Liability-driven investing (LDI) is a key strategy recognized mainly in developed financial markets. These markets offer robust liquidity and a wide range of derivatives, enabling investors to effectively hedge their long-term commitments. Instruments such as inflation-linked securities and long-duration corporate bonds help align investments with actuarial forecasts and meet regulatory standards. However, the application of LDI in emerging and frontier markets presents unique challenges, necessitating a more disciplined investment approach.
In Nigeria, where market depth is often limited and policy fluctuations are common, the focus of liability-driven investing (LDI) shifts towards timing and currency alignment. Here, LDI emphasizes a steadfast commitment to meeting cash flow obligations rather than relying on complex financial instruments. Although the ultimate goal remains consistent worldwide—to ensure reliable cash flow for liabilities—the approach in frontier markets requires a unique blend of adaptability, patience, and foresight.
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The unique landscape of liability-driven investing in Nigeria
Implementing liability-driven investment (LDI) principles in emerging markets requires a fresh interpretation of conventional practices to address the challenges of a volatile financial environment. For insurers in Nigeria, especially those managing life and annuity products, a disciplined approach is essential. This strategy helps navigate frequent liquidity crises, currency devaluations, and changing regulations. In this setting, the focus shifts to managing liabilities instead of prioritizing returns, ensuring that financial decisions align with existing obligations.
Types of liabilities in the Nigerian insurance sector
Liabilities within Nigerian insurance companies can be classified into three primary categories: life obligations, which feature predictably timed cash flows; general insurance reserves, which exhibit more variable cash flow timings; and embedded guarantees, sensitive to fluctuations in interest rates. A clear understanding of these categories is crucial for devising tailored strategies that effectively address specific liabilities.
Nigeria’s yield curve presents distinct challenges. Rather than a smooth continuum, it resembles a segmented structure shaped by government borrowing, institutional demand, and central bank interventions. The Federal Government of Nigeria (FGN) bonds, overseen by the Debt Management Office (DMO), are the most prominent instruments, with maturities ranging from two to thirty years, although issuances typically occur in clusters.
Challenges and strategies for effective LDI implementation
The secondary market for bonds in Nigeria remains limited. Pension funds currently hold approximately 60% of outstanding Federal Government of Nigeria (FGN) bonds, many classified as ‘held to maturity’ according to the National Pension Commission (PenCom). This situation restricts trading and reduces portfolio rebalancing opportunities for insurance companies, which face similar constraints under regulations from the National Insurance Commission (NAICOM).
Frequent changes in monetary policy can create short-term volatility, resulting in significant yield variations. For example, in the first quarter of this year, the yield on 10-year FGN bonds increased dramatically from 16.8% to 22.6% after an unexpected hike in the monetary policy rate, as reported by BusinessDay. Such fluctuations necessitate that liability-driven investment (LDI) strategies remain adaptable and responsive.
Practical creativity in portfolio construction
To construct a liability-driven investment (LDI) portfolio in Nigeria, investors must adopt a blend of pragmatism and creativity. The design of an investment portfolio should take into account the availability of instruments, regulatory limitations, and realistic trading liquidity. Proper alignment of durations is essential; a portfolio that averages a duration similar to its liabilities may still face volatility if it is overly concentrated in short-dated bonds, especially when liabilities peak at longer maturities, such as ten years.
Insurance companies with obligations to foreign entities, such as payments to offshore reinsurers, benefit significantly from maintaining reserves in US dollars or other instruments linked to dollar cash flows. The scarcity of foreign exchange hedging instruments in Nigeria means that any currency mismatches can expose these institutions to substantial risks.
Integrating scenario testing into risk management
Scenario testing in Nigeria’s insurance sector
In Nigeria’s insurance sector, scenario testing has become a critical aspect of risk management. The increasing frequency and severity of volatility in yield, foreign exchange, and inflation necessitate that institutions continually reassess their positioning. Each incident, whether stemming from policy changes, geopolitical tensions, or supply-side disruptions, acts as a test of an institution’s resilience.
Implementing regular stress testing within investment governance frameworks offers considerable advantages. Leading institutions conduct quarterly simulations that shape board-level dashboards and inform investment policy decisions. This approach promotes an adaptive liability-driven investment (LDI) process, moving away from a static allocation strategy.
The success of liability-driven investing (LDI) in frontier markets hinges not on access to complex financial instruments but on a disciplined approach to managing financial obligations amid volatility. The case of Nigeria exemplifies this principle. By focusing on aligning commitments with available capital, investors can achieve both solvency and stability. This illustrates that the core of LDI is about maintaining alignment even under challenging conditions.
