As the renewal season proceeds for p/c businesses, and other insurers reflect on this year's results, Tony Maximchuk considers the challenges and opportunities facing insurance companies as they assess potential investment returns in 2003.
Mean reversion, the return to longer-term averages and correction of valuation anomalies has, these last three years, been taking place with a vengeance in equity markets. At some point it will visit the bond markets. The fall in equity market values that began in 2000 has been in sharp contrast to the strong positive portfolio returns enjoyed by many insurers throughout the 1990s. However, the capitulation of equity markets in the present downward cycle may be close to completion. Bonds seem less attractive as a safe haven and, even though inflation is not an immediate issue, growth is occurring in the economies of the UK and the US while the fiscal position is deteriorating. Europe is not quite so fortunate as growth is hesitant but the deterioration of the fiscal position there has certainly been making the headlines. Against the background of better equity markets, generally stronger economic growth and deteriorating public finances, bond yields are likely to rise from current unusually low levels, especially in the UK and US. The best performing parts of these markets this year appear to have little value remaining for next year.
While premiums have hardened substantially in property and casualty (p/c) markets around the world, the outlook across different insurance markets is not as positive as company managers would like. Life insurers and other savings mutuals are reconsidering investment policies and closely monitoring solvency margins to protect their financial well-being. These businesses are not enjoying a hard market, but rather the attention of regulators who are critical of the cost and complexity of their products and who are applying continued pressure to their margins through additional regulation. Falling equity values have not only damaged solvency; they have also devastated the fees collected for investment products as retail investors have abandoned them. In the p/c sector, the future may look bright but, for many insurers, there remain the challenges created by business written during the past soft market. Whether you are in the US, the UK or Europe, insurers have had a turbulent year - turbulence created largely by investment markets.
Life and p/c insurers encountered two very different environments this year. Following the appalling World Trade Center tragedy and the continued spur that it gave to equity market volatility, many p/c companies either removed or reduced exposure to equity markets. For some, 2002 has been a year of hectic activity to rebuild claims-damaged balance sheets. However, given the heavy bias towards fixed income investments and the significant strengthening of cash-flow as a result of premium increases, investment returns and cash availability have not been a serious issue for senior management. The key black-spot has been claims development from prior years of soft markets and difficulties created by the sharp fall in their own shares.
Life insurers have suffered a much worse environment. Both assurance and savings product margins continue to suffer in the face of aggressive competition. The heavy bias towards equity investments, combined with a third year of falling equity markets, has sharply reduced solvency levels at a number of life insurers and is drawing the increasingly negative attention of rating agencies. Earnings from savings products have suffered throughout the period of falling equity markets as the plummeting value of managed investments has severely cut fee income.
In 2003 we expect financial returns from both bonds and equities to be significantly different. The on-going asset-allocation trade into bonds by life insurers and pension funds seeking to improve solvency ratios or correct liability mismatches continues to look unattractive from an investor's perspective. The bond-equity yield gap is at a decade low of close to 1% (yield on ten year gilts - yield on FTSE 100), with many FTSE 100 stocks yielding more than gilts. While confidence has been hit by lingering credit concerns, the risk of further corporate failures, the threat of terrorism and the possibility of war in the Middle East, recent earnings have generally matched or exceeded expectations.
The switch to bonds described above has driven the yields on gilts and high quality non-government debt to levels we consider unsustainable. To the extent that liabilities allow, allocation to cash, lower quality debt and equities may all result in higher total returns. P/c insurers will need to budget for lower than normal investment returns in their budgets. If, as we anticipate, a period of growth, possibly accompanied by lower volatility returns to equity markets, life insurers should acquire some increased solvency flexibility and see a rise in consumer income flows directed towards savings products.
These expectations are predicated on average gross domestic product (GDP) growth in the UK of 2.5%, a recovery in global confidence and continued substantial real increases in government spending.
US credit storm
Most US insurance companies have a preference for investment income. This leads them to overweight `spread products' such as corporate bonds and mortgages in their portfolios. In fact, these two asset classes comprise more than 55% of life company assets and 47% of p/c portfolios. When spreads widen, such portfolios suffer. And spreads certainly have been widening in this year of extremes.
Extremes abound: the lowest interest rates in 40 years; the highest risk premiums in 20 years; statistically, relative to their long-run averages, price to earnings (P/E) ratios have fallen to their most attractive levels since the second world war; and, we see the highest level of residential mortgage prepayments ever. Spreads for both mortgage-backed securities (MBS) and corporate bonds have expanded in response.
Insurance company surplus accounts have had to absorb the effect of an all-out panic in the credit markets. Cheap securities get cheaper, financial reports are routinely restated for the worse and rumours of reporting violations and flawed accounting practices abound. What do we do now?
One should first recognise - not necessarily easy to do when standing in the middle of a storm - that the capital markets are reacting severely, but not atypically, to a post-bubble bear market. The implication is that it will end as all others have ended and that, when it does, we must be prepared for the challenges and opportunities the new trends will bring.
A second point to recognise is that these new opportunities are likely to be found in sectors of the market different from those that have attracted our recent focus, both good and bad. Investments such as MBS and highly rated corporate bonds have been viewed as a safe haven and, as such, do not offer attractive prospects for future returns. Sectors that have suffered greatly and that, in fact, have led the crisis - telecom and energy trading come to mind - have to rationalise much more before they can attract more capital. While current valuations may not support a sale, it takes aggressive assumptions and a leap of faith to expect full recovery. The best we can do is re-deploy the current asset value to sectors that will produce better results.
During the period leading up to the recent credit crisis, the best advice that portfolio managers could have given to their clients was to avoid being under-compensated for risk, maintain a bias towards quality, and ratchet-down expectations for nominal returns. Those who followed it are much more sanguine today about their chances of weathering this storm than those who did not.
Does this posture still hold today? There certainly is a great temptation to answer yes, for the following reasons:
Although risk aversion is still quite high, the fundamentals are getting better. Corporate earnings are improving and valuations are much more rational than they were just a few quarters ago. The fear in the markets affords opportunities that insurers should not pass up.
The best advice in today's market is to avoid a `bunker' mentality. The biggest risk lies in missing the recovery when it comes. All those securities that have held their value and out-performed this year are likely to under-perform in the recovery as the weaker sectors close the gap. Portfolios should be set up to take advantage of this changing environment.
Overall, our forecast is that the general level of US interest rates will rise further through the year-end and into 2003. Other expectations are for GDP growth of near 3.5%, modest inflation and a gradually recovering equity market.
Financial market returns in Europe during 2002 have been similar to those in the US and UK. Government and other high-quality debt have delivered positive returns. Bonds benefited from the flight from equity and a decaying economic outlook. Insurance companies with significant exposure to equity and lower quality debt markets (much less common in Europe) suffered like their British and American counterparts.
Europe's economic circumstances contain few reasons for optimism in 2003. It lacks the strength of consumer consumption and the service sector which have helped the UK, it has not received the stimulus that we can expect in the US as a result of the Federal Reserve Bank's accommodative moves on official interest rates and it continues to suffer from structural rigidities. Consumption is expected to fall as a result of rising unemployment in a continuing environment of sub-trend GDP growth and excess capacity in many industry sectors.
This situation raises the distinct possibility of a further reduction in interest rates by the European Central Bank as it perceives a likely fall in inflation with little sign of stimulation of growth. While bond yields may ultimately rise by the end of 2003, positive real returns are the outcome we expect as most likely from high-quality debt. Interest in real estate as an asset class with investment income has seen renewed attention. Equity markets remain vulnerable. In recognition of these difficulties, while we may see near-term equity market strength into the year-end, insurance companies should not anticipate a return to strong equity market returns in 2003.
Where does this leave insurance investors on the continent? In parts of Europe, impairment of equity portfolios and their pending year-end revaluation has placed reviews of asset allocation strategy and existing investment arrangements on hold until reported profit and loss issues are resolved. Some have not been able to afford to delay their asset allocation review and, in order to calm markets, clients and rating agencies, they have moved much of their remaining investments heavily into fixed income securities and raised capital to repair balance sheets. Next year, many companies will be focussing heavily on their core underwriting skills to guide the recovery of their business.
This focus is required because many life insurers have been driven to the edge of technical bankruptcy by capital and interest-rate protected products that may see little relief in the year to come. P&C companies, some caught by the fall in equity values, have also been dealing with a recent history of extremely high claims. M&A activity may recover sooner here than elsewhere as further consolidation is needed in the light of market over-capacity and anticipated demutualisations.
Recent events have shown that, in a number of instances, insurers are under-capitalised and very fragile when markets become volatile. A core issue is to achieve a strategic, or medium-term, asset allocation that will allow their balance sheets to face the scrutiny of clients and regulators.
All companies have to assess the options available for their surplus and consider the expected returns available to underwriting or other activities that can benefit their stakeholders. Equity markets now appear more attractive to us than bonds but making tactical shifts in allocation should be done gradually over time. Asset allocation changes should also be conducted with a clear understanding of the impact that a negative outcome will have on an insurer's balance sheet. That understanding can be better brought about through the use of asset-liability management, a holistic assessment of the insurance enterprise's investment strategy. Using such outsourced solutions is becoming increasingly common. Outsourcing fund management has and will continue to be a natural and logical development in this field.
Interesting times and hard decisions will continue to be a regular feature of managing insurance company investments. But the best way to make those decisions is to bring all of the available information together in the most effective way possible to help insurers to identify the `best' investment policy for their firm.
By Tony Maximchuk
Tony Maximchuk is a client relationship manager at Swiss Re Asset Management. Rich Sega, the chief investment officer of Conning Asset Management - a wholly owned Swiss Re Group company - contributed to this article.