Matthew Bullock: Hello, and welcome to the latest recording in the Global Perspective series. My name is Matthew Bullock. I’m the Head of Portfolio Construction and Strategy for EMEA and APAC here at Janus Henderson and I’m very fortunate to be joined today by Jay Sivapalan, Head of Australian Fixed Interest here at Janus Henderson. Welcome, Jay.

Jay Sivapalan: Thanks Matt, good to be here.

Bullock: Now, today, we’re going to be talking about all things insurance. So before we sort of talk about the market environments, and the opportunities and so on, I want to sort of do a bit of a high level understanding of what are the key differences between running a portfolio for insurance companies versus a non insurance company? And, in particular, are there any exposures that you think are right for insurers that may not be right for others as well?

Sivapalan: Yes, so the key considerations for insurance portfolio management is quite different to a pension or superannuation fund, and indeed, the broader investment market. And the main differences really, when you’re managing insurance portfolios, it’s a marriage of the total return assumptions, what we call MoRoCa, that is move, roll and carry, as well as the capital usage, in particular at risk capital usage, and profit volatility. And certainly, that’s worth talking about today. Now, it’s also a different mindset to portfolio construction. So when we think about best practice insurance portfolio management, the bread and butter is asset liability management and matching. The second part is efficient use of capital for the instruments that we choose. The third one is some opportunistic ideas that we implement for clients, in particular, where there are some market distortions and opportunities. The fourth one is then risk overlays, whether they be through the cycle or financial year dependent.

Bullock: In that transition for an insurance portfolio versus other portfolios, does that then require a different skill set to be able to do that?

Sivapalan: Yeah, it certainly does. The way we think about it is it’s a different focus. Different level skill sets can be quite helpful. And then different systems and tools can also be helpful, so let me just explain what I mean by that. The first thing that we believe is really valuable, is to understand the insurance business. What are the product lines? Is it life insurance? Is that death policies? Is it total permanent disablement? Is it Business insurance, Health insurance, General or is it Home and Contents Insurance? And the other one is also the ownership structure, and this comes back to capital volatility, so the ownership structure is critical. So, if I walked through the differences that we have in Australia as an example, those that are listed on the share market, clearly, they’re very worried about profit year to year, and quite concerned about the volatility in that, then we’ve got some domestic insurers who are wholly owned by global parents, and so they’re concerned about whether they repatriate dividends back to the parent, and whether they have to call on capital from time to time, we have government insurance in Australia who are less concerned about the capital side of things, and so on. So understanding all these nuances is important. The other aspect that’s quite helpful are actuarial skills. For my part, whilst I’ve been doing asset management for 23 years, prior to that I was in the Life Insurance world, actuarially trained, and I’m fortunate enough to have an Investment team that has three or four other actuarially trained individuals, and so when we’re thinking about insurance portfolios, asset liability management, and capital efficiency, these are all the natural language that we speak, and we effectively work with our clients almost as an in-house investment department of an insurer. And the last part is to build out some of the capital efficiency frameworks into our investment system. So we have a system called Janus Henderson 1, where we’ve built out the whole APRA LAGIC framework into the front office systems.

Bullock: A bit later on, I’ll ask you more about your outlook, in particular, around the credit market. But if I think about the current market environment and I think about what you just said about the differences between insurance portfolios and other portfolios, are you seeing any sort of opportunities and the sort of sweet spots in how you think about running these sorts of portfolios?

Sivapalan: In today’s environment, there’s some great opportunities for active management of insurance portfolios, but what’s really key is to utilise the different levers. Now a traditional insurance portfolio tends to be a bit more buy and hold with some credit carry or income carry. That is quite valuable. And we certainly encourage that, but we think taking some active positioning in rates, be it duration, be it inflation breakeven, be it in yield curve positioning, and then the sweet spot that we see today in different sub-industry sectors of the investment grade credit market, certainly can position insurance portfolios, much better than in the past.

Bullock: As you said earlier, we talked about differences about implementation. So how do you think about implementation when it comes to LAGIC in practical terms, and then how do you manage the risk through a cycle?

Sivapalan: So when we’re thinking about insurance portfolios, and managing insurance portfolios, knowledge of those capital standards is critical, it’s almost a non-negotiable. Of course, in Australia’s case, we’re talking about APRA’s LAGIC framework, which covers both Life & General insurance, and then more recently, the Health insurance industry. But we also have for our global clients, very good knowledge of Solvency II as an example.

Bullock: And are they are reasonably similar?

Sivapalan: Certainly the European and Australian standards, are in principle, quite similar, the detail is differentiated but the US has a little bit more nuanced, compared to the Australian standards and there are also differences for each of the segments that I mentioned: Life, Health, General insurance, and so on. So for example, in Health, we have to be concerned about the Australian assets test, and GPS 120. So, aspects like that are really important to know when we’re managing these portfolios. Probably the other thing that’s worthwhile talking about is the framework itself that most insurers operate in, in Australia, the LAGIC framework, and the different stresses that they apply. So whether it’s real interest rates, whether it’s inflation, whether it’s credit, and within credit, subcomponents of spreads test, as well as default test. And then of course, we’ve got equity and property shocks as well. Incorporating that, and then taking advantage of those active choices we have in deliberate mismatches, once you’ve got the asset liability matching, that’s really the key to managing these portfolios.

Bullock: Got it. So I want to talk about asset risk charges for a moment because many insurers have hard capital risk budgets. And so in turn, you have really strict duration bands and credit risk limits. So what’s your suggestion of how insurers should manage portfolios to those limits?

Sivapalan: Yes, so the asset risk charge limits, often derive from LAGIC itself, they are a great tool for ensuring that insurers have sufficient capital against our regulatory needs. You know, if I would have put it very bluntly, and simply, you don’t want to have an insurance company ever in a position to be writing or speaking to the regulator saying “We haven’t got enough capital and we’re not solvent”. So that’s what you’re trying to avoid in the non-negotiable, but that’s one angle and one instrument. The other part is profit volatility, which has a lot more to do with what is tolerable within an insurance organisation. And this is where the ownership structure really comes into it. Now, of course, listed insurers can raise capital if you have a very bad year, unlisted insurers, less so. And so the appetite, an internal appetite, and internal frameworks, like the ICAT framework really come into play. So it’s useful to have an asset risk charge budget, and we often work with our insurance clients with a specific budget, and we work backwards in terms of portfolio management. But it’s also useful to have other credit risk measures like credit spread duration, and scenario analysis that really show if we have a GFC moment tomorrow, how will the portfolio perform and what will the impact on your profit be, and so on. And so we would always suggest really defining each one of these and prioritising them when we’re speaking to clients and there’s always a trade off between capital volatility, profit volatility, liquidity, drawdown and of course, the risk of permanent loss of capital.

Bullock: So, Jay, we’ve seen significant volatility in interest rates, which would normally reinforce the argument to match liabilities, but what are your thoughts on asset liability mismatches and the current market environment?

Sivapalan: Certainly the starting point, always should be a fully immunised and matched asset portfolio, to the liabilities and by product line, ideally. So if an insurer has nominal liabilities, we should match it with nominal assets. And if it has inflation linked liabilities, we should match it with inflation linked assets. And then similarly, annuity liabilities would as best as practical and annuity based assets. Now, that’s a starting point and that’s useful because you provide capital relief, and you’re really minimising the amount of capital that’s used by the organisation. But once we pass that point, then we can start talking about opportunistic mismatches, deliberate mismatches that provide a really strong return on invested capital for insurers. And so one of the things that we work with, with our insurance clients is the every day mismatches that we’re allowed under the investment guidelines, but also opportunistic ideas that we present, to their ALCOs, their asset liability committees, and also to their boards. Now, just to walk through what some of those tools are, because these can be very valuable active management tools, it can be quite capital efficient to introduce deliberate mismatches when we’re talking about bond swap spreads, when we’re talking about duration mismatches, curve mismatches but maintaining the same overall duration, that’s very capital efficient, taking advantage of rolldown in portfolios, it can be capital efficient. So there are many ways to introduce mismatches that aren’t too capital intensive, and can provide a strong return on capital. So, you know, we encourage insurance portfolios to take advantage of many levers. If I think about the outlook today, and really roll in what I’ve been talking about, so a couple of immediate things, and areas really come to mind. So firstly, we know that the economy is reaching the latter stages of the cycle, the Reserve Bank of Australia in our assessment, is likely to contemplate, you know, easing monetary policy from late this year. So it’s a good opportunity to pull the duration trigger and lever at the moment. And that’s something that we’re doing for our clients, but in a very targeted, nuanced way, so you can express that with yield curve mismatches and for our part the two to four year part of the yield curve, seems to be the sweet spot. The other area is to take advantage of bond swap spreads and bond semi spreads today.

Bullock: Got it. So if I look at the regulatory standard LAGIC, which essentially if I’m right pushes Australian insurers to being significantly exposed to Australian credit, and largely the big four banks. So, given that sort of credit exposure, the sensitivity to spread widening, what stress tests do you run? And how are you thinking about that when you’re running portfolios for Australian insurers?

Sivapalan: Certainly we’re stressing the portfolio for capital and drawdown of capital for the insurance clients. But secondly, against client’s own internal capital frameworks, and then thirdly, scenario testing. And we find that scenario testing is really useful when you’re speaking to a board or an ALCO committee. And that’s because they can understand a Global Financial Crisis environment or a tech bubble environment or an oil price shock or an inflation shock. And to really simulate and walk through what that means for their liabilities, their assets, and then turn that into a profit shock number and really speak in terms of profit, rather than what we traditionally speak of, you know, as asset managers, just returns, so really speaking the language of insurers.

Bullock: I mean, from your experience doing that, and talking to insurers, what scenarios are the ones that they’re asking you to perform?

Sivapalan: It often will be those past shocks that are still relatively fresh in their mind if you’ve been, you know, operating in the market for the last 25 years or so. But also, it’s about navigating a shock over time. So one of the things that we’ve found useful is, typically, in insurance portfolios, you’re dealing with relatively high investment grade portfolios, so permanent loss of capital is not an issue, it’s about mark to market shocks. And so in fixed interest, as you know, mark to market shocks are effectively time shifting of returns, what you give up over the next year, you get the year after and the year after that. And what we found quite useful for some of our boards is actually to talk through okay, let’s assume in year one, you get the immediate shock, very unlucky, this is what happens and this is the impact on profit. What does your year two and year three and year four profit look like? And that’s actually encouraged and allowed some of our insurance clients to really redefine and think about risk and take risk, which has actually worked out well, for their for their long term profitability.

Bullock: Okay, so, Jay, within credit, where are you seeing the opportunities?

Sivapalan: Yes, so the whole investment grade spectrum is a sweet spot. But Australian investment grade stands out, it’s largely due to some of the nuances of the journey we went on in the aftermath of the pandemic, the term funding facility, and the repayment of that by our banks meant that our credit spreads were left high when global credit spreads continued to rally. And then as I mentioned before, if we applied a total return framework, to capital efficient assets, and married yield per unit of capital used, or dollar of capital used, even favouring areas like BBB airports, which would typically be unefficient or inefficient assets, they’ve certainly performed very well in the past. So if to bring that to today, the sweet spot would be AA-rated Universities, AAA-rated residential mortgage backed securities, and even a little bit more controversial, A-rated REITs, in our market, in particular office, shopping centres. These are areas that are quite resilient, we’ll continue to be resilient, lowly geared and from a total return perspective, we would expect an 8% plus or a CPI plus 5% type of return.

Bullock: And then it to wrap us up, I want to sort of step back out again a little bit and then think about what should be front of mind for insurers thinking about their investment portfolios today. So what’s the sort of direction of travel? How are you thinking? What are the opportunities? What are the threats?

Sivapalan: Yeah, so we are entering the latter stages of an economic cycle. So the sweet spot for investors in in the insurance world is really to take advantage of the higher rates and duration that exists today, but also that sweet spot inside investment grade credit, where default risk is not really a matter. In terms of the threats, clearly the consumer centric, consumer-sensitive, rate-sensitive areas are the areas to avoid and the low quality pockets of credit, where the defaults may be forthcoming. I guess just to pull all of this together, you know, if insurance portfolios and portfolio managers could have the discipline of marrying the total return, the capital usage and the profit volatility, and then using those multiple levers to construct portfolios, that’s likely to lead to good profitable outcomes over time. And then from a risk management perspective, as I shared earlier, it’s really the risks that matter to the organisation that we should prioritise and focus on and the other risks should be borne, it would be our view and as I said, today, there’s some great opportunities to be able to do that for insurance portfolios.

Bullock: Great. Well, Jay, we’re out of time. I want to thank you very much for all your thoughts on insurance, and also to thank all of our listeners. So of course, if any of our listeners wish to know more about Janus Henderson’s investment views, or if you have any other questions, please don’t hesitate to contact your client relationship manager or visit our website. So with that, Jay, thank you once again.

Sivapalan: Thank you, Matt.