Richard Major says that reinsurers can benefit from taking a fresh look at their investments
Investments for reinsurers tend to receive less attention than their other financial aspects, not from management at reinsurers, of course, but from persons outside them. From the outsiders' vantage point, growth in premiums, earnings and equity tend to command attention, along with volatility in claims. Growth is where the story has been since property/casualty rates began to harden in early 2001. This revitalised a sector of the insurance market that had been languishing amid suspicions of reinsurers buying business, even if their executives had universally disavowed having done so.
Several factors have coincided to direct our attention, and reinforce management's, towards investments. Interest rates in the developed economies had generally trended down from 1982 before reversing direction in 2003.
Consensus opinion has that reversal continuing, though more mordant views have this trend resolving itself into a spike. Either eventuality should concern the holders and sources of the capital (that is, the reinsurers and their investors) that has entered the insurance market since Hurricane Andrew and more recently 9/11, which has ridden declining interest rates.
Rates are now increasing, which diminishes fixed income values, and therefore capital and, ultimately, the volume of premiums that a company's capital may support.
From historic highs in 2000, indices for large capitalisation equities declined dramatically into 2003, before recovering somewhat through 2004.
In reaction to this decline in market values, many reinsurers decreased their allocations to equities, causing them to miss the benefit of this correction. Equities might, of course, ultimately take up the slack from future declines in fixed income values. However, increasing an insurer's allocation to them raises several questions. These uncertainties include when will equities take up this slack, the degree of certainty that this will occur, and the likelihood any particular insurer's liabilities (say, those of a property catastrophe reinsurer) might reduce their duration to 'now', thus converting the market risk of equities into actual realised losses.
Another immediate concern is the softening of premium rates in the property/casualty segment. Property premiums are flat or declining. Casualty premiums as yet remain more resilient, with continued rate increases in some lines.
Both have, however, enjoyed several years of dramatically improved pricing.
The knock-on effect of good prices was that the reinsurers that received them were able to be more selective about the risks they underwrite, yet still post dramatic improvements in earnings.
Although insurance executives knew as an intellectual matter that prices would eventually revert to some sort of mean, their emotional response seemed to be that their companies, and the property/casualty industry generally, had recaptured for the long term their rightful place in the sun and that a more rational economic regime had taken hold. Unfortunately, the phenomenon was transient. Visions of all 'decent' companies being able to generate 'appropriate' underwriting gains have given way to the depredations of 'irrational' competition and 'irresponsible' companies buying business.
It seemed that for as long as the hard market lasted, companies adding decent investment returns to expanding underwriting profits would transform the insurance industry into an effective competitor for capital. Reinsurers' returns on equity would compare favourably with those of banks, investment banks, and other types of financial institutions. The new capital that both established and newly organised reinsurers attracted, clearly demonstrated that this was true for a few years. Declines in premium rates, or rates of growth in certain segments, have now increased the relative significance of investment earnings to reinsurers' financial performance.
These trends - rising interest rates, erratic equity returns, and a softening property/casualty market - have combined to reactivate a search for earnings.
Reinsurers have only a few sources of earnings: underwriting; other; and investments. Underwriting profits will possibly see a decline. 'Other' might be fee income or lines of business outside insurance. Fee income may be nonrecurring or narrow-margined. An example of the former is a firm reinsuring its cedent and then writing a derivative that mirrors its reinsurance liability, so that a non-insurance investor may buy the derivative to invest directly in insurance risk. The latter might be administrative services such as claims management. Neither can easily sustain the financial performance necessary to support a decent earnings multiple or initial public offering price.
Having acknowledged this, where do reinsurers look? A variety of possibilities include the following, which incorporate both assets and programmatic approaches.
- Hedge fund of funds - If managed well, a fund of funds may offer equity-like returns with bond-like volatility. Significant trading volume in the underlying funds may also generate taxes without producing funds to pay them. With a couple of notable exceptions, companies active in hedge funds allocate a small percentage of invested assets to them, so their effect on overall earnings remains limited. Still, depending on the underlying investment strategies, fund-of-funds returns tend to demonstrate limited correlation to interest rates, an attractive quality as the latter increase.
- Alpha overlays - Properly structured, an actively managed portfolio of derivatives (equity, bond, and currency) has a limited correlation with long bonds. They may act as a standalone portfolio or be managed in the context of the rest of the reinsurer's investments to minimise the aggregate portfolio's overall correlation. Depending on the risk a company is willing to accept, such a strategy may add one or a few percentage points to a company's investment return. One percent added to an existing return of 6% represents a 17% increase, an attractive pick up.
- Real estate and private equity - This is not a significant class of investment for reinsurers, and should probably remain so. Still, in funding liabilities with durations that far exceed that of available fixed income securities, or in investing surplus funds, real estate and private equity may offer long-term appreciation without current taxation, though with the obvious drawback of illiquidity.
- Credit default swaps - Investing in credit default swaps instead of bonds permits investing in credit risk without the concomitant interest rate risk and with a smaller outlay.
- Treasury inflation protected bonds (TIPs) - TIPs increase their principal amounts according to inflation and then apply the coupon rate to that principal amount. This avoids future interest rate risk though at the cost of earning only a risk-free rate of return. A second drawback is the accretion to principal generates a current tax liability.
- Interest only securities (IOs) - As interest rates increase, mortgage refinancings decrease, thus increasing the value of the related IOs. The converse also applies. Refinancing mortgages terminates interest payments under them, reducing to zero the value of any related IO. A conviction that interest rates may continue to increase makes IOs an appealing hedge, though being wrong can be expensive.
- Hedge interest rate risks of specific bonds - Although this is a basic strategy for portfolio management, it can be both expensive and cumbersome.
Its benefits include not being controversial and its leaving undisturbed the reinsurer's existing portfolio.
- Swapping from longer duration bonds into shorter ones - This is another basic technique. At the cost of generating realised losses now, shortening a portfolio's duration may mitigate the potential for greater realised or unrealised losses in the future.
Writing an increasing volume of business will produce growth in new funds for investments that may also tend to accelerate. An increasing flow of new investments across rising rates may average down a portfolio's sensitivity to further rate increases. This simple expedient runs, of course, in the face of decreasing premium rates. Accordingly, increased premium volumes will have to come from increasing market share, which is a goal that all reinsurers will share with every one of their competitors.
Most of these approaches present obvious challenges and practical difficulties.
These explain why the industry has taken less advantage of them than it might have.
- Regulatory - State insurance laws in the US generally limit the extent to which an insurer can invest in derivatives, often permitting only effective hedges on specific securities or writing covered calls. The UK's Financial Services Authority is more lenient, subject to the general proviso that derivatives activity must be consistent with an insurer's sole purpose as being to conduct the business of insurance. Reinsurers in Bermuda are fortunate to operate in a jurisdiction that regards its insurance industry as self-regulating. This, possibly to a greater extent than the tax regime, provides its reinsurers with a competitive advantage. They are able to focus on economics and risk enterprise risk management, rather than on regulatory considerations.
- Capital charge - The sophistication of rating analysts varies widely, along with their willingness to look through the form of an investment to the actual economics and risks. Investing in hedge funds may bring little advantage if the analyst purports to 'remember long-term capital' and proposes a 100% capital charge.
- Accounting - US reinsurers must file a Schedule D that lists all securities held at the conclusion of the relevant accounting period, as well as each security purchased or sold during the same period. Jurisdictions other than US states impose less onerous filing requirements for transactions or none at all. The more limited the requirements for disclosure, the simpler are the reinsurers' conversations with its rating and securities analysts.
- Tax - Some strategies, such as TIPs and hedge funds, may generate current tax liabilities without producing funds to pay them. Larger and more diversified reinsurers are more able to support such mismatches than smaller or single line reinsurers. Tax is, of course, an academic matter to reinsurers in jurisdictions that do not tax corporate income.
- Managing realised gains and losses - The volume of premiums a reinsurer writes is proportional to its capital, so reinsurers are concerned with managing realised gains and losses. Strategies with volatile gains and losses may interfere with a closely managed approach.
- Headline risk - Trust and the market's perception of a reinsurer as being an appropriate counterparty for significant and often long-term promises are important to its vitality. Other financial institutions, insurance or otherwise, having had bad experiences with a particular asset class makes that class a much more difficult sell.
- Exchanging yield for return - Investment yield is closer to cash than total return. Reinsurers need yield to pay claims and expenses without liquidating assets. Further, and though different forms of statutory and GAAP treat gains and losses differently, yield comprises a part of operating income, where gains and losses may not. As interest rates decline, total return becomes more interesting to reinsurers. As they increase, yield is more of a concern. Some alternative strategies produce total return, not yield.
In the last analysis, reinsurers are not complete masters of their domain in setting investment strategy. The control that a regulator might exercise is one example. Another relates to analysts at rating agencies, investment banks, institutional investors, cedents, insurance brokers, and other counterparties.
Analysts lean toward discounting capital gains and not rewarding for innovative investment programmes. The former is sensible, particularly in respect of a company with a history of lumpy or occasional out-sized gains. It becomes less so to the extent a company has a record of reasonably consistent gains from alternative assets, particularly if they demonstrate only a limited correlation with its core bond portfolio. Finally, this orientation reflects the last several years' more compelling growth from increased premium rates. A growth rate for premium revenues of, say, 10%, is more compelling than, for instance, a strategy to add one percentage point to returns that requires explanation by the company and consideration by various analysts. If, and as underwriting margins constrict, that latter may become increasingly interesting.
Reinsurers generally can benefit from taking a fresh look at investments.
Property/casualty insurers could, in particular, benefit from an additional strategy for managing through another market cycle. Many insurers have sophisticated investment managers, either as employees or as independent investment managers, though new investment techniques emerge continually.
Whether or not a company decides to adopt any of them, staying with a current approach is more informed for having considered and foregone the others.
Richard Major is director and insurance strategist in the Insurance Advisory Services Group at Deutsche Asset Management (the marketing name in the US for the asset management activities of Deutsche Bank AG, Deutsche Bank Trust Company Americas, Deutsche Asset Management Inc., Deutsche Asset management Investment Services Ltd., Deutsche Investment Management Americas Inc, and Scudder Trust Company).