Against the backdrop of shrinking risk-free asset allocations and growing allocations to alternative investments to maintain book yield, a well-designed strategic asset allocation (“SAA”) framework could help companies navigate risk and improve investment efficiency. We believe an SAA that is assessed from multiple angles is likely to exhibit superior characteristics and improve resilience against a wider range of outcomes, relative to one assessed from a narrower perspective. We show that the risk measure used to optimize an SAA has a substantial impact on the output. With that in mind, we introduce the “Solvency Sharpe Ratio” as a new risk measure for insurers’ SAA optimizations. We argue that this measure is intuitive for all insurance company stakeholders, and show that it tends to justify a less risk-averse and long-term oriented SAA than other, commonly used risk measures. The Solvency Sharpe Ratio provides useful addition to the set of risk measures an insurer can use when they are considering SAAs from multiple perspectives.
Executive Summary
- Declining government bond yields are a challenge on both the asset and the liability side of insurance companies’ balance sheet, and investors have responded by allocating more to credit and alternative assets.
- The growing complexity of investment portfolios is putting greater demands on Strategic Asset Allocation (SAA).
- We set out the pros and cons of existing SAA optimization techniques.
- We show the importance of conducting SAA optimizations using multiple risk measures by demonstrating how much of an impact changing the risk measure has on the output SAA.
- In addition to the commonly used surplus volatility, solvency capital requirement (SCR) and tail risk measures, we introduce a new risk measure for insurers: the “Solvency Sharpe Ratio,” calculated by dividing surplus return by solvency ratio volatility.
- We argue that this measure is intuitive for all insurance company stakeholders, and show that it tends to justify a less risk-averse and more long-term-oriented SAA than other risk measures.
- Using a hypothetical case study and stochastic asset return scenarios, we show that a Solvency Sharpe Ratio optimization would result in an SAA that reduces short-term volatility and aims for better long-term performance.
- We argue that the Solvency Sharpe Ratio encourages insurance asset allocators to focus more on diversified growth than on short-term capital consumption not caused by the insurer’s own business activities, and is therefore a useful addition to the set of risk measures an insurer can use when they are considering SAAs from a range of risk perspectives.
The Solvency Sharpe Ratio Risk Measure Generates an Optimal Portfolio With a Relatively High Expected Return (2.8%, "Mp2"), as Opposed to Standard Risk Measures, Which Generate a Lower-return Optimal Portfolio (1.8%, "Mp1")
Source: Bloomberg, Neuberger Berman. Asset classes used: Euro Government Bonds, Euro Covered Bonds, Euro IG Corporates, U.S. IG Corporates, Euro HY, U.S. HY, EM Sovereigns. Index ticker information is available in Appendix II.