Applying the prudent person principle to Multi-Strategy Fixed Income

Capital preservation, predictable returns and diversification benefits have kept fixed income front of mind for insurers.

Low starting yields on fixed income assets mean there is a limited cushion when prices fall. Furthermore, duration, which measures a bond’s sensitivity to changes in interest rates, has been drifting higher as well as companies and governments have sought to lock in low interest rates and issue longer-dated debt.

In this environment, multi-strategy fixed income products – designed to draw on a wider range of sources of risk and return, resulting in a return profile that is less dependent on the overall trajectory of bond markets – are getting greater attention. These strategies could be valuable additions to insurers’ toolkits, helping to increase diversification within portfolios.

The investment strategies of European insurers are governed by the Prudent Person Principle (PPP), which requires insurers to have a thorough understanding of the risks arising from their investments. While the rules governing investment strategy and risk assessment vary in other jurisdictions, they tend to share this common purpose.

In this paper, we explore how an insurer might apply the PPP to an allocation in an absolute return fixed income strategy, including:

A. Risk identification – Transparency of risk exposures

B. Risk management – Integrating risk into portfolio construction

C. Assessing solvency – Calculating Solvency Capital Requirements

In the process, we hope to throw some light on the key considerations for insurers considering an investment in multi-strategy fixed income.

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Key risks

Investment risk

The value of an investment and any income from it can go down as well as up and can fluctuate in response to changes in currency exchange rates. Investors may not get back the original amount invested.

Credit risk

Bond values are affected by changes in interest rates and the bond issuer's creditworthiness. Bonds that offer the potential for a higher income typically have a greater risk of default.