanding their allocation to property, private equity, high yield bonds and secured loans, further improve diversification.
One of the reasons why some funds are reluctant to increase their allocation to international investments is because of the exchange rate risk. Equity investments are often seen as being naturally currency hedged anyway but for other overseas assets, exposure to foreign currencies can be hedged by using forward exchange rate contracts.
In order to keep track of performance, fund managers and customers typically agree a benchmark (usually an index or some combination of indices) against which the fund manager is measured. Performance in excess of this is often called alpha. Many with-profits funds seek to generate returns in excess of a benchmark through active management. In doing so it is important that the alpha being generated is as diverse as possible. Alpha can come from various sources including asset allocation, stock selection, liquidity trading, currency allocation, relative value strategies and duration.
Low cost
In today’s low interest rate environment, fund management fees can be a significant proportion of a portfolio’s return so with-profits funds should give consideration to the fees charged by their investment manager.
Asset manager fees will depend on various factors including asset class, whether management is active or passive and the perceived ability of the asset manager to outperform. The problems in assessing this last aspect has lead many clients to request performance related fees so that investment risk is shared between the asset manager and the insurance company.
The fees that need to be paid to get access to the market returns for certain asset classes e.g. equities, gilts and credit have reduced significantly over the last 10 years.
Many insurance companies run their asset management in house although, increasingly, it is being outsourced. In our view, smaller insurance companies cannot achieve the necessary economies of scale, while medium-sized companies still have problems managing specialist asset classes mentioned above making some outsourcing desirable for both groups.
With-profits funds are medium to long-dated investors and when customers surrender early, companies often have the option of imposing an MVA. Therefore excess returns can be generated by investing in illiquid assets such as property, private equity, secured loans and private placements. These asset types all suffer to an extent from reduced liquidity but in return the investor achieves a higher yield than they otherwise would. FSA regulations offer some restrictions on these assets and also require a liquidity calculation for the company as a whole. However, to the extent that regulations permit, we believe that these classes offer important opportunities for with profit funds.
Hypothecation of assets
The mechanism for allocation of fund returns to groups of policyholders can have a significant impact on the appropriate investment strategy. Generally speaking, the closer assets are allocated to an individual policy level (hypothecation) the greater the proportion of volatile assets the fund can invest in.
There is a large number of asset and liability considerations to include when designing an investment portfolio for a with-profits business. Most insurance companies still have a relatively conservative mix of assets so there are plenty of opportunities for them to increase returns or diversification by using new asset classes.
Adrian Lawrence is director of insurance funds at Henderson Global Investors.
adrian.lawrence@henderson.com
Tel: 020 7818 5796
TYPES OF LIFE POLICY
- Non-profit:
Policy with fixed benefits in return for fixed premiums, e.g. an annuity that pays a fixed income until death
- Unit linked:
Contract exposing policyholders directly to the performance of the assets.
- With-profits:
In return for a regular or single premium, with-profits policies provide a sum assured that may be increased from time to time by so called reversionary bonuses and then at maturity or death usually pay a terminal bonus.
KEY TERMS
- Alpha:
The extent to which a fund manager outperforms the benchmark.
- Benchmark:
An index or basket of indices that the fund manager has to beat.
- Equity Backing Ratio:
The proportion of assets held in equity and property.
- Free assets:
Assets in excess of those required to meet liabilities and
regulatory minima
- Free asset ratio:
Free assets expressed as a proportion of liabilities
- FSA:
The Financial Services Authority – the main regulator for UK
Life companies.
- Market Values adjustor (MVA):
An adjustment to surrender values to allow for market movements
- Policyholders’ reasonable expectations (PRE):
Limits on the discretion that life companies can exercise regarding
policyholders
- Reversionary bonus:
Annual increases in benefits under a policy
- Swap:
A contract to exchange the cashflows on one debt for another.
- Swaption:
An option to enter into a swap contract
- Terminal bonus:
One off increase in benefits under a policy at maturity of death
SPECIAL ASSET CLASSES
- Property:
Property is a useful asset class for with profit funds because it tends to provide a higher running yield than equities and still has the real asset qualities.
- Private equity:
Private equity offers potentially much higher returns than listed equity while also increasing diversification.
- Secured loans:
These loans are often issued as part of a private equity deal. They offer typically 2-3% pa in excess of LIBOR.
- Private placements:
Again offer greater return than listed equity
- Emerging Market Debt:
Emerging market debt provides a higher yield than most assets. Typically it is denominated in US$ so would be hedged into sterling for a UK with-profits contract.
