Friday, April 27, 2018

Guaranteed to end badly?

Insurers in Asia are taking ever bigger risks to meet increasingly unrealistic guaranteed returns promised to policyholders.

Despite persistently low interest rates and a challenging environment for investment returns, guaranteed products still make up 51% of the asset mix among insurers in Asia Pacific, according to a survey of investment and risk professionals at insurance companies in six markets in the region conducted by Standard Life Investments.

To meet these guaranteed returns, insurers have been on a desperate hunt for yield that has inevitably resulted in asset-liability mismatches in both directions — short duration liabilities backed by long-dated assets and vice versa.

This is particularly the case with Chinese and Hong Kong insurers, which have generated huge growth in recent years through the sale of wealth management products that offer high guarantees over relatively short durations, in competition with banking products.

Such guaranteed savings products make up 87% of the insurance product mix in China, and to meet the average target return of 4.9%, insurers have relied on generating strong returns from illiquid assets such as infrastructure.

“There are issues associated with this because, strictly speaking, the assets are too long for the liabilities and that generates liquidity risks when those assets are required to pay customer benefits,” says Bruce Porteous, investment director of insurance solutions at Standard Life Investment. “It feels like they’re doing it by taking more risk.”

In Hong Kong, the average target return for guaranteed products is 5.3% — double what’s on offer in Europe, even though the risk-free rate of just 1.6% is roughly the same. Even so, insurers in Hong Kong and China are both successfully generating excess returns thanks to the investment risks they are taking.

The fear is that these insurers will experience something similar to what the Korean life industry is going through, where guaranteed returns are higher than current and expected returns.

China’s industry regulator is acutely aware of this problem and has cracked down on the excessive sale of universal life policies, which led to a 59% drop in year-on-year sales during the first five months of 2017 — though that still represents Rmb308 billion (US$45.4 billion) of business during the January-to-May period.

China is also set to release new regulations in the middle of 2017 to quantify and assess asset-liability management risk for insurers, as a supplement to existing solvency requirements.

Nevertheless, respondents to the survey said they expected 21% growth of guaranteed products during the next three years

Guaranteed products are still a US$2 trillion business in Asia, but it might be time to re-think the model. Indeed, if regulators impose tougher standards of asset-liability matching, insurers will need to innovate. And asset managers such as Standard Life Investments would like to bring the lessons they have learned in Europe to the Asian market.

“It’s starting to happen in Asia; you’re seeing a trend away from traditional insurance with guaranteed rates of return towards investment-linked propositions where the customer takes the investment risk,” says Porteous. “Europe’s at an earlier stage in that journey but we’re also seeing evidence of it in Asia.”

With tougher solvency rules coming on stream and a generally more aggressive approach by regulators, combined with insurers’ need to still meet return expectations, external managers are pitching their expertise in sourcing assets that Asian insurers are less familiar with, such as international equities, infrastructure, real estate and private equity.

Of course, the most sensible step would be to move away from guaranteed returns, but competitive pressures within the industry and the expectations of investors mean that insurers will remain hooked on selling them — and will continue to offer rates of return that are in line with historic expectations instead of future ones.

Whether they can come up with investment strategies to justisfy this approach is an open question, but history suggests not.


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