Identifying opportunities for gold among Japanese insurers

Appendix I: An overview of Japanese insurers

A closer look at Japanese life and P&C insurers

As mentioned previously, life and P&C insurers hold most Japanese insurance assets. According to 生命保険事業概況 | 生命保険協会 (seiho.or.jp) and 統計｜日本損害保険協会 (sonpo.or.jp), among life insurers the dominance is primarily attributed to Nissay, Japan Post, Meiji-Yasuda, Dai-ichi, and Sumitomo. These traditional five companies account for 63% of the total life market. For P&C insurers, dominance among the major players is further accentuated, with Tokio Marine, Mitsui Sumitomo, Sompo Japan, and Aioi Nissay Dowa accounting for 87% of the total P&C market.

Life insurers’ asset management 

Life insurers offer a diverse array of products to cater to customer needs. These include whole life insurance, term insurance, endowment insurance, health insurance and annuity products for both individuals and corporates. 

For life insurers’ general accounts (GAs), premiums are pooled from different types of policies and invested collectively to meet the fixed guaranteed rates of return (crediting rates) to policyholders. The combination of long-term liabilities and guaranteed crediting rates means life insurers face a number of risks, namely market risk, credit risk and liquidity risk. To mitigate these, life insurers construct their investment portfolios through Asset-Liability Management (ALM).

Historically, whole life policies accounted for the majority of life insurers’ value of in-force as they were viewed as a reliable and stable form of coverage. This also aligns well with the Japanese society’s cultural values around financial security. However, since there was limited availability of long-term fixed-income assets at the time, Japanese insurers were often exposed to a large duration mismatch between assets and liabilities. After the collapse of the Japanese bubble economy in the early 1990s, long-term interest rates declined sharply. 

Due to the large duration mismatch, this sharp decline in interest rates led to a huge burden for Japanese insurers. They struggled to meet their obligations to policyholders, which led to the insolvency of seven small- and medium-sized life insurers between April 1997 and March 2001. These events acted as a catalyst for the remaining life insurers to place greater emphasis on Liability-Driven Investments (LDIs) in order to mitigate as much risk as possible.

For instance, they increased their allocation to longer-term fixed-income assets with extended maturities, mostly 30-year and 40-year Japanese government bonds (JGBs). This highlights the active efforts by insurers to reduce the duration mismatch.

Japan’s ultra-low interest rate environment, which has now persisted for many years, has led to an increasing need for life insurers to invest in alternative assets for yield-enhancement. Such needs have seen insurers turn to global private equity funds and hedge funds, as well as increase their allocations to foreign stocks and other alternative assets. 

P&C insurers’ asset management 

P&C insurers exhibit distinct liability characteristics compared with life insurers. P&C insurers, whose main products are auto, fire, marine and cargo, accident and other casualty insurance products, have much shorter liability durations as their coverage usually spans only one year before policy renewal. Consequently, P&C insurers consider their primary risk to be the potential liquidity risk stemming from unforeseen catastrophic accidents.

P&C insurers allocate a meaningful share of around 23% to domestic bonds, including JGBs, highlighting this need for liquidity. While P&C insurers, similar to life insurers, invest in safe JGBs and high investment grade corporate bonds from an ALM perspective, they have much greater room and risk appetite for yield-enhancing assets. This is due to the fact that most P&C policies are short term without any guaranteed crediting rates. Thus, interest-surplus losses arising from interest rate declines in the 1990s had a lower impact on them compared with life insurers. With this historical perspective in mind, Japanese P&C insurers are in a relatively better position to use their capital to invest in higher yield assets with lower liquidity, such as private equity funds.

Appendix II: The liquidity of gold

A closer look at the liquidity of gold 

As mentioned previously, the gold market is large, global, and highly liquid. Its daily trading volume is higher than many other major financial markets and assets (Chart 10). 

The scale and depth of the market means that it can comfortably accommodate large, buy-and-hold institutional investors. One market expert suggests that gold should be tradable up to around 25% of the average daily trading volume. For more information, see: Gold Trading Volume | Gold Daily Volume | World Gold Council.

“Typically, it is recommended to remain under 20-25% of the average daily volume to minimise the market impact…

Quote from a gold ETF Manager on the liquidity of gold

Appendix III: The inflation hedging effect of gold

A closer look at the inflation hedging effect of gold 

As mentioned previously, many insurers have argued that assets such as REITs and equities already provide the inflation hedge required. Thus, they do not see the need to invest in gold. To test their argument, we compared the correlations between the CPI change and returns for each asset class as shown in Chart 11, where the two colours indicate periods with a CPI change of greater than 5% y/y (dark blue), and less than or equal to 5% y/y (light blue). 

Chart 11 demonstrates that gold and the US CPI have a historically weak linear relationship. In fact, when calculating R-squared linear regression of the whole data set only 19% of the variation in gold prices since 1971 – when the US Gold Standard ended – can be explained by a linear relationship to changes in CPI inflation. However, it can be inferred from the two plotted regression lines that the correlation between the two variables becomes significantly stronger during periods of extremely high inflation, i.e. when the change in the CPI is higher than 5% year-on-year. The positive correlation of the regression line for periods of high inflation, signified by the dark blue line, indicates that, on average, the higher the CPI level, the higher the nominal return of gold, as long as the inflation rate is greater than 5%. Moreover, in comparison with the data for the FTSE REITs and S&P 500, it is clear that the high performance of gold during periods of extremely high inflation is a unique advantage that is not matched by the other two asset types (Table 2).