27 May 2020
Norman Peard is an independent consultant with Investment Committee chairing experience and experience as a Director of a Corporate Pension Trustee, working with leading life insurers and roles in investment banking and regulation.
I was kindly approached to write a blog on the above, but the more I reflect on it, isn’t it less than half the question? What about the liabilities? What about the asset and liability interactions?
For some, the COVID-19 pandemic will have shown the resilience of their current Asset Liability Modelling (ALM) arrangements. For others, it will have set the gaps in their approaches in stark relief.
What is clear is that a fundamental reassessment is required of current exposures, risk budgets and plans, going “back to basics”.
It seems far too early to form any precise views as to the future, say five years from now. Scenario analyses are likely to be the most informative approach.
Matters which could usefully be considered under each scenario include:
- Liquidity
- Equity market performance; Interest rates; Credit and default experience; Property market performance
- Mortality, longevity, persistency and expense experience
- Inflation path; Currency exposures
- Volatility of each of the above
- The balance between the monetary and fiscal responses adopted in dealing with the considerable economic fallout
- The ability to raise capital if required/employer covenants
Possible scenarios include:
- Infection rates have peaked in developed economies and are now falling, efforts to ease restrictions will be successful without triggering a second wave, a vaccine is developed by the end of 2021 and much of the world returns to where it was in most respects
- There are two or three main waves of infection as countries ease and tighten constraints and a vaccine is developed by the end of 2021
- There are multiple waves of infection and tightening before a vaccine is developed in, say 2 years’ or 5 years’ time
- No vaccine is developed, but social distancing, tracking and the like is sufficient to control and eliminate the virus in most countries within, say, 1 year, 2 years, or 5 years
- The virus is globally endemic, there will be no successful vaccine for many years, if ever and the citizens of developed economies will live with increased risk going forward
One thing which seems immediately apparent is that none of these scenarios is obviously the one which is going to come about in reality, nor obviously implausible. However, the varying impact of the different scenarios on each of the matters being considered will be considerable. We have already seen evidence for this in the volatility of markets when the outlook appears to switch from one potential regime to another. From this it seems likely we can safely assume considerable market volatility for some time to come. Also insurers and pension funds can usefully consider what action to take in each scenario, or on a regime switch, as that will inform thinking even if the exact scenario doesn’t play out.
More subtly, perhaps, it needs to be noted that analysis cannot be simply at a macro level. For example, whilst the FTSE-100 Index is down about 27% in Q1 2020, five individual stocks rose in that period and five fell by more than 55%. The divergence between sectors and even within sector is significant. It is easy to see why the leisure and travel sectors have been hit hard and why some pharmaceutical companies have done well, for example. The point I wish to draw out, however, is that investors need now to consider not just their high level Strategic Asset Allocation across the major investment types, but also look in much more detail as to the nature of their detailed exposures. This is even more important against a backdrop of the impact of environmental concerns on some asset values. This links to the related point of the implications for the existing trend to focus more on ESG (Environmental, Social, Governance) aspects, which may potentially receive a fillip largely inconceivable 6 months ago.
This holds not just for equities, but also for the other asset classes. What are the underlying exposures for property investments (whether leases or freeholds, in development or occupied, etc.)? Will bonds allocated to Matching Adjustment portfolios continue to produce a reliable, fixed income stream or are they exposed to imminent downgrade, or downgrade under one of the scenarios? What about each employer’s covenant?
And for insurers writing new business, what are the implications of each scenario for pricing new business, new business volumes, capital requirements and, consequently, profitability?
I placed liquidity first in my list of matters for consideration under each scenario. In general it has seemed to me for some time that insufficient detailed consideration has been given to this subject. At the current time, having access to a reserve of liquidity will undoubtedly enable emerging opportunities to be capitalised upon, as well as meeting claims or pensions obligations. At the other extreme, it could make the difference between financial survival and financial failure.
In answer to the question, what can insurers and pension funds do, perhaps the answer is to be as realistic as possible in setting a range of plausible best case to worst case scenarios, set realistic risk budgets and agree a plan of operation which will enable them to come through the next 5 years in the best possible shape. That will be to the benefit of all their stakeholders. No doubt the COVID-19 pandemic will entail significant changes, both operationally and in terms of outlook assessments for various asset classes and individual holdings. What is happening is both a powerful wake-up call and an opportunity for improved understanding, strengthened systems and greater resilience going forward.