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Home > Asset Management Best Practice > A Practitioner’s Perspective on Investment Management for Shareholder Funds of European Insurers

Asset Management Best Practice

A Practitioner’s Perspective on Investment Management for Shareholder Funds of European Insurers

by Kambiz Deljouie and Corrado PistarinoAviva Investors1

This Chapter Covers

•The push toward Solvency II has lead to a detachment of assets and liabilities and an increase in mark-to-market volatility as liquidity premium is squeezed out.

  • This creates a focus on the sustainability of return on (economic) capital over time.

  • The sustainability over time of traditional buy-to-hold strategies is questionable.

  • Simple buy-to-hold strategies are unable to withstand adverse market scenarios over a multiperiod horizon, when the cost of capital is nonlinear.

  • This is demonstrated by applying a simple algorithm to a portfolio of equity and credit.

  • Thus, there is a conflict between long-term assumptions and the leveraged nature of an insurer’s balance sheet. Additionally, there is a need to implement tactical investment views.

  • A new practitioner’s approach to managing shareholders’ funds is proposed, while stressing the key role of integrated investment governance.


The leveraged insurer’s balance sheet is the key structural element to consider when designing an investment framework for managing shareholders’ funds. Capital is a scarce (and costly) resource to replenish. With the exception of unit-linked products, all other books of business contain payment obligations, which are ultimately guaranteed by the company’s shareholders and are met by the performance of the investment portfolios. To ensure that those expectations are realized and the solvency position of the company is preserved, a robust investment discipline is needed.

Although gaining recognition across the industry, the emphasis on capital preservation and on maximization of return on capital over a multiperiod horizon is not yet fully established.

The in-force regulations (e.g. premium matching for the annuity book, which shelters capital from mark-to-market volatility of assets), overemphasis on liquidity (e.g. the perceived need of property and casualty insurers to hold extremely liquid portfolios with small market risk), and the complexity of the business (e.g. the embedded optionality in with-profit funds) all conjure to favour simplified investment frameworks such as buy-to-hold investing, long-term investment return (LTIR), etc. Therefore, the interaction between capital preservation and portfolio management is largely ignored.

The aim of this chapter is to illustrate that, despite the introduction of a risk-based solvency regime for capital calculation, the impact of mark-to-market on the insurer’s balance sheet can severely strain its solvency position, making the interaction between capital and investment activity paramount. By focusing on the shortcomings of traditional (and still very popular) buy-to-hold investing, including the rather unshakable faith in the power of diversification, and by highlighting the alarming weakness in the insurer’s balance sheet, we hope to convince the reader that a change to more dynamic investment approaches is needed.

Regulatory Challenges

In the United Kingdom, where a risk-based framework for computing regulatory capital has been in existence for a number of years, the transition to Solvency II is expected to be smoother than in other European jurisdictions. The notion of the survival of capital over a given time horizon, based on the aggregate risks of an insurer’s balance sheet, is already part of the existing regulatory framework.

However, a large portion of the insurance business is still managed under a legacy solvency regime which allows discounting of the insurer’s liabilities using part of the expected future returns on assets. The net effect of using this approach is the “capitalization of the liquidity premium,” which, essentially, is the creation of a buffer of capital by recognizing an intrinsic net positive value in the asset portfolio. This approach is particularly prevalent in UK annuity management and is sometimes referred to as “premium matching.”

Premium matching is done using fixed-income assets, and capitalization of the liquidity premium is justified by observing that cash bond credit spreads are often higher than historical defaults. This implies that the liquidity premium is related to the type of assets that an insurer holds, and therefore that the discounting basis for liabilities is endogenous (i.e. derived from the actual portfolio of assets held by the insurer). This creates a direct link between assets and liabilities, which effectively immunizes the insurance capital from the mark-to-market volatility in the asset portfolio.

The recognition of a liquidity premium has practical consequences on the investment framework: it disincentivizes asset reinvestment strategies and creates a strong preference for a cash flow matching approach to portfolio construction. Besides, there is little motivation for active management of the investment portfolio, despite the obvious fact that optimality in portfolio construction changes with time.

Solvency II is set to implement significant changes to the valuation of the liabilities by moving from a real world (using asset yield) to a market-consistent discounting curve. Because the discounting basis is exogenous (it is not linked to the particular type of investment), it should lead to a detachment between assets and liabilities and exposure of capital to mark-to-market volatilities. If the liquidity premium is squeezed out or deemphasized, the following outcomes are likely.

  • The traditional, static cash flow matching approach fails to achieve portfolio optimality; worse, with no recognition of a liquidity premium, it would attract a significant amount of solvency capital.

  • Capital preservation will instigate a fresh appetite for reinvestment risk as the simplest risk-reduction strategy.

  • The modular approach to capital calculation will force an explicit deconstruction of the various sources of market risk and will enhance clarity of purpose. The distinction between risk-taking decisions and hedging strategies will become clearer.2

  • Although not explicitly stated, the alignment of solvency and economic capital (and market reality!) should imply the inclusion of government bond risk within the larger spectrum of credit risk. There is no longer a risk-free instrument available for perfect cash flow matching.

This new regulatory regime, in its purest form, seats capital in the midst of mark-to-market moves. To protect the new and fragile capital the insurer has to give attention to dynamic investment and think about downside protection. A more dynamic approach to investment should inevitably improve investment governance as well as giving greater focus to the investment and risk management issues in the asset–liability management context.

A number of objections have been raised by the insurance industry regarding the impact of the new solvency regime on the day-to-day conduct of its business. Among the industry’s concerns—especially in the United Kingdom—are the capital strain on the annuity business, the cost of continuing to hold large portfolios of long-term credit assets post the implementation of Solvency II (or the cost of disposal of the long credit book), and a potential increase in the cost of retirement products. In response to those concerns, the latest version of the regulatory framework, the Fifth Quantitative Impact Study, or QIS 5, allows for a long transition phase in which an element of liquidity premium3 will continue to be recognized. However, this new form of liquidity premium will continue to be exogenous, with no connection with the running yield of the asset portfolio. As a result, the principle of detachment of assets and liabilities would remain unscathed, and so would the need for a change in the insurers’ investment perspective.

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Further reading


  • Heston, S. L. “A closed-form solution for options with stochastic volatility with application to bond and currency options.” Review of Financial Studies 6:2 (Summer,1993): 327–343. Online at:
  • Hibiki, Norio. “Multi-period stochastic optimization models for dynamic asset allocation.” Journal of Banking and Finance 30:2 (2006): 365–390. Online at:
  • Longstaff, Francis A., and Eduardo S. Schwartz. “Valuing credit derivatives.” Journal of Fixed Income 5:1 (June, 1995): 6–12. Online at:
  • Manning, Mark. J. “Exploring the relationship between credit spreads and default probabilities.” Working paper 225, Market Infrastructure Division, Financial Stability, Bank of England, 2004. Online at:
  • Zhang, Benjamin Yibin, Hao Zhou, and Haibin Zhu. “Explaining credit default swap spreads with equity volatility and jump risks of individual firms.” BIS Working paper 181, Monetary and Economic Department, Bank of International Settlements, September 2005. Online at:

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