DISCLAIMERS: The opinions expressed herein are those of the panellist and do not reflect the opinions of Milliman or its employees. Facts cited by the panellists are presumed to be accurate and have not been externally verified. This document may not be used in whole or in part without the express written permission of Milliman.

A panel of senior insurance investment professionals joined Milliman in late July to share thoughts on the economic implications of COVID-19.

We conducted the meeting under Chatham House rules, and below we summarise the key points from a fascinating discussion. Our thanks to those who took part.

Participants:

• Joseph Canavan - Head of Capital Management at Royal London
• Andrew Dickson - Head of Asset-Liability Management at Aegon
• Michael Eakins - Chief Investment Officer at Phoenix Group
• Prasun Mathur - Head of Private Assets at Aviva UK Life
• Corrado Pistarino - Chief Investment Officer at Foresters Friendly Society

Moderators:

• Paul Fulcher and Russell Ward of Milliman

How are the current environment and the outlook likely to influence the investment decisions of insurers? For example, given the rising UK government deficit is there a point at which insurers will become uncomfortable funding this via purchases of gilts?

One common theme was that it was too early to fully understand the economic impacts of COVID-19. The shorter-term impact may become clearer as more data emerges over the next two to three months. But there is a significant amount of uncertainty around the longer term impact, and insurers should be considering a range of different scenarios, some of which could have a severe downside.

That said, the impact of COVID-19 has clearly been material. At the start of the year, the UK economy was expected to grow by 1% to 1.5% in 2020, but is now forecast to shrink by approximately 10%. The government bond markets are subject to a combination of increased borrowing and the drop-off in economic activity. However, most of the panellists were generally relatively sanguine about the prospect for gilts.

The appetite to invest may differ between assets backing guaranteed liabilities and those with a more accumulation-type nature, where gilts might indeed offer less attractive returns than other assets. But for assets backing guarantees, gilts can form a natural “near risk-free” asset, particularly for insurers that don’t have the ability to access more complex strategies such as currency hedging and interest-rate swaps. Government borrowing elsewhere has been equally impacted by COVID-19-- for example the proposed new recovery fund in the EU and the already high levels of government debt in the US. Therefore, insurers are still likely to provide a natural bid for gilts.

Further, central banks have been active in supporting the economy in general, and government bond markets in particular. In the UK, the Bank of England has purchased £745 billion of gilts and were expected to increase that further. In the US there has been over $1 trillion of quantitative easing, including investment grade corporate bonds and fallen angels. Increased government deficits therefore may not cause a re-rating of government bonds as central banks would be expected to step in and buy them if required – though this should not be seen as a cast-iron guarantee against downgrades.

Participants emphasised the need for nimbleness to take advantage of the investment opportunities that might arise from the current economic volatility. The prospects for different asset classes and, for each asset class, different sectors – for example retail versus office versus residential in the property space – may have been changed by the pandemic and need to be carefully thought through. In some cases, COVID-19 has served to reinforce trends that were already present, such as the relative attraction of UK versus overseas assets in light of Brexit and the reversal of globalisation.

One potential new trend could be increased long-term government support for public sector investments, leading to a more supportive environment and a potential re-rating. And public-private financing initiatives may play an increasing role in future, particularly to fund recovery projects, with a potentially key role for insurers as providers of long-term capital.

There is a debate around inflation. In the short term, central banks such as The Bank of England seem concerned around inflation undershooting and the risks of deflation, but in the longer term could the economic response to COVID-19 lead to higher inflation?

The participants expressed a variety of views, again highlighting the uncertainty and wide range of possible outcomes.

Generally, inflation was expected to be low in the very short term.

However, presently consumers appear to be accumulating money in current accounts, which suggests the potential for a boom in spending when restrictions are lifted and confidence returns, causing a possible spike in inflation.

On the medium- to long-term effect, one view was that current analyses typically look at past recessions, which misses the crux of the unique circumstances of COVID-19, which is more comparable to a wartime scenario. Post World War II, economic recovery was achieved by the government inflating itself out of accumulated debt, and this may be a feature of this recovery.

Some participants felt higher inflation was a significant risk, and monetary policy alone may not be able to control this. Indeed targeting medium-term inflation may relinquish its place as the primary goal of monetary policy given the highly uncertain economic outlook arising from the pandemic.

Other participants noted that, in the recovery since the global financial crisis, the last decade has seen significant inflation but this has been in asset prices with consumer price inflation remaining subdued. In the recovery from COVID-19, the greater role being played by fiscal policy to support the economy, and to potentially correct perceived wealth imbalances, could change that picture.

The potential for sterling depreciation, either due to perceived fiscal pressures on the UK or the impact of Brexit, could also lead to inflation being imported. COVID-19 was also expected to lead to some re-engineering of global supply chains implying a reduction in cross-border trade, which could have an impact. Generally, the high level of uncertainty means it is more important than ever that insurers prepare for a wide range of potential outcomes, considering the scale and direction of balance sheet inflation exposures and then find a way to protect these against adverse movements.

There has been an increase in the Central Bank's activity in the purchasing of assets ("buyers of last resort"), including, in the UK, gilts and some corporate bonds, and in the US the Federal Reserve’s purchase program has been extended to include high yield bonds. Most markets (with the exception of interest rates) have largely bounced back from where they were in March. Are central bank policies driving an increasing wedge between market performance and economic reality? Is the increased purchase of assets by the central banks sustainable?

Panellists observed that a wedge between market performance and economic reality is not a new concept; it has been present to some degree ever since central banks began quantitative easing.

Indeed, in one view, it is the job of the central bank and monetary policy to support the economy and to help create the conditions for the economy to overcome adverse shocks. The existence of a wedge reflects the tendency of markets to anticipate and price in expectations for the future success of these strategies. There is, however, certainly a risk that people lose sight of the true long-term value of assets, which is a different question entirely.

Some panellists argued that there is a limit to central banks’ ability to conduct expansionary monetary policy. There are even some public figures advocating that the US return to the gold standard, specifically Judy Shelton, President Trump's nominee for the Federal Reserve board of governors.

Other panellists noted that the stock market recovery, including the over-performance of the S&P500 over the Dow Jones index, was driven by technology companies. Firms such as Google, Facebook, Amazon and Microsoft make up around 20% of the S&P500 and the outlook for those companies has actually improved substantially as a result of the pandemic due to the increasing reliance on technology.

Is there going to be a fundamental reshaping of cashflows from investments? The coupons of recent gilt issues have been very small (the last issue was 0.125% - almost a zero coupon bond). Also there is reduced dividend income on UK equities (over a 50% reduction expected this year for the UK market) and the likelihood of reduced rental income from properties. Are we facing a cash flow challenge after this, and a significant re-profiling of what we can expect to get from investments in the future?

Participants observed that liquidity risk management was key – whether insurers had enough cash-like assets to match potential outgo. And from an ALM perspective, the reduction in yields will have increased the value of assets whose cash flows are seen to be secure. Hence, if liquidity and ALM risks are managed appropriately, as they were generally felt to be in the UK sector, then reductions in investment yields should not cause a major issue.

Certain asset classes, such as commercial property and SME loans, could be exposed to irrecoverable losses, such as permanently lost rent or defaults, which would impact their valuation and their ability to match liabilities. It will be key for insurers to engage in active credit management with robust assessments of both base case forecasts and scenario testing.

Generally for markets, a key question is to what extent the current market valuations factor in expectations of future changes and of market recovery. Asset owners are still working this through, so at this stage longer term structural changes are still uncertain.

We are seeing structural changes and trends such as reduced demand for office space and large scale shopping facilities. Are there other trends generated or perhaps accelerated by the crisis that may impact the demand for certain asset classes over the coming years?

From a UK life company perspective, three immediate lessons were highlighted for long-term asset allocation, all of which relate to already existing trends.

Firstly including a level of diversification in your asset portfolio – specifically around geographical spread and currency diversification. This crisis has, for example, exposed the fragility of the sterling investment grade corporate bond market (as also seen in 2010-11), with significantly reduced liquidity compared with US dollar-denominated bonds. The term structures available in the UK (where over half of 15-year or longer duration bonds are concentrated in utility or finance companies) are not as attractive to insurers compared with bonds available in the US dollar bond market.

Secondly, a preference for investing in private rather than public credit markets, due to compressed public market yields, the ability to structure private asset cashflows to meet benefit liabilities, and the typically greater asset security offered versus unsecured debt.

Thirdly, on the sustainability/ESG agenda. For example, previously there was a headwind to allocate investments in airlines/airports, and this crisis has halted both globalisation and international travel. This crisis could also offer a rehearsal for a crisis caused by climate change, and indeed also shows how quickly sentiment can transition. Overall, the pandemic is expected to bring a greater focus on sustainability in long-term asset allocation decisions.

Do we see state intervention being helpful? Once state intervention has begun it is difficult to remove. With up to £37 billion of infrastructure contracts planned to be awarded in 2020/21, do we have confidence in the government to invest in the right things?

Generally, participants expected the government to attempt to taper their support to the economy as soon as possible and the current level of spending, e.g., on furlough schemes, was seen as unsustainable.

However, with exceptional government spending contributing a significant element of economic support of the economy, this would need to be replaced-- for example, with infrastructure projects.

The impact of the pandemic might also lead to a significant reappraisal of the role to be played by government industrial policy given the potential unwind of globalisation and the importance of controlling strategic supply chains.

Panellists saw a key role for longer term investors, such as insurers and pension funds, to work in partnership with government to invest in the recapitalisation of the UK economy. Indeed both the insurance industry and their regulators may be put under political pressure to enable this to happen. Insurers should expect to work with the government on more innovative private-public financing solutions.