Rethinking the risk-reward dynamic for alternative assets

Amidst economic volatility and evolving market challenges, insurers are increasingly considering alternative asset classes within their strategic asset allocation (SAA) exercises.

Such shifts underscore the critical need to adhere to the Prudent Person Principle (PPP), according to Punil Chaubal, insurance investment advisory leader at WTW.

In recent years, the financial landscape has been disrupted by a series of crises, from the COVID-19 pandemic to geopolitical tensions and economic upheaval. Traditional asset classes such as equities and bonds have faced significant pressures, prompting insurers to explore other avenues like private debt, infrastructure, and hedge funds in search of higher returns.

“SAA provides a means to optimise risk-adjusted returns through exposures to a range of asset classes combined appropriately for the insurer’s liabilities and investment goals,” Chaubal said. “However, every SAA exercise should include a determined focus on compliance with PPP.”

This ensures that the insurers maintain a rigorous focus on risk compliance and identification, safeguarding policyholder commitments and mitigating regulatory scrutiny.

Alternative assets in a struggling “conventional” environment

Chaubal emphasizes the emerging risks associated with these new investment avenues.

“Recent years have seen financial markets rocked by crises including the COVID-19 pandemic, geopolitical conflicts and economic challenges,” he said. “Conventional asset classes, including equities and fixed-income securities, have struggled. Many insurers have therefore broadened their search for return. Asset classes such as private debt, infrastructure and hedge funds have all attracted significant interest.”

SAA exercises have been instrumental in this transition, aiding insurers’ efforts to adopt an investment strategy more aligned with achieving their goals in these increasingly volatile times. Nevertheless, these exercises sometimes exhibit shortcomings in identifying and quantifying risks, occasionally neglecting various types of risk associated with complex investment strategies.

Chaubal notes that this deficiency does not meet the standards set by the PPP. Insurers must ensure that their investments in assets and instruments are ones where they can adequately identify, measure, monitor, manage, control, and report on all associated risks.

With new risks ahead, “PPP must remain paramount”

The emphasis on PPP within SAA practices ensures that insurers consider these risks comprehensively. This includes evaluating the adequacy of their own capabilities in managing these assets and the associated risks effectively.

“During periods of liquidity strain for an insurer, such as a large catastrophe or mass policy lapse event, an insurer may not be able to redeem their holdings in a timely manner or at favourable pricing, potentially resulting in the need for cash injections from shareholders,” Chaubal said.

The PPP is intended to guarantee that these risks are taken into account. Chaubal notes that a basic risk-return analysis might suggest a significant allocation to these complex assets is suitable.

“However, an SAA exercise incorporating the PPP would recognise the additional risks, incorporate an understanding of the insurer’s capabilities, and use that additional information to set appropriate allocations to those asset classes,” he said.

However, the integration of alternative assets should not suggest a shift away from traditional investments. Instead, insurers are advised to balance pursuing potential higher returns with the imperative of protecting policyholders’ interests by keeping the PPP in focus.

“The bottom line? New asset classes offer insurers a more sophisticated and nuanced investment strategy that could help them navigate ongoing market turbulence and enhance returns. But the PPP must remain paramount,” he said.

Further expertise and specialist knowledge might be necessary as insurers expand into unfamiliar asset classes. Techniques like stress testing and scenario analysis could play crucial roles in understanding the impacts of these new investments on the insurers’ financial stability and operational capabilities.

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