White Paper August 2017

For professional clients only

Insurance companies’ asset allocation

drivers – Part III
Asset allocation under US Risk-Based Capital
Authored by:
Andries Hoekema, Global Head of Insurance Segment
Pierre Dongo Soria, Strategist, Global Multi Asset Research

Any views expressed were held at the time of preparation,

reflected our understanding of the regulatory environment; and
are subject to change without notice. The value of investments
and any income from them can go down as well as up and
investors may not get back the amount originally invested.
Insurance companies’ asset allocation drivers part III
Asset allocation under US Risk-Based Capital (RBC)

Introduction Page 3
Proposed RBC changes Page 4
What is changing? Page 4
What are the implications? Page 5
Optimising under RBC Page 6
Setting up our framework Page 6
Case 1: L&A insurers Page 8
Case 2: P&C insurers Page 11
Conclusion – navigating the complexities of optimisations Page 13
Appendices Page 14
Authors Page 17
Important information Page 19

Executive summary

 Through this white paper series, we have aimed to explore

potential optimisations that could help improve outcomes for
insurers’ portfolios in the context of their core business and
regulatory constraints.

 In this paper, we evaluate the proposed changes in the US RBC

framework and look at how these would influence asset
allocation optimisations. We distinguish between Life/Annuity
(L&A) and Property/Casualty (P&C) insurers to take into account
different liability profiles.

 There are some clear winners – such as ABS and high Yield –
and losers – namely municipal bonds – when we optimise under
the proposed rating table versus current RBC rules for L&A
insurers.

 The outcome is different for P&C insurers’ optimised portfolios,

where non-US developed market government bonds emerge as
a relative winner and hedge funds as a loser.
 Interestingly, our results suggest that US RBC does not
significantly impact efforts to optimise portfolios for economic
capital efficiency, which is in marked contrast to certain other
regulatory regimes such as Solvency II.

2
Introduction

In the first part of this series, we began with an
overview of insurance companies’ key asset
allocation drivers. Before going into the detail of core
business operations, we broadly identified four
influencing factors: regulation, the local availability of
investment options, the historical development of
local investment expertise, and the dynamics of
competition. Whilst these factors undoubtedly
constrain insurers’ strategic choices, we argued that
portfolio optimisation remained possible, and
explored several options taking all but regulation into
account.
Because the core business of an insurer is what
drives its liabilities, we looked at Life & Annuity (L&A)
insurers on the one hand, and Property & Casualty
(P&C) on the other1. In the second paper in the
series, we explored how the introduction of the
European Solvency II regulatory requirements
impacted our optimal allocations. In this part,(part III)
we discuss the proposed changes in the US RBC
framework and look at how these would influence
asset allocation optimisation for both L&A and P&C
insurers.
The longer time horizon of US RBC also explains
why there is no charge2 for interest-rate risk on any
liabilities, as is the case with Solvency II. This will be
an important driver of differences in asset allocation
compared to European insurers.
That said, the US RBC system has been under
review for several years, and a number of changes
have been proposed recently. In this paper, we
provide an overview of some of these and of their
possible impact on asset allocation for US insurers.
We then briefly describe the working of the US RBC
calculations and the assumptions we made around
our optimisations. Finally, we look at optimised
portfolios for L&A and P&C insurers and use these
results to provide some suggestions for
improvement.

The Risk-Based Capital system in the USA has been

in place for a significant number of years. The basic
form of the capital calculations uses stresses for a
number of categories: investment risk, counterparty
risk, various insurance risks and a few other
categories. The stresses are different for L&A, P&C
and Health insurance companies. Another key
element is that US RBC takes a run-off view towards
investments: the emphasis is on default risk rather
than mark-to-market movements. This is an
important distinction as compared to Solvency II in
Europe, which is strongly focused on mark-to-market
movements over a one-year time horizon.

1 It is possible to distinguish a number of additional categories of

insurer, such as health insurers, reinsurers and captive insurers.
We briefly touched on health insurers and reinsurers in the first
paper in this series. For the purposes of this paper, we will
concentrate on Life/Annuity and Property/Casualty insurers since
the differences between the liability profiles of these categories
are the most profound.
2 RBC does contain a capital component (C3) that covers interest-
rate risk and market risk around certain groups of liabilities where
the liabilities themselves are sensitive to market movements, such
as variable annuities.

3
Proposed RBC changes
What is changing?
According to the National Association of Insurance
Commissioners (NAIC), “RBC is intended to be a
minimum regulatory capital standard and not
necessarily the full amount of capital that an insurer
would want to hold to meet its safety and competitive
objectives. In addition, RBC is not designed to be
used as a standalone tool in determining the financial
solvency of an insurance company3.”
It is obvious that the larger an insurance company’s
capital buffers over and above the regulatory
minimum, the more freedom it will have in its asset
allocation strategy. However, insurers typically strive
to maintain a stable buffer above the minimum
requirements, so any proposed changes to the rules
could have an impact on the optimal asset allocation.
Common stocks
The current tax-adjusted factor for L&A insurers
remains unchanged at 19.5% (30% before tax), but
the after-tax factor for P&C insurers is set to increase
from 15% currently to 19.5%. The existing difference
in capital requirements across different types of
insurers for the same equity risk has its origins in the
different assumptions that were originally made on
how to measure sensitivity to market volatility.
Exhibit 1: Current and proposed C1 factors - Logarithmic scale
100.00%
10.00%
1.00%
0.10%
Aaa Aa1 Aa2 Aa3 A1 A2 A3
Source: NAIC, March 2017, for illustrative purposes only
Fixed income
The NAIC are proposing changes to the capital
charges applied for bonds of various credit ratings
under RBC for Life & Annuity insurers4 – the “C1”
component, which covers regulatory capital charges
for credit risk, deferral risk, subordination risk and
event risk. These changes produce a much more
granular set of NAIC ratings, increasing the number
of ratings from 6 currently to 13 in the “compressed”
proposal, and as many as 19 rating levels in the
“uncompressed” proposal. Exhibit 1 illustrates the
current and proposed factors for each rating
category. Detailed numbers are given in Appendix 1.
3Source: NAIC
http://www.naic.org/cipr_topics/topic_risk_based_capital.htm
4 Whilst the focus of the proposed new rating categories is on the
C1 component for L&A insurers, it is expected that the same set
of rating categories will also be applied to the RBC calculations for
P&C and health insurers. The calibration of the capital
requirements may differ between categories of insurer.
Before tax current factors
before tax proposed factors uncompressed
before tax proposed factors compressed
after tax proposed factors compressed
Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3
4
Proposed RBC changes
What are the implications?

Although the most significant RBC amendment
concerns fixed income, particularly for L&A insurers
which are not impacted by the proposed equity
changes, we will explore the impact of the proposed
new rules on the whole investment universe, as we
want to find out more about the overall impact on
regulatory capital.
Key implications
On equities, there will be no change for L&A insurers,
but P&C insurers often have a significant allocation to
the asset class. The proposed higher equity factor
may well force them to review their investment
strategies. Interestingly, the equity charge is the
same for developed and emerging market equities in
contrast to other regimes such as Solvency II.
Historically, capital requirements for US insurers have
developed around a philosophy of capturing the most
important risks, but not necessarily every risk.
Another example of this is that there is no charge for
FX risk under US RBC, which largely reflects the fact
that non-USD investments typically only represent a
small part of a US insurer’s investment portfolio.
In fixed income, insurers can currently buy a fixed-
income fund with a given NAIC rating, of which there
is a significant offering in the USA, often without a
need for look-through because the fund is directly
rated. If the proposed changes to NAIC ratings are
implemented, many of these funds may have to be
restructured. Under the proposed rules, not only can
the overall rating of a fund change, but so can its
various underlying ratings, meaning insurers may
benefit from the ability to look through to the
underlying assets for more accurate regulatory capital
calculation.
The new factors also make holding high-yield debt
comparatively less painful. In the old regime there
was a significant jump in terms of capital charge
when moving from IG to HY debt. The increase in
granularity may make it more attractive to invest in
the lower end of the BBB spectrum as well: the
impact of a single-notch rating downgrade will be
much smaller.
Although these changes are significant in terms of
calculating how much regulatory capital is needed, it
doesn’t necessarily mean insurers will make
immediate adjustments to their asset allocations.
Strategic allocations depend heavily on a number of
other factors such as how insurers account for
assets, diversification requirements, asset and
liability management including required levels of
return, and in-house investment guidelines on
derivatives, and regulatory capital buffers.
L&A insurers may only shift their allocations over
time, as they roll their portfolio. Given the long
duration of their investments, this is likely to be a
gradual change.
Whilst P&C insurers may roll over their investment
portfolios – and therefore feel the impact of the new
rules – more quickly than L&A insurers, they typically
hold less fixed income, particularly single-A-rated,
and are likely to be less impacted by the proposed
changes.
In theory, this indicates that asset allocation
adjustments should be incremental over time,
although in practice insurers may well be more active
than our analysis suggests.

The new fixed income factors aim to smooth out the

steps from one rating level to the next, to eliminate
the current “cliff effect” (which also exists under
Solvency II rules).

The current factors have a single capital charge for all

credit assets rated single A and higher; the proposed
factors would lower the capital charge for Aaa bonds
while making the charges for Aa2 down to A3 more
onerous. Whilst the amendments are significant in
relative terms, the absolute changes are relatively
small. In time we may see some rotation out of single
A-rated bonds into Aa1 or Aaa-equivalents if the
primary objective is to reduce capital charges. Such a
move could be beneficial for certain asset classes
that contain more highly-rated bonds in their universe,
such as ABS.

5
Optimising under RBC
Setting up our framework

In our optimisations, we work from the perspective of
allocating at asset class level, thus we do not
calculate separate expected returns for each
individual rating level. Therefore, in order to estimate
capital requirements, we have used benchmarks and
their constituent securities. This should enable
insurers to identify broad requirements and
allocations, on the basis of which they can optimise at
a more granular level depending on their in-house
expected return calculations.
The Risk-Based Capital formula applied by the NAIC
revolves around three risk categories: Asset Risk,
Underwriting Risk and Other Risk. The relative
importance of these risks varies between different
types of insurers, with different parameters for L&A,
P&C and Health insurance companies. For example,
only the L&A RBC formula has a parameter to cover
interest-rate risk.
For Life & Annuity insurers, the RBC categories are
as follows:
Insurance affiliate investment and (non-
C0
derivative) off-balance sheet risk
C1cs Invested common stock asset risk
Invested asset risk, plus reinsurance credit risk
C1o
except for assets in C1cs
C2 Insurance risk
C3a Interest rate risk
C3b Health provider credit risk
Business risk - guaranty fund assessment and
C4a
separate account risks
Business risk - health administrative expense
C4b
risk
Of these categories, only the C1 categories and the
interest-rate risk (C3a) are relevant for asset
allocation optimisation. The square-root formula
allows for some diversification benefit between
equities and fixed income (the latter including
interest-rate risk).
For P&C insurers, the categories are as follows:
Insurance affiliate investment and (non-
R0
derivative) off-balance sheet risk
R1 Invested asset risk - fixed income investments
R2 Invested asset risk - equity investments
Credit risk (non-reinsurance plus one half
R3
reinsurance credit risk)
Loss reserve risk, one half reinsurance credit risk,
R4
growth risk
R5 Premium risk, growth risk
The RBC formula for P&C is:
𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝐴𝑐𝑡𝑖𝑜𝑛 𝐿𝑒𝑣𝑒𝑙 𝑅𝐵𝐶𝑃&𝐶 =
𝑅0 + 𝑅12 + 𝑅22 + 𝑅32 + 𝑅42 + 𝑅52
In this formula, there is the same allowance for
diversification between equities and fixed income,
although interest-rate risk does not exist as a
category in its own right.

They are combined into one formula:

𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝐴𝑐𝑡𝑖𝑜𝑛 𝐿𝑒𝑣𝑒𝑙 𝑅𝐵𝐶𝐿&𝐴 =

(𝐶1𝑜 + 𝐶3𝑎)2 +𝐶1𝑐𝑠 2 + 𝐶22 + 𝐶3𝑏 2 + 𝐶4𝑏 2 + 𝐶4𝑎

6
Within both RBC formulas a number of categories
are not relevant to determine an optimal asset
allocation. To neutralise these in our calculations, we
took the following steps:
• We calculated the Company Action Level RBC
using industry-wide data collected by the NAIC5;
• We optimised the asset allocation for a maximum
Sharpe Ratio using mean-variance optimisation
by keeping both the overall RBC and the non-
investment-related categories constant;
• We re-ran the optimisation for a number of
different levels of RBC close to the industry
average.
In the case of P&C, this means R0, R3, R4, and R5
are kept constant in calculating the overall RBC level
for each optimisation.
Strategic versus Dynamic Asset Allocation
Optimisation
In the type of asset allocation optimisation we have
performed in this paper, expected returns have a
significant impact on results. It is therefore important
to establish a clear link between the objectives of the
optimisation and the methodology used to produce
the expected returns. A strategic asset allocation
optimisation is typically designed to produce a stable
base that is not expected to change significantly over
time, whereas a dynamic allocation optimisation is
designed to take advantage of current market
circumstances. In this paper we focus on the latter,
emphasising a tactical asset allocation.
HSBC Global Asset Management’s Expected Returns
methodology is based on a number of core concepts:

The L&A RBC calculations incorporate a Portfolio • The excess volatility exhibited by markets;
Adjustment Factor calculation to reflect the • Time-varying risk premia;
diversification of an insurer’s bond portfolio. These • Long-term return predictability.
calculations penalise bond portfolios with lower
numbers of issuers and a larger spread of invested These concepts can be combined to produce
amount per issuer. Because we have performed our expected returns that are driven by 1) current
calculations using benchmarks, which typically valuations and 2) long-term equilibrium levels.
contain very large numbers of issuers weighted by
Because valuations can move around significantly
issue notional, the effect of applying the Portfolio
over time, an asset allocation optimisation based
Adjustment Factor would be minimal and we have
purely on expected returns driven by current
ignored this part of the calculations in our
valuations will itself be very dependent on timing. A
optimisations.
strategic asset allocation should instead be based on
The optimisation uses expected returns for each long-term economic relationships, whereby the point-
asset class as determined by HSBC Global Asset in-time expected returns are blended with
Management‘s Multi-Asset research team as at end “equilibrium” returns to construct a robust set of
of June 2017. These returns are listed in Exhibit 2. expected returns for each asset class. For a dynamic
They are all expressed in USD, except for EM allocation optimisation, there can be a stronger
Equities which are in local currency. emphasis on the point-in-time expected returns and
therefore on current valuations. This can produce
useful signals for tactical asset allocation decisions.
Exhibit 2: Asset-class expected returns
Assets Expected returns
By running the optimisations at the industry-
US Treasuries 2.00%
aggregate RBC levels, as well as at higher and lower
Developed Markets Bonds 2.10% levels, we can get a broad sense of how the optimal
Investment Grade Corporate Bonds 3.20% asset allocation might change as the regulatory
Municipal bonds 2.60% budget increases or decreases. We have done this
for both Life and P&C optimisations.
ABS 2.40%
Mortgages 2.54% The covariance formula provides some diversification
Emerging Markets debt 6.80% benefit but, for example, not as much as Solvency II
High Yield 3.80%
does. This has a large impact on the results of mean-
variance optimisations, which have a tendency to
Real estate (US) 6.00%
produce skewed portfolios, an effect that can be
Developed Markets equities 5.30% mitigated by incorporating certain constraints on
Emerging Markets equities 8.70% individual asset classes. We illustrate the relevance
Private Equity 7.90% of this effect under US RBC by showing optimised
allocations for a given set of constraints: a 20% limit
Hedge Funds 3.40%
on individual asset classes.
Cash 2.40%
Source: HSBC Global Asset Management, June 2017, 5NAIC, Aggregated Life RBC and Annual Statement data 2015
for illustrative purposes only and Aggregated P&C RBC Data 2015

7
Optimising under RBC
Case 1: L&A insurers

Life insurance companies have long-dated liabilities Using these assumptions and our expected returns
and a portion of their investments is typically as per the end of June 2017, we have produced 2
allocated to cash-flow hedging or duration matching sets of optimised asset allocations: one for the
for the long end of their liability profile. This is done as current rules and one for the proposed rules. We
a matter of policy and, in effect, assets used for this compare these to each other and to the reported
purpose will not be taken into account when actual allocations for L&A insurers as a group.
optimising an allocation. For the purpose of this
paper, we have assumed a hypothetical insurer with a
long-dated liability profile and a policy of matching all
liabilities beyond 15 years. In our example, this
insurer has assets equal to 115% of the present value
of liabilities, with a present value of just over 30% for
the liabilities beyond 15 years. This leaves just under
85% (out of 115%) to optimise (See box below for
more details on our assumptions).

Life Insurers’ asset allocations constraints:

In order to more concretely define the investment constraints driven from the long-dated liability profile of a Life-
insurer investor, we had to make the following assumptions:
• A portfolio of US Treasuries can be structured to produce the expected liability cash flows beyond 15 years
at the time they are due.
• The market value of Treasuries to be purchased is equal to the present value of the liabilities they will match,
discounted at the USD swap curve as per 30 June 2017.
• We exclude assets and liabilities beyond 15 years from the optimisation since they are cash-flow matched
and the RBC capital for US Treasuries is zero.
• The size of the investment portfolio is equal to 115% of the present value of the liabilities.
• Using the hypothetical liability profile in the diagram below, the part of the portfolio invested in Treasuries to
match liabilities beyond 15 years is 30.15% based on the USD swap curve as of 30 June 2017.
.

Life Insurer Hypothetical Cash Flow Profile

120
Expected payments

100

80

Assets
60
Liabilities

40

20

0
1 6 11 16 21 26 31 36 41 46 51 56
Year

Source: SHBC Global Asset Management, June 2017, for illustrative purposes only

8
Exhibit 3: US L&A insurers’ existing asset allocations

Bonds
3.9%
10.5% Common Stock
4.2%
Mortgages, First Lien
0.3%
2.7% BA & Other
3.3%
Cash & Short-term Investments
1.4%
0.3% Contract Loans
0.6%
Derivatives
0.9%
Real Estate
0.2%
Preferred Stock
72.4% Securities Lending (Reinvested Collateral)
0.2%
Other Receivables
Mortgages, Non First Lien

Source: NAIC, as of December 2015 - US Life & Annuity insurers - portfolio distribution as of end 2015, for illustrative purposes only

Exhibit 4: Optimised L&A allocation under current RBC rules

Current Rules - Optimised Allocations (L&A)

100%
ER 1.98% 2.53% 3.04% 3.45%

80% Vol 2.90% 3.00% 3.59% 4.47%

SR -0.15 0.04 0.18 0.23
60%
RoRBC 99% 101% 101% 98%

40% Duration 5.7 5.6 5.2 4.9

20%

0%
2% 2.50% 3% 3.50%
US Treasuries DM Bonds IG Corporate Bonds
Muni bonds ABS Mortgages
EM debt EM equities

Source: HSBC Global Asset Management as of 30 June 2017, for illustrative purposes only

Exhibit 5: Optimised L&A allocation under proposed RBC rules

100%
ER 1.94% 2.32% 2.68% 2.99%
80% Vol 2.67% 2.73% 3.03% 3.38%
SR -0.17 -0.03 0.09 0.17
60%
RoRBC 97% 93% 89% 85%

40% Duration 4.7 4.3 4 4.1

20%

0%
2% 2.50% 3% 3.50%

US Treasuries DM Bonds IG Corporate Bonds

Muni bonds ABS Mortgages
EM debt EM equities

Source: HSBC Global Asset Management as of 30 June 2017, for illustrative purposes only

9
The comparison between existing rules, proposed
rules and actual asset allocations produces a number
of interesting observations.
The proposed rules lead to optimised portfolios with
lower expected returns for the same level of RBC.
Volatility is also lower, but overall the risk-adjusted
returns as measured by the Sharpe ratios decline.
The optimised allocation to mortgages is at its
maximum of 20% regardless of the RBC risk budget.
The expected return compares very favourably to the
RBC capital charge. The proposed rating ladder does
not affect this. In contrast, actual allocations to
mortgages for NAIC regulated L&A insurers at end
2015 were around 11% on average.
ABS is consistently less attractive in the
optimisations under the current rules than actual
allocations by insurers would suggest (c. 23.3%), but
very attractive under the proposed new rating ladder
(maximum allocation of 20%, as per existing
allocations). This is the result of the high average
rating of these structured securities as compared to
other credit asset classes.
In contrast, municipal bonds are less attractive under
the proposed ratings, although both optimisations
suggest a much larger allocation to municipal bonds
than is currently the case in the industry. This
suggests that in the benchmark used for
optimisation, there is an overweight of low single-A
rated bonds that get penalised under the proposed
rules. In the optimisations under proposed rules,
municipal bonds are largely replaced by ABS.
10
The preference for ABS over some other fixed
income asset classes such as municipal bonds under
the proposed rules has an impact on the duration of
the optimised portfolios: the proposed rules produce
portfolios with shorter durations. L&A insurers may
want to include some additional constraints before
optimising portfolios under the proposed rules, in
order to ensure interest rate risk is kept within the
desired boundaries.
Whilst the 20% cap on allocations makes a significant
difference to IG credit (c. 43% of actual allocations by
L&A insurers at end 2015), developed market
government bonds and EM debt gain under both sets
of rules. DM bonds represent 20% of the portfolio
under both regimes and across RBC levels. EMD add
more value under the current rules than the new, but
remain a significant player in the higher-level RBC
portfolios under the new rules.
Finally, equities are an interesting asset class. Our
optimisations only allocate to EM equities, whereas
US L&A insurers predominantly invest in domestic
equities in current portfolios6. Our expected returns
for EM equities are significantly higher (8.7% versus
5.3%) and there is no penalty in terms of regulatory
capital in the form of higher equity charges or RBC
for currency risk.
6 Overall EM exposure across the US insurance industry was less
than 1% at year-end 2016. Source: NAIC,
http://www.naic.org/capital_markets_archive/170524.htm
Optimising under RBC
Case 2: P&C insurers

The optimisations for P&C insurers were performed with only one real constraint: a concentration limit of 20%
per asset class. Because of the short-dated nature of the liabilities, the duration gap for a P&C insurer is
typically much smaller than for a life insurer, so matching liability duration is not required.

Exhibit 6: US P&C insurers: current asset allocations

P&C insurers - portfolio distribution as of end 2015

0.7% Bonds
28.3% Common Stock
Mortgages, First Lien
7.8% BA & Other
Cash & Short-term Investments
0.8% Contract Loans
5.2% Derivatives
0.7% Real Estate
Preferred Stock
1.5% 0.2% Securities Lending (Reinvested Collateral)
Other Receivables
0.5%
55.8%

Source: NAIC, as of December 2015 - US Life & Annuity insurers - portfolio distribution as of end 2015, for illustrative purposes only

Exhibit 7: Optimised P&C allocation under current RBC rules

Current Rules - Optimised Allocations (L&A)
100%
ER 2.35% 4.01% 4.60% 4.69% 4.80%
80%
VOL 3.24% 5.72% 6.03% 6.36% 6.80%

60% SR -0.01 0.28 0.36 0.36 0.35

RORBC 23% 36% 38% 36% 34%

40%
Duration 5.99 5.19 4.51 3.89 3.33
20%

0%
10.3% 11% 12.0% 13% 14.0%
US Treasuries DM Bonds IG Corporate Bonds
Muni bonds ABS Mortgages
EM debt DM equities EM equities
Hedge Funds

Source: HSBC Global Asset Management as of 30 June 2017, for illustrative purposes only

Exhibit 8: Optimised P&C allocation under proposed RBC rules

100%
ER 2.62% 3.91% 4.37% 4.57% 4.61%
80% VOL 3.39% 4.63% 5.51% 5.92% 6.06%

60% SR 0.06 0.33 0.36 0.37 0.36

RORBC 25% 36% 36% 35% 33%

40%
Duration 6.24 5.11 5.17 4.78 4.44
20%

0%
10.3% 11% 12.0% 13% 14.0%

US Treasuries DM Bonds IG Corporate Bonds

Muni bonds ABS Mortgages
EM debt EM equities Hedge Funds
Source: HSBC Global Asset Management as of 30 June 2017, for illustrative purposes only

11
Comparing existing allocations with the optimisations
under the current and proposed rules leads us to a
number of observations.
The limited number of constraints in the P&C
optimisations mean the allocations are predominantly
determined by our expected returns. For example,
there is no room for US Treasuries anywhere in the
allocations except at the lowest level of RBC capital,
since the expected return in USD for US Treasuries
is slightly lower than for non-US government bonds,
which also carry zero RBC capital charge. In
contrast, when trying to minimise the RBC, with a
20% concentration limit we cannot reduce the RBC
below 10.3% and even this result is only achieved
through a maximum 20% allocation to US
Treasuries.
In addition, the expected returns for any given level
of RBC are slightly lower under the proposed rules. A
few factors help explain this: at lower RBC levels
(except the lowest possible level), the optimisations
slightly favour ABS over EM equities, and at higher
RBC levels they support allocations to DM bonds and
(to a lesser degree) municipal bonds over hedge
funds. This effect is very much driven by the set of
expected returns; it is possible that in future the
comparison might favour the proposed rules.
Finally, the proposed rules generate portfolios with
higher durations than the current rules. The
difference in duration increases as the RBC budget is
increased, which suggests that the proposed rules
may favour duration assets slightly more than the
existing rules do – although we would caution against
reading too much into this: asset-class expected
returns will change in the future, both in absolute and
in relative terms. This will influence the relative
attractiveness of asset classes with different duration
profiles. Furthermore, the optimisations were
performed at the asset class level using the
characteristics of relevant benchmarks. In practice,
an insurer will have the freedom to deviate from
benchmarks within asset classes in order to manage
elements such as duration and credit quality for
increased efficiency under the RBC rules.

Meanwhile, the best Sharpe ratios can be found

around the 12% RBC mark, and interestingly this
area along the RBC curve also produces the highest
expected Return on RBC. This is the case for both
existing and proposed rules, which is encouraging as
it suggests that the RBC framework (current and
proposed) does not have an unduly negative impact
on a P&C insurer’s ability to allocate for the best
economic risk/return profile. This is in contrast to
certain other regulatory systems such as Solvency II,
which sometimes force insurers to choose between
optimising for regulatory and economic capital
efficiency.

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Conclusion
Navigating the complexities of optimisations
We have performed a series of asset allocation
optimisations under US RBC to allow us to make
some sensible observations around two questions:
1. How do the actual asset allocations of US
insurers compare to a theoretical quantitative
optimisation under US RBC based on today’s
expected returns?
2. What is the impact of the proposed changes to
US RBC for credit ratings and equity factors on
optimised asset allocations for L&A and P&C
insurers?
In terms of the first question, we observe a number of
significant differences between our optimised
portfolios and the actual investment portfolios of US
insurers, both L&A and P&C. This is not particularly
surprising: the optimisations are focused on
maximising the expected return for a given level of
regulatory capital, and insurers will typically apply a
wider set of measures in deciding on asset allocation.
In addition, constraints such as the accounting rules
applied to investment portfolios can make it difficult to
effect significant changes to investment portfolios as
valuations and expected returns change over time.
Nevertheless, the analysis provides a number of good
suggestions for making changes to asset allocations
within the other constraints under which an insurer
may operate.
We have run the optimisations for a number of target
levels of RBC capital. One interesting observation we
can make from this exercise is that the portfolios with
the highest expected return on RBC also tend to have
the highest Sharpe ratio. This suggests that US RBC
does not significantly impact efforts to optimise
portfolios for economic capital efficiency, which is in
marked contrast to some other regulatory systems
such as Solvency II.
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With regard to the second question, there are some
clear winners and losers when we optimise under the
proposed rating table and higher equity charge (for
P&C only). ABS is a clear winner, being an asset
class with a higher proportion of highly-rated bonds
and a good expected return as per end of June 2017.
High Yield bonds also receive more attractive
treatment under the proposed rules, but the expected
return is currently unattractive versus other asset
classes and so HY does not make an appearance in
our optimisations. Municipal bonds are the big loser
in our L&A optimisations – the RBC capital of the
benchmark we have used nearly doubles using the
proposed rating table. Interestingly, for P&C insurers
the same replacement effect does not occur for
municipal bonds; instead we see developed market
(non-US) government bonds emerging as a relative
winner and hedge funds as the loser. This may be
explained by the fact that the RBC formulas for L&A
and P&C are slightly different.
In summary, our analysis provides a number of
suggestions to help US insurers improve their asset
allocations in the current environment, both from the
perspective of valuations and expected returns, and
in terms of the proposed changes to the calculation
of regulatory capital under US RBC. The results
suggest that the proposed RBC changes will not
force insurers to implement significant changes to
their asset allocations, so we expect the impact of
the proposed changes to be limited initially. If and
when the proposed changes are implemented, we
expect a gradual increase in focus on asset classes
and implementation strategies that are more efficient
under the new rules. We expect any RBC-driven
changes to be gradually implemented as part of the
insurer’s existing strategic and tactical asset
allocation processes.
Appendices

Appendix 1: proposed RBC factor changes for fixed income securities

Proposed before-tax
Current Proposed Current before-tax Proposed before-tax Proposed after-tax
Bond rating factors -
category category factors factors - compressed factors - compressed
uncompressed
Aaa 0.28%
P1 0.34% 0.25%
Aa1 0.43%
Aa2 0.63%
P2 0.72% 0.52%
Aa3 NAIC1 0.40% 0.79%
A1 0.96%
A2 P3 1.13% 1.16% 0.84%
A3 1.30%
Baa1 P4 1.49% 1.49% 1.07%
Baa2 NAIC2 P5 1.30% 1.68% 1.68% 1.21%
Baa3 P6 2.01% 2.01% 1.45%
Ba1 P7 3.55% 3.55% 2.56%
Ba2 NAIC3 P8 4.60% 4.39% 4.39% 3.16%
Ba3 P9 5.62% 5.62% 4.05%
B1 P10 5.99% 5.99% 4.32%
B2 NAIC4 P11 10.00% 7.86% 7.86% 5.66%
B3 P12 10.31% 10.31% 7.42%
Caa1 14.45%
Caa2 NAIC5 P13 23% 19.85% 17.31% 12.46%
Caa3 29.82%

Source: NAIC, March 2017, for illustrative purposes only

Appendix 2: optimised allocations under current rules for L&A

Existing rules Weights given RBC constraint

ER Duration 2% 2.50% 3% 3.50%
US Treasuries 2.00% 8.8 50% 30% 30% 30%
DM Bonds 2.10% 8 20% 18% 20% 1%
IG Corporate Bonds 3.20% 7.5 0% 20% 6% 20%
Muni bonds 2.60% 7 20% 20% 18% 19%
ABS 2.40% 0.5 5% 0% 0% 0%
Mortgages 2.54% 4.7 20% 20% 20% 20%
EM debt 6.80% 5 0% 5% 19% 20%
HY 3.80% 4 0% 0% 0% 0%
Real estate (US) 6.00% 0 0% 0% 0% 0%
DM equities 5.30% 0 0% 0% 0% 0%
EM equities 8.70% 0 0% 1% 2% 5%
Private Equity 7.90% 0 0% 0% 0% 0%
Hedge Funds 3.40% 0 0% 0% 0% 0%

Source: HSBC Global Asset Management, June 2017, for illustrative purposes only

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Appendices

Appendix 3 – optimised allocations under proposed rules for L&A

Proposed rules Weights given RBC constraint

ER Duration 2% 2.50% 3% 3.50%
US Treasuries 2.00% 8.8 50% 30% 30% 30%
DM Bonds 2.10% 8 20% 12% 20% 20%
IG Corporate Bonds 3.20% 7.5 0% 20% 20% 6%
Muni bonds 2.60% 7 5% 12% 0% 3%
ABS 2.40% 0.5 20% 20% 15% 16%
Mortgages 2.54% 4.7 20% 20% 20% 20%
EM debt 6.80% 5 0% 0% 8% 16%
HY 3.80% 4 0% 0% 0% 0%
Real estate (US) 6.00% 0 0% 0% 0% 0%
DM equities 5.30% 0 0% 0% 0% 0%
EM equities 8.70% 0 0% 2% 3% 3%
Private Equity 7.90% 0 0% 0% 0% 0%
Hedge Funds 3.40% 0 0% 0% 0% 0%

Source: HSBC Global Asset Management, as of 30 June 2017

Appendix 4 – optimised allocations under current rules for P&C

Current rules Weights given RBC constraint

ER Duration 10.3% 11.0% 12.0% 13.0% 14.0%
US Treasuries 2.00% 8.8 20% 0% 0% 0% 0%
DM Bonds 2.10% 8 20% 20% 20% 15% 8%
IG Corporate Bonds 3.20% 7.5 3% 4% 0% 0% 0%
Muni bonds 2.60% 7 20% 20% 14% 11% 11%
ABS 2.40% 0.5 17% 0% 0% 0% 0%
Mortgages 2.54% 4.7 20% 20% 20% 20% 20%
EM debt 6.80% 5 0% 20% 20% 20% 20%
HY 3.80% 4 0% 0% 0% 0% 0%
Real estate (US) 6.00% 0 0% 0% 0% 0% 0%
DM equities 5.30% 0 0% 0% 0% 0% 1%
EM equities 8.70% 0 0% 16% 20% 20% 20%
Private Equity 7.90% 0 0% 0% 0% 0% 0%
Hedge Funds 3.40% 0 0% 0% 6% 14% 20%

Source: HSBC Global Asset Management, June 2017, for illustrative purposes only

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Appendices

Appendix 5 – optimised allocations under proposed rules for P&C

New rules Weights given RBC constraint

ER Duration 10.3% 11.0% 12.0% 13.0% 14.0%
US Treasuries 2.00% 8.8 20% 0% 0% 0% 0%
DM Bonds 2.10% 8 20% 20% 20% 20% 20%
IG Corporate Bonds 3.20% 7.5 3% 3% 3% 0% 0%
Muni bonds 2.60% 7 20% 19% 20% 18% 13%
ABS 2.40% 0.5 11% 9% 0% 0% 0%
Mortgages 2.54% 4.7 20% 20% 20% 20% 20%
EM debt 6.80% 5 5% 20% 20% 20% 20%
HY 3.80% 4 0% 0% 0% 0% 0%
Real estate (US) 6.00% 0 0% 0% 0% 0% 0%
DM equities 5.30% 0 0% 0% 0% 0% 0%
EM equities 8.70% 0 0% 10% 17% 20% 20%
Private Equity 7.90% 0 0% 0% 0% 0% 0%
Hedge Funds 3.40% 0 0% 0% 0% 2% 7%

Source: HSBC Global Asset Management, as of 30 June 2017

Appendix 6 – Benchmarks used for optimisations

Asset Class Index Name Bloomberg Ticker

US 10y Gov't Bond US Treasury 10 year YCGT0025 Index

Global Bonds Blooberg Barclays Global G7 TR LGG7TRUH Index
US Corporate BofA ML US Corp C0A0 Index
US Municipal Bonds BofA ML US Municipals U0A0 Index
US ABS Barclays US ABS
US MBS Barclays MBS Fixed Rate
Local EM Debt JPM EM GBI Global Diversified JGENVUUG Index
US High Yield BofA ML US High Yield H0A0 Index
Real Estate REITs
World MSCI World M2WO Index
Emerging Markets MSCI EM M2EF Index
Private Equity Cambridge Associates PE
Hedge Funds CS Hedge Fund Asset Weighted Index HEDGNAV Index

Source: HSBC Global Asset Management, June 2017, for illustrative purposes only

16
Authors
Andries Hoekema
Global Head, Insurance Segment
HSBC Global Asset Management
Andries Hoekema has been Global Head, Insurance
Sector in the Client Strategy team in London since 2016.
Andries is responsible for strategic engagement and
dialogue with insurance companies. Andries joined HSBC
in 2006 and has been working in the industry since 1997.
Previously, Andries held a number of roles in Global
Markets at HSBC in London, including cross-asset
Strategic Solutions coverage of institutional clients in the
Netherlands and latterly Institutional Equity Derivatives
coverage of insurance companies and pension funds in the
Netherlands and Nordic countries. Prior to joining HSBC,
Andries was Executive Director in Structured Credit at
Rabobank International in Utrecht and London,
predominantly responsible for the structuring and
marketing of Structured Credit products. Andries holds a
PhD in Business Engineering from the University of
Twente in the Netherlands.
17
Pierre Dongo Soria,
Strategist, Global Multi Asset Research
HSBC Global Asset Management
Pierre Dongo Soria has been a Strategist in the Global
Multi Asset Research Team in London since 2016, when
he joined HSBC. Pierre is responsible for developing the
House Views and performing multi asset research. Pierre
has been working in the industry since 2009. Previously,
Pierre was an Investment Manager at Rimac Seguros, the
largest insurance company in Peru, responsible for
managing EM portfolios and building asset allocation
strategies, and a Portfolio Manager at Central Bank of
Peru, responsible for managing euro and usd fixed income
portfolios, both in Lima. Pierre holds a Bachelor’s degree
in Economics from Universidad del Pacifico in Peru and a
Master’s degree in Finance from the London Business
School in the UK. Pierre is also a CFA charter-holder.
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