Did asset allocation models lead to the Greek financial crisis?

As Greece continues to negotiate with the European Union, a significant question is whether asset allocation models contribute to financial instability?

An excellent case study is the German insurance market. As at the end of 2012, German life insurers held investments to the value of EURO 768.9 billion. Of this, 90% of total assets were held in fixed-income securities.

The current low-yield environment has led Germany’s Reserve Bank, Deutsche Bundesbank to raise questions about the potential for German insurers to become insolvent if low yields persist.

In a discussion paper issued in October 2014, Deutsche Bundesbank researchers Anke Kablau and Matthias Weiß analysed the impact of protracted low yields on solvency. According to Kablau and Weiß one option was for insurers to take on additional risk. “They could try to increase the net return in order to enlarge the allocations to the bonus and rebate provisions, part of which is recognised as own funds. Increased risk-taking would have to be viewed critically in terms of financial stability. Insurers’ risk management systems would certainly need to be progressively adapted.”

The German insurance dilemma raises the broader question of the macro-economic impacts of asset allocation. At a micro-economic level it makes complete sense for an insurer to adopt an asset allocation model where 90% of assets are invested in fixed-income securities. But when a whole system, which in this case is not just German insurers but pension funds globally, adopts the same asset allocation model we create problems.

What we need to see is differentiation, not herding, in investment strategy. Regulators have a role to play in supporting this. Rather than frowning upon risk, which the language of the Deutsche Bundesbank discussion paper implicitly does, regulators need to understand that by encouraging herding behaviour of investors we actually increase systemic risk.

The German insurance model, and others like it, created a platform where government bonds would be purchased, even where risks were deteriorating. We may be facing a Greek crisis today, but the makings of future crises exist in the sustainability of US debt.

The core message for investors is that whether we like it or not we have to step up and recognise that what we do contributes to the health of the global economy. Adopting investment strategies that look cost effective from a micro perspective, does not mean we don’t have responsibility at a macro level for their outcomes.

LINKS

Anke Kablau and Matthias Weiß, Deutsche Bundesbank, How is the low-interest-rate environment affecting the solvency of German life insurers?
https://www.bundesbank.de/Redaktion/EN/Downloads/Publications/Discussion_Paper_1/2014/2014_10_27_dkp_27.pdf?__blob=publicationFile

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