In the 1930s, during the Great Depression, John Maynard Keynes spearheaded a revolution in economic thinking. Casting doubt on the established precepts of neoclassical economics, he ultimately transformed approaches to monetary and fiscal policy.
Describing the process of gaining acceptance for his groundbreaking theories, Keynes once remarked: “The difficulty lies not so much in developing new ideas as in escaping from old ones.” Today, as they face a near-relentless parade of emerging challenges, insurers may wish to keep this observation in mind.
Inflation has defined 2022 and will still play a major role in 2023, while various regulatory initiatives are also set to come into force next year. As this article explains, these and other dynamics could force insurers to reconsider long-held investment habits.
Inflation, the way ahead and the quest for outperformance
The record inflation levels witnessed during 2022 have been notably testing for insurers. As discussed in detail in an earlier article, the industry is uncommonly vulnerable to the erosion of purchasing power.
This is because inflation can affect both sides of an insurer’s balance sheet. Sometimes it can produce the double whammy of a fall in asset values and a simultaneous rise in liability values.
Going forward, inflation’s path will continue to shape monetary policy. This, in turn, will determine the nature and speed of recovery. Central banks will carry on tightening policy if inflation persists, but there could be a pause if inflation moderates over the coming months.
Invesco’s 2023 Investment Outlook favours the latter as a base-case scenario. It argues that we are currently in the contraction phase of the economic cycle, with growth below trend and decelerating, and that recovery – assuming inflation does not stay stubbornly high – will start to unfold later in the year.
Recovery should bring an acceleration in growth, albeit still below trend. Since asset prices are themselves cyclical, it should also result in the outperformance of risk assets over time.
An inevitable question for investors of all types, then, is which assets are most likely to outperform as a new economic cycle gets under way. For insurers, however, this dimension is likely to be only part of the story, with 2023 also poised to be a critical year in terms of regulatory reform.
A shifting regulatory landscape
Long-awaited amendments to Solvency II requirements could at last be finalised in both the European Union and the UK in 2023. Like inflation, these revisions and refinements are likely to impact insurers’ investment thinking.
In light of significantly diverging views on the optimum direction of travel, there is a possibility that negotiations in the EU could hit a wall. Nonetheless, it may be sensible to assume proposals on insurance recovery and resolution will be ready by the middle of the year1.
In the UK, meanwhile, the Treasury has already published a package of recommendations. These include reducing the Risk Margin by 65% for life insurers and 30% for non-life insurers, as well as broadening the asset and liability eligibility criteria for the Matching Adjustment – a move that would enable investment in a wider array of assets2.
Regulators are also ready to maintain – and even intensify – their focus on sustainability in 2023. For example, both the EU’s European Insurance and Occupational Pensions Authority and the UK’s Prudential Regulation Authority are to continue scrutinising progress in integrating climate risk3.
Relatedly, the EIOPA has been granted a mandate to investigate greenwashing in the industry – particularly with regard to implementation of the Sustainable Finance Disclosure Regulation, the EU Taxonomy and Insurance Distribution Directive sustainability preferences4. The UK may follow suit in time.
Consumer protection will remain under the microscope as well. The UK Financial Conduct Authority’s Consumer Duty principle – which will oblige all financial providers to act in their clients’ best interests – is due to come into effect in July5, while the EIOPA is likely to begin applying a new methodology for gauging value for money from unit-linked products6.
Benefiting from diversification
Even by recent standards, it is hard to make predictions with anything like absolute confidence at present. We might not yet have seen the worst of the markets, as our 2023 Investment Outlook concedes. Nonetheless, it seems reasonable to arrive at a few informed conclusions about the way forward.
Maybe the most important is that “business as usual” is unlikely to be an ideal guiding philosophy for insurers’ investment decisions. Old habits might die hard, as Keynes intimated, but the reality is that they are rarely suited to situations characterised by radical churn and change.
Another key inference – one closely connected to the above – is that the oft-quoted adage about not putting all your eggs in one basket has become especially apt. Insurers that cling to a reliance on conventional fixed income assets in uncertain times need to recognise the likely benefits of diversification.
The turmoil wrought by inflation will be with us a while yet, even allowing for the most optimistic forecasts. This means proxy inflation hedges are likely to have a place in a well-constructed, far-sighted, multi-asset portfolio.
The debt universe is home to several potentially attractive options, including Senior Secured Loans and unrated debts. Increased exposure to alternative investments with direct links to inflation – for instance, real estate, infrastructure and commodities – could also assist in offering protection and generating solid returns.
Crucially, this kind of diversification might also be seen as fundamental to meeting mounting regulatory demands. This is because conventional strategies could prove inadequate in managing the risks associated with a fast-evolving economic landscape – conceivably leading to shortcomings in ensuring sustainability, serving clients’ interests and delivering value for money.
