In the 2008 investment race, the tortoises beat the hares. But some fund managers are urging their clients to take advantage of the current fear, writes David Sandham.

Last year was the worst 12 months for investors in most peoples’ lifetimes – a financial cataclysm, the consequences of which are as yet to be fully worked out. Although originating in credit markets, the financial tsunami was also devastating for equities and corporate bonds. Investors lie disorientated, battered and bruised. The crisis also exposed the ignorance of company leaders about the risks they were exposed to. For example, AIG made less than 1% of its revenue from credit default swaps, yet its involvement with these derivatives cost the entire company.

Reinsurers have been hit too, but they fared better than the banks. Insurers’ financial structures are more conservative and they have lower asset to equity ratios (about 5-to-1 for many P&C insurers, compared with 30- or 40-to-1 for many banks). Guy Carpenter calculates that 18 of the world’s largest reinsurers (excluding Lloyd’s vehicles, many of which have yet to report) lost $20bn in shareholders’ equity in 2008, and ended the year with 18% less shareholder’s equity than they started it with. This is bad, but it is not terminal. Chris Klein, global head of business intelligence at Guy Carpenter (pictured right), describes this wound as “painful but not mortal”. The effect may be judged by observing reinsurance rates. Though there has been upward movement, especially in peak zones, there has not been a sharp upward spike in reinsurance pricing such as one might expect were the sector in deep trouble. The loss in shareholders’ equity has not been large enough to create a “hockey stick turn” in the reinsurance market, Klein says. The damage to shareholders’ equity stems from various factors (see chart on page opposite), but investment losses are the largest single factor.

Most reinsurers were relatively protected in the financial crisis for three reasons. First, they were protected by the constraints under which they invest. Randy Brown, global head, Deutsche Insurance Asset Management, says that investment strategy for an insurance company is not just about maximising returns, but is also about “appeasing multiple constituents” such as shareholders, boards, regulators, auditors and ratings agencies. A fund manager in insurance has to do everything that a total return manager has to do, while also managing these constituencies. It’s a “very specialised field” of fund management, he says. P&C insurers are generally more conservative investors than mutual funds or pension funds, and are often “80%-85% in bonds”.

Second, unlike general investors, reinsurers must manage investment portfolios with an eye to future insurance liabilities. This also tends to makes them conservative. Reinsurers need bonds to come due when they need to meet the liability. “Duration management is an important part of investment strategy,” says Klein.

Brown says that most P&C reinsurers prefer bonds of a 3 ½ or 4 year tenor. They are “predominantly in single A or higher rated bonds”, although they also include BBB rated, higher yielding bonds and structured products (except for the notorious Collateralised Debt Obligations and Special Investment Vehicles) in their portfolios, Brown says.

Third, reinsurers’ liabilities are not liquid as banks’ are, so unrealised losses causes less pain. Depositors at a bank can demand their money back immediately, but policyholders cannot cash in their policies. Klein says that unrealised investment losses hurt reinsurers less acutely than a major natural catastrophe, when insurers “have physically to write cheques”.

Though reinsurers differ from one another as to investment strategy, as a group they are much more conservative than banks. This conservatism has partially protected them in the financial crisis. Reinsurance is not banking. Those pressing for tougher regulation of the financial services sector should bear this in mind.

FEAR

Reinsurers differ widely in their investment strategies, ranging from the very conservative, such as companies at Lloyd’s, through to the more aggressive, such as Swiss Re. Conservatism has proved the winning policy. Swiss Re recently lost its chief executive Jacques Aigrain after announcing terrible investment losses.

Higher risk approaches may have been partly motivated by an attempt to offer lower reinsurance rates, and thus grow market share. While Klein was not willing to comment on the activities of another company, he says: “You have to ask why it is that a variety of companies felt they needed this more risky activity to generate returns. Perhaps the reason is that they are generating an inadequate return on the capital allocated to underwriting.” If underwriting is at a combined ratio of above 100%, then the company must rely on investment income to make a profit. For “people writing in the upper 90s, it will be a significant part of their returns,” he says.

Since the financial crisis, there has been a general retreat from risk. Swiss Re is currently de-risking its investment portfolio through a combination of sales and hedging. As of the end of 2008, Swiss Re’s portfolio was already more conservative – as well as smaller in value – than at the end of 2007 (see pie chart on facing page).

How should de-risking be done? The obvious method is simply to sell off risky assets. But hedging can also be used. Hedging involves the dreaded derivatives that cost so many so much in the first place. However, there is a difference. In its Credit Default Swap agreements, AIG, Swiss Re and XL (which has since sold off that division) were taking risk from others. But in hedging a portfolio, the aim is to pass on risk to others. Brown recommends hedging using Credit Default Swaps. “We recommend CDS as protection,” he says, despite the “taboo”, and especially in cases where “selling the assets would fall foul of large bid to offer spreads in an illiquid market or the cash position has a large unrealised loss.”

More generally, Brown recommends that investors “take advantage of the current mood of fear” by obtaining higher yields on quality corporate bonds. The more risk averse choice, government bonds, forces investors to accept very low yields. “Buying a diversified portfolio of single and double A rated corporate bonds is not a big risk, but gives a very nice return,” he says. Brown’s current favourite investment is rated super senior Commercial Mortgage Backed securities.

David Sandham is Editor of Global Reinsurance

Swiss Re to outsource equities and ALT

Swiss Re is in the process of outsourcing its equity and alternative investments, says Tim Dickenson, a spokesman for Swiss Re. “A new Investment Platform Division will be created, managing external mandates in these asset classes,” he says. Swiss Re has traditionally run its own portfolios via Swiss Re Asset Management.
The reason for the change is that equity and alternative investments are predominately focused on absolute returns, not on backing liabilities. In these assets, “Swiss Re tends to lack the critical size to have a competitive advantage in the market,” Dickenson says. At the end of 2008, Swiss Re’s asset allocation in equities and
alternative investments was 8% of its total portfolio.
Many smaller reinsurers outsource all their fund management. Randy Brown, global head, Deutsche Insurance Asset Management, says that outsourcing is popular among Bermudian reinsurers, where “real value is added on the liabilities side”. But there is now “movement up the food chain”, he says, with larger reinsurers outsourcing more. One reason for the trend toward more outsourcing, he says, is that “insurers who ran money internally are coming to realise that they do not have the expertise they once assumed.” An insurer with about $5bn of assets might have a team of people running its investment portfolio, he says. By contrast, Deutsche Asset Management, one of the world’s largest third party asset managers, has roughly 50 credit analysts worldwide, and about 300 people in fixed income asset management.
For fixed income mandates of at least $100m, fund managers in general have historically charged around 15–20 basis points (0.15-0.20%). They charge more for active equity mandates of this size, typically 30–35 basis points (0.30-0.35%).

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