Rethinking the risk-reward dynamic for alternative assets

Rethinking the risk-reward dynamic for alternative assets

Rethinking the Risk-Reward Dynamics for Alternative Investments | Insurance business America

WTW wonders what needs to remain “priority.”

Risk management news

By Kenneth Araullo

Given economic volatility and evolving market challenges, insurers are increasingly considering alternative asset classes as part of their strategic asset allocation (SAA).

According to Punil Chaubal, head of insurance investment advisory at WTW, such changes highlight the urgent need to adhere to the Prudent Person Principle (PPP).

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

“SAA provides a means to optimize risk-adjusted returns through exposure to a range of asset classes, combined according to the insurer’s liabilities and investment objectives,” Chaubal said. “However, any SAA exercise should include a determined focus on PPP compliance.”

This will ensure insurers maintain a strict focus on compliance and risk identification, protecting policyholder obligations and mitigating regulatory scrutiny.

Alternative investments in a difficult “conventional” environment

Chaubal highlights the emerging risks associated with these new investment opportunities.

“In recent years, financial markets have been rocked by crises such as the COVID-19 pandemic, geopolitical conflicts and economic challenges,” he said. “Conventional asset classes, including equities and fixed income, have struggled. Many insurers have therefore expanded their search for returns. Asset classes such as private debt, infrastructure and hedge funds are all generating strong interest.”

The SAA exercises have been critical in this transition, supporting insurers’ efforts to pursue an investment strategy more aligned with achieving their objectives during these increasingly volatile times. Nevertheless, these exercises sometimes have shortcomings in identifying and quantifying risks and occasionally neglect various types of risks associated with complex investment strategies.

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

Faced with new risks, “PPP must remain first”

The focus on PPP within SAA practices ensures that insurers fully consider these risks. This includes assessing the adequacy of their own abilities to manage these assets effectively and the risks associated with them.

“In times of liquidity constraints for an insurer, such as a major disaster or mass termination event, an insurer may be unable to repurchase its shares on a timely basis or at favorable prices, potentially resulting in the need for cash injections from shareholders.” said Chaubal.

The PPP aims to ensure that these risks are taken into account. Chaubal notes that a basic risk-reward analysis may suggest that a significant allocation to these complex assets is appropriate.

“However, an SAA exercise incorporating the PPP would recognize the additional risks, incorporate an understanding of the insurer’s capabilities and use this additional information to determine appropriate allocations for these asset classes,” he said.

However, the integration of alternative investments should not lead to a move away from traditional investments. Instead, insurers are advised to balance the pursuit of potentially higher returns with the need to protect policyholders’ interests by keeping the PPP in focus.

“The final result? New asset classes offer insurers a more sophisticated and differentiated investment strategy that could help them navigate ongoing market turmoil and increase returns. But the PPP must continue to come first,” he said.

As insurers expand into unfamiliar asset classes, additional expertise and specialized knowledge may be required. Techniques such as stress testing and scenario analysis could play a crucial role in understanding the impact of these new investments on insurers’ financial stability and operational capabilities.

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2024-04-22 18:10:06