• Liquidity
  • Fixed Income
  • Insurance

Liquidity optimisation for insurers

Building a bespoke portfolio solution

9 July 2024 6 minute read
Author

In the third part of our liquidity optimisation series, we look at how bespoke liquidity portfolios that take into account the interplay between different assets can suit the needs of insurers.

Important information

Read this article to understand:

  • The key features of effective liquidity solutions for insurers
  • The importance of “the interplay effect” between assets
  • Liquidity, capital-stability, yield and capital-efficiency considerations

The topic of liquidity has come into greater focus in the wake of recent market events and regulatory changes. Regulators around the world are asking investors to hold more liquidity or placing greater emphasis on existing rules. Recent liquidity risk events have pushed many investors towards higher liquidity allocations.

The first article in our liquidity optimisation series addressed the amount of liquidity investors need to hold. You can find out more on this topic in “A bigger splash”.1 In our view the amount of liquidity any investor should hold represents a delicate balancing act between potential liquidity needs and wider allocation choices. No easy task, but one that can be approached through a combination of scenario analysis and good liquidity-risk governance. Liquidity needs to be valued appropriately in a broader strategic asset allocation.

The second article in our series addressed the characteristics of liquidity investors need to hold. You can find out more on this topic in “Finding the right blend”.2 For many investors a liquidity pool may just mean cash deposits with banks and/or government bonds. While such an allocation may be intuitive, it is not necessarily optimal. Investors need to consider whether the liquid assets they hold are the right assets for their needs.

In this the third article in the series, we provide a case study of how one of our clients worked with us to build a bespoke liquidity portfolio. The investor in question, a multi-line insurer, had complex liquidity needs and a sophisticated understanding of liquidity risk and liquidity assets. We worked with the client to design and build an optimised portfolio factoring in liquidity, capital-stability, yield and capital-efficiency considerations.

Case study: Scale liquidity optimisation

A client approached us with a request for a liquidity solution based on an extensive set of requirements.

The client profile

  • A multi-line insurer with sophisticated knowledge of investment strategies and instruments, including advanced liquidity-risk management expertise.
  • Potentially significant unpredictable cashflow needs, resulting in a high liquidity need. Or to put it another way, this client had a large operating liquidity segment. Beyond this operating segment the client needed robust liquidity laddering in the reserve and strategic liquidity segments to allow prompt replenishment of operating liquidity if there were a major liquidity call.
  • Focus on high credit quality: minimum credit rating of “A”, to minimise risk of adverse price movement at point of need.
  • Sensitive to volatility: no appetite for interest-rate risk duration and limited appetite for spread duration (maximum of 1.5 years),
  • Limited appetite for non-base currency exposure and requirement for full hedging.
  • Sensitive to insurance capital requirements – the UK Solvency II regime.
  • Need for through-the-cycle-yield exceeding cash rates.
  • >£1billion portfolio.

The process

We operate an iterative process when designing client mandates. We typically find that client requirements may evolve during the process as the client considers the interplay between the different factors relevant to liquidity portfolio design.

We maintain a set of liquidity asset class-specific risk and return assumptions

We maintain a set of liquidity asset class-specific risk and return assumptions. Unlike the conventional, index-based risk-return assumptions available in term markets, short-term markets require more work. These markets are opaquer than term markets and have fewer indices.

We therefore build and maintain bespoke datasets based on inputs from our traders and specialist portfolio managers active in each sub-asset class. We periodically test our assumptions against latest market conditions, updating as needed.

We feed these assumptions into our proprietary MATLAB-based liquidity optimisation tool. This tool provides significant input flexibility, allowing us to consider a range of parameters.

Figure 1: How we design and build bespoke liquidity portfolios

How we design and build bespoke liquidity portfolios

Source: Aviva Investors, April 2024.

The portfolios

We generated a series of ten different portfolios with differentiated profiles to share with the client.

The relationships between returns and underlying risk characteristics are not necessarily linear. Conversely, using multiple levers can offset the effects of other levers.

For example, as shown in Figure 3, portfolios seven and eight have approximately the same level of liquidity, but portfolio eight can potentially generate a higher excess return. This is an important observation. It highlights the interplay effect central to developing robust liquidity portfolios.

Figure 2: Risk-return profiles

Past performance is not a reliable indicator of future returns.

Source: Aviva Investors, April 2024.

Figure 3: Selected portfolio characteristics (per cent)

Past performance is not a reliable indicator of future returns.

Source: Aviva Investors, April 2024.

The outcome

  • Portfolio two: Like a “standard” money market fund (MMF), with very high liquidity and a lower return target.3
  • Portfolio eight: Longer spread duration and lower liquidity. Tolerates some limited exposure to “A” category assets, contributing to a higher performance target.
  • Portfolio ten: A lower liquidity solution both in terms of the level of liquidity and settlement times of the instruments held (most with settlement two days after the trade [T+2], as opposed to most same day [T0] or next day [T+1] in the prior two portfolios). Increased performance target driven by exposure to return enhancers such as AAA-rated asset backed securities (ABS). The ABS we selected were all in the simple, transparent and standardised (STS) format, therefore benefiting from low spread capital charges under Solvency II.

Conclusion

Ultimately the client selected a higher liquidity portfolio which was close to portfolio two, albeit with a higher allocation to AAA STS ABS. This decision balanced liquidity with yield enhancement from the AAA STS ABS, while delivering a high level of capital efficiency.

The key insight for the client was the interplay effect. The client well understood the asset classes involved; what was revealing was how the asset classes worked together to build a diversified, optimal portfolio. With this interplay effect in mind, the client needed an investment manager with the breadth of capability and expertise to manage exposure to these asset classes. We believe many clients could benefit from such an approach.

The information provided is for illustrative purposes only and should not be construed as an investment recommendation.

References

  1. Alastair Sewell, “A bigger splash: How much liquidity do I need?”, Aviva Investors, July 2, 2024.
  2. Alastair Sewell, “Finding the right blend: Optimising asset allocation in liquidity pools”, Aviva Investors, July 9, 2024.
  3. A “standard” MMF is one of the four MMF types available in Europe. It is subject to the full requirements of the MMF regulation. It differs from short-term MMFs in being able to assume slightly more duration.

Subscribe to AIQ

Receive our insights on the big themes influencing financial markets and the global economy, from interest rates and inflation to technology and environmental change. 

Subscribe today

Related views

Important information

THIS IS A MARKETING COMMUNICATION

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable but, has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is issued by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London EC3M 4AE. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material.  AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act 2001 and is an Exempt Financial Adviser for the purposes of the Financial Advisers Act 2001. Registered Office: 138 Market Street, #05-01 CapitaGreen, Singapore 048946. This advertisement or publication has not been reviewed by the Monetary Authority of Singapore.

In Canada and the United States, this material is issued by Aviva Investors Canada Inc. (“AIC”). AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province and territory of Canada and may also be registered as an investment fund manager in certain other applicable provinces. In the United States, AIC is registered as investment adviser with the U.S. Securities and Exchange Commission, and as commodity trading adviser with the National Futures Association.

The name “Aviva Investors” as used in this material refers to the global organisation of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.