Increasingly, insurance companies in Australia are looking to better match liabilities and assets by creating customised portfolio benchmarks. PIMCO’s Adam Bowe, fixed income portfolio manager in Sydney, and Vijendra Nambiar, a product manager for liability-driven investments, discuss how bespoke solutions, combined with active portfolio management, can help insurers meet and potentially exceed their expected liabilities.
Q: What is driving the demand for customised insurance liability benchmarks?
A: We have seen insurance companies looking to optimise the way they manage their plan assets in the context of their insurance liabilities, resulting in significantly more customisation in their insurance portfolios and the underlying benchmarks. Some of this interest in bespoke liability-aware insurance benchmarks stems from the companies’ desire to create a better link between assets and liabilities for risk management purposes. We suspect that the heightened attention to asset-liability considerations is also regulatory-driven, with a greater emphasis on following the risk-based capital requirements in the life and general insurance capital standards (LAGIC) framework from the Australian Prudential Regulation Authority (APRA).
Q: How does PIMCO think about constructing the appropriate benchmark for insurance portfolios?
A: The first step for us in constructing the appropriate benchmark is to develop a rigorous understanding of the underlying insurance product or business line and the unique liability profile of the company. We do this by analysing the projected liability cash flow profile in conjunction with a discount rate methodology that is consistent with the company’s risk and regulatory framework. The objective of this analysis is to translate the liability cash flows into a set of observable market-risk exposures, such as nominal interest rates, the shape of the yield curve, inflation, credit spreads and convexity.
The next step entails constructing an investable benchmark that has the same or very similar risk-factor exposures to the various market variables that could drive volatility in liability valuations. We do this by constructing a customised blend of physical fixed income indices to match the liabilities’ duration, credit spread duration, yield curve exposure, convexity and weighted average yield as closely as possible. If a benchmark matching those liability risk exposures cannot be designed using a blend of physical bond indices alone, we may supplement the physical benchmark with derivatives, such as interest rate swaps, to tighten the fit to liabilities.
The customised benchmark does not necessarily have to be restricted to Australian commonwealth government bonds. For example, some insurance companies may seek a higher yield on the benchmark relative to the yield on the liabilities, and to help them meet this, we can incorporate semi-government and corporate bonds into the liability benchmark as well, while still minimising differences versus the liabilities’ broader risk exposures.
The resulting custom benchmark is designed to be a strategic anchor to the risk profile of the insurance liability, and is typically not positioned to reflect an investment view. We believe tactical views are best reflected by actively managing the portfolio of assets relative to the individual client’s custom benchmark.
Q: What quantitative tools has PIMCO developed to address Australian insurer asset-liability modeling needs?
A: PIMCO’s technology and analytics platform lends itself to addressing insurance and pension liability investment issues, and we have developed a proprietary system called PIMCO Optimizer, which is used extensively in our asset-liability modeling. It helps us understand the risk characteristics of our clients’ liability profiles and in this way, helps us structure customised liability-aware benchmarking solutions. PIMCO Optimizer, along with our other proprietary analytics, is integral to our liability-driven investing (LDI) business, which includes customised pension and insurance portfolios totaling approximately A$140 billion.
Q: How does PIMCO manage insurance company portfolios?
A: Our general approach to managing fixed income portfolios revolves around the principle of diversifying return sources. We believe that no single risk should dominate returns. By diversifying strategies, or relying on multiple sources of value, we are confident that we will be able to generate consistent risk-adjusted returns.
We seek to add value through the use of ‘top-down’ strategies such as our exposure to interest rates, or duration, changing volatility, yield curve positioning and sector rotation. We also employ ‘bottom-up’ strategies involving analysis and selection of specific securities. With our liability-aware portfolios, the degree of freedom that we take relative to the benchmark will be constrained by the client’s tolerance for tracking error versus the benchmark or the insurance liability stream.
Once the appropriate liability-hedging benchmark has been tailored to reflect the client’s objectives, we believe ongoing dialogue with the client and/or their investment consultant is key to the successful implementation of the strategy. In particular, some insurance clients may be focused on total return while others may be more concerned about book income, and to make sure the portfolio is managed with those specific tilts in mind, these objectives can be part of the investment guidelines for the portfolio manager. We also recommend revisiting the liability benchmark when updated cash flows are available after the actuarial valuation so that any changes can be accurately reflected in the benchmark and strategy.
It is important to note that investment guidelines may not paint the entire picture as it relates to the client’s risk tolerances, and a qualitative assessment of preference is also helpful. For example, a subset of clients may seek alpha-generation potential in their portfolios and recognise that this comes with tracking error, while others will prefer to minimise tracking error as much as possible, even if it comes at the cost of more limited alpha potential. This is a conversation which will aid the portfolio manager in constructing the portfolio and scaling the allocation of investment strategies.
Q: Why does active management make sense in this context?
A: Our active management approach is built around a thorough understanding of the risks embedded in the liabilities and the selected market benchmark. We are able to incorporate diversified return sources within insurance portfolios that collectively are designed to deliver positive excess returns while minimising risk relative to the benchmark (and the underlying liabilities).
As markets evolve and client objectives change, active portfolio managers have access to deeper, more liquid investment pools and have greater flexibility to select appropriate securities. While there is some unpredictability in insurance liabilities and the cash flow stream is only a best estimate subject to several assumptions, active management can also help position the portfolio to generate a higher yield to help offset the risk that actuarial assumptions may not be accurately realised.
In some cases, insurance companies need to achieve a certain yield for an underlying product line to be profitable or even sustainable. Depending on the nature of the product, that yield is often determined at product inception, but as economic environments shift − if interest rates fall, for example − it may be difficult to achieve that same yield in the liability-matching portfolio. We have seen some insurance companies attempt to enhance the yield on their assets by targeting other fixed income sectors/asset classes, but this may come with a significant degree of risk or tracking error versus their liabilities. Another way to cover this yield gap is through active management of diversified alpha sources, which we believe is better from a risk management perspective because the incremental asset-liability risk from active management is generally lower than the risk introduced by taking more passive allocations to riskier asset classes.
Q: How has PIMCO implemented this customised liability-matching process in Australia?
A: PIMCO uses an iterative client-focused approach in constructing customised liability-aware benchmarks to meet the specific needs of our Australian insurance clients. We have successfully implemented this process across pension and insurance company portfolios in Australia and globally, with varying mandate discretion and complexity.
Following the initial process of creating the liability-matched benchmark, it is important to establish a regular timeline to systematically review the evolution of the client’s liability profile against the agreed benchmark. This process of reviewing, and if necessary re-optimising, the benchmark to changes in the projected liability cash flows typically occurs every six months, but can be done more often if required and at any time on request. We typically construct mandates with multiple statutory portfolios for each individual insurance liability and a shareholders’ fund. The flexibility of the process allows PIMCO to adapt the customised solutions to the changes in the needs of our clients as their underlying businesses evolve and grow over time.