Equity Investing for Insurers: Keeping Steady on the Till in Rough Seas
August 01, 2022
“A smooth sea never made a skilled sailor.” - Old English Proverb
By Matt Reilly, Managing Director, Institutional Solutions
Equity markets had been smooth sailing for investors over the past decade with the S&P 500 Index returning 16.9% a year through 2021. However, as investors are learning in the beginning of 2022, these returns are not without risk. With the unwinding of pandemic-driven fiscal and monetary policy accommodation, levels of inflation not seen in decades, and heightened volatility from geopolitical shocks, choppiness has returned to the seas of financial markets.
As long-term investors, insurance companies face a unique challenge. Growth assets, stocks in particular, have played a key role in meaningful surplus growth amid meager reinvestment rates in predominantly fixed income portfolios. While yields are improving, real returns from fixed income are expected to be poor. Insurers need to decide what to do with their portfolio of growth assets amid increasing uncertainty.
Conning has reviewed recent equity performance, examined divergent asset allocations pursued by insurers, and proposes some analytical frameworks to help insurers keep a steady approach to investment strategy. Despite current equity market conditions, we remain convinced that many insurers would benefit from exposure to stocks and other growth assets over the long term and a number should consider expanding their equity holdings.
A Rising Market Squall
During the past decade equity investors regularly witnessed double-digit gains in equities with few exceptions. However, in 2022 the S&P 500 was down 20% through June (see Figure 1). Making the situation worse, the usual ballast of fixed income was also down due to higher interest rates and wider spreads in credit markets: the Bloomberg U.S. Aggregate index returned -10.3% through June 2022 (see Figure 1).
Recent historical equity drawdowns were more harsh: the S&P 500 fell 38% in the early part of 2020 due to the pandemic and was down 54% in less than a year amid the 2007-2008 financial crisis.2 With that in mind, insurers allocating to equities need to be mindful that the next bout
of choppy market performance may be on the horizon.
For insurers, these precipitous declines are exacerbated as balance sheets are typically leveraged (more dollars of investments than surplus) and equities are marked to market on balance sheets. An insurer with a 2-to-1 ratio of investments to surplus and a 10% allocation to equities would have lost 2.6% of surplus with the drawdown through June 2022. While this risk to hard-earned surplus and the fast-rising market volatility are far from ideal, these risks need to be reconciled with the higher returns equities could potentially deliver over the long term.
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Market, or systematic, risk is the risk that individual stock returns may be correlated with general market downturns regardless of the particular business conditions and outlook for the individual stocks. Inflation erodes the purchasing power of future cash flows from investments. In times of high inflation the value of securities may be reduced. Liquidity risk can occur when market conditions do not allow transactions to be made in a quick and orderly fashion in relation to indicative market prices.
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