Ashish Dafria, chief investment officer for Aviva, discusses the investment implications of the pandemic, climate change and the macroeconomic environment for a large insurer.
Low yields, the increasing urgency of climate action, demographic shifts and a previously unthinkable policy environment are transforming the way insurers need to approach their investments. These themes are creating challenges and opportunities, particularly in climate-related investments and real assets.
Insurers are transforming how they approach their investments
To discuss the impact of these structural shifts and the macroeconomic environment on investment decisions, we spoke to Ashish Dafria, chief investment officer for Aviva, in charge of more than £250 billion of assets across annuities, unit-linked and with profits investments.
In his role, Dafria is responsible for defining Aviva’s investment strategy, achieving its sustainable investment ambitions, helping develop customer investment solutions, and delivering investment performance for shareholder and customer investments.
His views offer valuable insight into the way insurers can navigate the complexities of near- and long-term trends to deliver on their fiduciary duty to customers and remain resilient.
What are the biggest investment opportunities and challenges you see over the near to long term?
There is a broad spectrum of themes. The first is the low-yield, or low-return, environment that all investors face, which raises a number of questions:
- Are we being rigorous enough with our risk appetite?
- Are we delivering the right value to customers?
- How do we generate returns to match liabilities?
- What are the investment choices? Are investors crowding into the same, increasingly narrow, choices?
Climate and sustainability is the big area with the potential for mispriced investment opportunities
Beyond that, we have the whole dynamic around climate and sustainability. It's equal part opportunity and challenge, and is the big area with the potential for mispriced investment opportunities.
Other important themes include demographic shifts, and the implications they have over a long time horizon, and policy. We are in a policy environment that would have been considered unthinkable ten years back. If somebody said that the fiscal situation and government balance sheets in the UK, US and other developed countries would be this stretched, they would have been laughed out of the room. And yet, here we are. On a longer-term basis, that's one to keep an eye on.
Over the past decade or so, central banks have occasionally blinked whenever the market reacts badly to any hint at a change in policy. Logic suggests policy must change eventually given how much debt is out there, but the timing is subject to many variables – is it difficult to plan for the long term?
There is a camp that says this is unsustainable and will all blow up. Then, you have the modern monetary theory camp saying this isn't a problem and is actually the beginning, with bigger and better things to come.
As long as the policy is transparent, as an investor you can do something about it
My view is somewhere closer to the centre; I'm an optimist so tend to think we have the capacity to solve it. I don't think central banks and policymakers are out of tools, but how it manifests itself could be a problem. As long as the policy is transparent, whether you agree with it or not is fine because as an investor you can do something about it. It's the unpredictability that’s an issue.
What will the policy environment be? Are we worried about inflation? Are we not worried about inflation? Are we worried about government deficits? Are we not worried about government deficits? It's those second-order questions that become important.
There is a convenience to it; many of those questions do not have to be resolved here and now, so investors often don’t focus on longer-term risks.
To what degree does the long-term impact of COVID-19 come into your positioning?
There is a significant human element to it, with stories of human tragedy and human resilience. Investment wise, as I’ve mentioned, there is a profound policy implication. The size of fiscal stimulus around the world is mind boggling; the amount of debt being issued is almost inconceivable.
The size of fiscal stimulus around the world is mind boggling
The second implication, which we are putting a lot of thought into, is the acceleration in structural shifts that we were seeing in the economy already. How do we pick the right sectors and companies? And, how do we work with individual borrowers to transition them to a better place?
We are a large UK landlord and mortgage provider; we have a large portfolio of offices. Clearly, we’re focusing on what the long-term future of offices looks like and the future for some of the businesses that we have exposure to through our investments. Some sectors look challenged, like parts of retail, but we can see positives from the further push in areas like renewables and electric vehicles.
Do you have any concerns about a meaningful increase in bond yields?
It depends on your starting point; if you pick a convenient starting point, you can make a trend appear wherever you want it to. Yields have increased fairly meaningfully and sharply over the last few months. To some, that can be turned into a narrative; interest rates are already significantly higher than where they were at their lows. Or you can step back and say: “Yes, there's been a sharp increase, but that has simply brought us back to levels that were themselves near all-time lows just 12 months ago.”
We are in a very different interest-rate and inflation regime than when we came out of the global financial crisis
The reality is that we are in a very different interest-rate and inflation regime than was the case when we came out of the global financial crisis, and that’s without going further back in history.
It's not something that we take an outright view on; I don't think we need to. We don’t view interest rate risk as being particularly well rewarded so, from that perspective, our focus is on making sure our portfolios are well managed and well matched. At the same time, you need to understand to what extent low interest rates are supporting valuations for other asset classes. It's not so much rate risk but valuation risk that you are taking.
Again, our view is we don't buy into the doomsday scenario that the low-rate or low-yield environment will all end quickly, but we are cautious. The consequence of being wrong when you take a cautious approach is much lower given the opportunity cost is lower.
What about inflation?
We go through cycles: suddenly people are talking about inflation as the big risk; not that long ago, deflation was talked about in the same way.
Again, we’re cautious on this and prefer not to take a lot of inflation risk. There are lots of basis risks in attempting to hedge it, so it's not quite as clean as interest rate which we can hedge better. At the same time, we have investments that are inflation-linked, either directly or indirectly, so they benefit from it.
Do you see any prospect of UK risk-based capital regulation in the UK moving away from Solvency II?
Solvency II has brought many benefits and I don't think anyone is expecting the UK to do away with it and have something completely different.
I don't think anyone is expecting the UK to do away with Solvency II
However, there might be an opportunity to revisit certain areas. Risk margin has been a topic of debate for some time, so that could be one area, and regulators may also look again at infrastructure investments, especially in a climate context, and how the rules support that. The government has already announced a new infrastructure bank and there are also discussions about a long-term asset fund. Complexity of regulation could be another area where this plays out. But in summary, what we’re looking at is the potential for incremental changes rather than something fundamentally different.
Aviva recently announced its ambition to become a net-zero emissions company by 2040. Given its peers are also setting targets, what impact will these competing pledges have on the industry’s investment book?
Firstly, it is fantastic this is now such a big topic of conversation. At the same time, there are challenges that go hand-in-hand with it. There is a growing alignment of views that we need to be mindful of long-term risks and work with investee companies and partners to get them on a transition path, just as we have our own transition path. We, as an industry, also need to communicate clearly to our customers on our progress and respond to their expectations.
Some of the risks will materialise over a longer time horizon. We know the investment industry in the past has been quite guilty of managing investments on a much shorter time horizon, so getting the balance right is critical. How do we say we are doing the right thing and managing a long-term risk but there is near-term underperformance? How we manage that and clearly communicate it to customers is important.
At the moment Solvency II doesn't make any distinction between green or brown assets
This also links to the Solvency II discussion. It's an evolving process, but at the moment the regulation doesn't make any distinction between green or brown assets. It says they are equally risky and therefore you need to hold the same amount of capital. I have no doubt that will change but, again, transitioning from here to there will present some challenges.
Another key issue is whether there is enough supply of suitable green investments. We know green bonds and other sustainable investments typically come at a premium or offer a slightly lower return. There is a risk of investors crowding in to buy the same narrow set of green investments, which further reduces their returns and distorts the reality.
So, there are various risks, but if we look at the substance and seek progress, not perfection, it is fantastic that we and our peers are on this journey. It is already beginning to have a profound impact on conversations and on the behaviours of companies, investors and end clients.
How do you avoid getting caught up in green bubbles?
Somewhat nervously is the honest answer. We have significant scale, which is both an advantage and a challenge. Our need for suitable assets is significant and we need to be mindful of where the supply comes from.
Investors can work with borrowers to help with the transition to a better future
On the positive side, there are some really exciting and interesting opportunities out there. We were recently involved in a real estate financing1, which Aviva Investors worked with us on, where the terms of the deal are such that the borrower benefits if it meets certain sustainability targets. That is a brilliant example of how investors can work with borrowers to help with the transition to a better future. Given our scale, history and our significant engagement programme, this is a big opportunity for us.
You mention the sustainability-linked loans programme; are there any other favoured asset classes from a climate perspective?
There are two lenses in which to look at this, and both have merit. Lens one is how to find low-carbon areas and low-carbon investments, whether green bonds, renewable infrastructure projects, and emerging areas like forestry and carbon capture and storage. These are potentially exciting areas for the portfolio.
We engage with the companies we invest in to get them on a more sustainable path
The other approach is around engaging with the companies we invest in, including some of those that have been among the largest emitters, to get them on a more sustainable path. If we can do something which, on the face of it, on day one looks like a high-carbon and therefore high-risk investment, but then work with the company to bring it on a low-carbon journey, that is solving a real problem. Over time, hopefully that also provides differentiated revenue or returns we can benefit from and pass on to our customers.
It’s not a choice of one or the other approach. Our view is that we need targeted investments; we need impact funds; but we also need to bring the broader portfolio up to the mark in this low-carbon journey. That’s where engagement has such a big role to play.
How do you see opportunities in real assets more broadly?
Real estate is still a significant area of investment for us given our history in this area. There are challenges in certain markets like retail but we still see more idiosyncratic, individual opportunities emerging.
Infrastructure plays into the UK’s Build Back Better theme
As I mentioned, infrastructure works well from a green, low-carbon investment perspective, and also plays into the UK’s Build Back Better theme. It’s a big area of focus for us.
The final area is structured finance and, again, there are some really interesting opportunities. Given the shifts in the market and in other investors’ risk appetite, there is an opportunity for us to step in given our size, expertise, and ability to understand and manage complexity. So, that's perhaps one area where we might look to increase our exposure.