Salvatore Correnti and Stephen M Sonlin consider whether the investment markets have settled yet, and how re/insurers should approach their asset management strategy
At the top of the music charts for months, Billy Joel's hit song of 1989, We Didn't Start the Fire, details a timeline of significant world events dating from 1949 through the 1980s. The song's lyrics give credence to the idea that many events have lasting societal impact decades after they occur and no one in particular is to blame.
For insurance companies, numerous global business and economic events - all occurring since the dawn of the new millennium - have had a dramatic and lasting impact on the industry's reserves, underwriting practices, capital, surplus and investments. Although insurance executives had no hand in starting these fires, they have the challenging responsibility of fighting them and dealing with their aftermath.
Major catastrophic events and losses seem to have become the norm within the property/casualty industry. Today, these losses stem not only from traditional catastrophe exposures but also from the emergence of loss exposures associated with terrorist activities. In addition, some companies in the industry continue to increase asbestos reserves.
The life industry is not without its own set of problems as companies suffer through the effects of low interest rates and tight corporate credit spreads. The combination of these events has increased the cost associated with minimum interest rate guarantees and made it difficult to offer competitive rates and maintain profitability on fixed annuity business. The variable annuity business also has not escaped unscathed as the backup in the equity markets aggravated the problems associated with unhedged positions on guaranteed minimum death benefits (GMDB).
In addition, the extended bear market that began in 2000 has made it clear to investors that the equity markets are, in fact, risky - valuation levels can go down as well as up. Ironically, just as investors seemed to be learning this lesson and reducing their equity positions, the market reversed itself once again.
Corporate accounting scandals, bankruptcies and rating downgrades spurred large losses in investment holdings within the financial markets. The recent Parmalat scandal demonstrated that this exposure is not limited to the US. The net result of these events is depleted capital positions, increased regulatory scrutiny, rating downgrades, increased corporate governance and increased solvency requirements.
Fortunately, 2003 provided some relief for insurers and reinsurers. Underwriting and pricing practices carried on seeing improvements as the continued hard market paid out. The global stock and bond markets posted positive returns, helping to reduce GMDB reserves and replenish company surplus positions. Almost all major economies showed positive trends in GDP growth, with the US and China leading the way. With these recent economic improvements and a positive overall economic forecast, the operative question is, "What should insurers/reinsurers be doing with their investments now?"
If anything, the past sequence of tumultuous events and lack of certainty clearly illustrates the need for a well-reasoned, prudent investment approach.
Overreaction to short-term events can result in whipsaw effects, in turn leading investors to make the wrong calls at the wrong times.
At Conning, we advocate a long-term strategic approach for re/insurers through the use of disciplined asset-liability management (ALM). We believe successful long-term financial results require implementing an appropriate asset allocation strategy that supports each company's unique business objectives in the context of its risk tolerance, liability profile, business plans, capital position and regulatory constraints.
While a company with large capital resources has the ability to take calculated risk on both sides of its balance sheet, most re/insurers have limited capital resources and are faced with continual pressures from shareholders, rating agencies and regulatory bodies. As such, investment strategy becomes a complex assessment of interrelated factors and their inherent trade-offs. A comprehensive ALM-based approach creates an investment framework with understandable and acceptable risk and reward parameters.
Output can be communicated in financial terms that are understood and used by executive management in making daily decisions concerning the key business questions.
Thus, an effective ALM approach can be used to evaluate the answers to strategic business and investment questions such as, "What is the potential impact of this strategy on my GAAP and regulatory results?" or "What is the best economic decision for the long term and what impact might such a strategy have on my ratings or solvency?"
Key investment strategy decisions involve assessing appropriate asset mix, currency exposure, credit quality and fixed income duration targets.
Likewise, such decisions must be consistent with a company's risk/reward profile. Pure 'total return' asset management is not practical for most insurers because of the myriad of industry operational constraints. Long-term success is possible within the insurance industry by managing investments within an ALM context, not by 'swinging for the fences'.
Opportunities and pitfalls
John Maynard Keynes once quipped that "In the long term we are all dead." While mindful of this sentiment, a core premise of the insurance industry is that effective risk management allows for long-term planning and the creation of economic value. So, how should an insurer implement a long-term investment strategy in light of today's economic and capital market environment?
The investment of new cash flows and the rebalancing of existing portfolios require the consideration of current conditions and future economic and capital market expectations. Thus, the investment process can be compared to the process of assessing current pricing conditions in determining where to allocate new capital and how to rebalance existing capital allocations.
Often, economic data produces conflicting reports that could lead one to expect either a continued trend of positive GDP growth, or alternatively lead one to forecast doom on the horizon. However, it is hard to envisage a more accommodative set of fiscal and monetary policies than those that currently exist in the US. With the Federal Funds rate at 1%, core inflation well under 2%, aggressive federal spending and tax cuts and a weakened dollar aiding exports, we believe we will see strong GDP growth in the US for 2004, with growth projections in the 4.0-4.5% range. This bodes well for the global economy, where, in our opinion, we expect even stronger economic growth in China and a continuing positive growth - but at a lower rate - for Japan and Europe.
Interest rates are sitting near 45-year lows and credit spreads are at historically tight levels for both dollar- and euro-denominated bonds.
However, the growing US federal deficit and the record level foreign trade deficit loom menacingly in the background. On the positive front, inflation remains in check and we believe is likely to continue to do so with sustained productivity gains but weak employment recovery. As the economy improves, we believe employment will gain momentum, leading the Federal Reserve to most likely raise rates sometime in the second half of 2004 or early 2005.
Even with the expectation of rising interest rates, we believe that companies should maintain consistent ALM strategies and benchmarks. Although companies with latitude in their duration targets may want to position their fixed income portfolios slightly short of their duration benchmarks, the current steepness of the yield curve will discourage any significant shortening of existing fixed income portfolio structures. In our opinion, premium growth should help keep cash flow positions positive, allowing most companies to ride out a rising interest rate environment without suffering realised capital losses because of forced sales.
Equity allocations among property/casualty insurers have been falling as a result of both capital losses and lower target allocations. These lower target allocations have been driven by weakened surplus positions and the need to allocate existing capital to support underwriting activities during the hard market. Given these reduced equity target allocations, we believe that insurance companies should maintain a neutral or close-to-target weighting for equities.
While equity valuations are constantly being scrutinised, the positive economic forecast and continued productivity gains should translate into continued good corporate earnings that will be able to support current market valuation levels. However, technology sector valuations are of concern with nearly an 80% increase since the sector lows of 2002. As we enter the later stages of the current recovery, we foresee a shift into more defensive sectors.
From 1978 to 2000, investment returns were the key drivers of profitability for insurers as underwriting results suffered. Although 2003 provided some relief to investment portfolios, the industry should be preparing itself for investment returns that are significantly lower than those experienced over the past two decades or so. We expect that investment results will no longer be the drivers of profitability and companies will be forced to maintain underwriting discipline in order to achieve acceptable returns for their shareholders.
Insurers need to practice sound investment discipline, enabling them to control risk, complement their liabilities and support their capital strategies. Unexpected fires always have and always will crop up, but insurers that employ a prudent and disciplined investment approach will have the best opportunity to survive and thrive in these turbulent times.
- This article should not be considered investment advice nor does it purport to be complete. The views reflected herein are subject to change without notice.
Sal Correnti is President and CEO of Hartford, CT-based Conning Asset Management Co, a subsidiary of Swiss Reinsurance Company of Zurich. Steve Sonlin is Managing Director and Head of Insurance Advisory Service at Conning. Website: www.conning.com