A new reality for investment income
Getting better returns requires new thinking and asset allocation
By Michael J. Moody, MBA, ARM
The effects of the recent financial crisis are still being tallied. Many will not be known for years. However, one of the consequences within the insurance sector has been the increasing importance of investment management. While much of the insurance sector fared better than other industries, a new respect for asset management has emerged within the insurance industry.
Investments have always been important. Along with underwriting results, they are the engines that drive the industry. Today, as investment returns continue to remain on the low side, asset management is a central focus for most insurers. And fallout from the "crisis" is causing insurers to rethink entire investment strategies.
A recently published report by Swiss Re, Insurance Investment in a Challenging Global Environment, provides some valuable insight into the current situation. As the report points out: "In today's economic and regulatory landscape, investment performance has become the number one concern for many insurers." The reason is that many insurers realize that "today's low yield environment, coupled with increasingly stringent regulatory standards, could hamper insurers' investment returns and, in turn, lower profits in the industry." Ultimately, this could lead to higher rates for policyholders.
The Swiss Re study documents how insurers are exploring creative ways of offsetting these lower investment income returns. The real problem is that, in the aftermath of the financial crisis, "government bond yields have reached historically low levels that may persist until the global economy truly recovers."
Couple this with the fact that most insurance carriers are required to invest in the very investments that are providing the lowest yields. For the most part, "insurers tend to invest conservatively," having the majority of their assets in government securities. Today, according to the study, this is detrimental because "yields are extremely low and sovereign bonds are no longer fail-safe investments."
An example will quickly illustrate the negative effects of the situation. For U.S. insurers, an allocation of 50% to Treasury bills and 50% to Treasury bonds would, according to the study "have reduced returns by 1.5% a year from 1991-2008." Put another way, the study notes, if such a "requirement were applied to the industry's global insurance assets of $23 trillion, it would cost insurers over $1 trillion within three years."
The Swiss Re study indicates that insurers are responding to the challenges in several ways. Among some of the new realities within the insurance investment community are:
• Insurers are managing their investments with an awareness that crises occur regularly.
• For some insurers, investing in equities can improve their overall risk profiles.
• Emerging markets can offer insurers many investment opportunities.
• A growing number of insurers are using third-party asset managers who specialize in programs for the insurance industry.
While much of the information noted in the Swiss Re study is directed at traditional insurance companies, they are not the only ones facing such challenges.
Captives feel the pinch
The new investment realities have also struck the captive insurance industry. However, in the case of captives, the situation may be more critical. First and foremost, captives typically are formed with minimal capital and surplus. As a result, most captives view investment income as a means of paying current operating expenses. In addition, since most captives are formed to cover the risks of their parent(s), the financial results generated are typically more volatile compared to traditional insurers. Investment income historically has been available to offset any short-term, adverse underwriting results.
Investment income often is a critical reason for the formation of a captive, with many captive managers citing the availability of investment income as one of the primary benefits that justify their formation. Captives usually prefer to be risk averse in their investment choices; however, that is no longer a viable option. "Extending maturities in fixed income portfolios to generate income may have worked in the past," notes Claude Parenteau, president of Parenteau Associates, LLC, and past president of CICA. But today, he says, "Amounts generated via low interest rate vehicles frequently do not warrant the risk."
More to the point
Investment managers have been trying to develop products that will provide insurers with an opportunity to earn higher rates of return. In recognition of the size of the captive insurance market, investment managers specializing in the captive space are working to develop specific products for their industry. To date, few ideas have made it off the drawing board.
However, one captive investment manager, represented by Parenteau, has put together two specialized investment vehicles for the captive insurance market. Both of these higher yielding institutional products have been designed specifically for the captive insurance market with the latter of the two being available exclusively to Parenteau's clients at the present time.
The first product, International Sovereign Debt, takes advantage of fixed income securities by investing in a portfolio of the sovereign and quasi-sovereign debt of developed and developing nations. All securities are denominated in U.S. dollars, thus limiting direct currency risks and potential regulatory reporting problems. As such, Parenteau notes, they do not pose any settlement problems for bank custodians. This investment, which presently averages approximately 4.5% current yield, is available with a minimum investment of $1 million, and has been designed to focus on higher levels of principal stability by blending the highly rated developed nation debt with the higher yields of developing nations.
The portfolio manager of the product is Rajesh Gupta, chief investment officer of Seacrest Investment Management, LLC, and the former head of Global Fixed Income at Morgan Stanley's Investment Management Unit. The key aspect of the product, according to Gupta, is that it is comprised of the best of the developed market sovereigns such as Germany, Canada and Australia as well as strong "emerging markets," such as South Africa, Russia and Brazil.
Seacrest has also developed a second product for Parenteau Associates that is a hybrid income matrix product. This product, notes Parenteau, "in dynamic, fluid fashion performs critical relative value analysis." The analysis is performed "between different sub-sectors of the higher dividend-paying segments of the equity markets" that historically have low correlation to the equity market.
Coupling these equity sectors with select fixed-income investments has the effect of providing a more desirable income stream with considerably less volatility than investing in equity markets only. The resulting product, according to Parenteau, provides about a 5.5% yield and is completely liquid (i.e., everything trades on U.S. exchanges). Gupta states that the product would be typically accepted by all bank custodians as collateral, "at perhaps a 70% credit advance rate." Hence, 70% of 5% yield provides about 3.5% net-net returns, "which is quite a bit better than the current passbook rates of other investment instruments," notes Parenteau.
Swiss Re's study has provided some useful guidelines for the insurance industry that reflect the realities of the current investment environment. While the study was aimed at traditional insurers, the same information clearly applies to captive insurance companies as well. The old ways of looking at investments are no longer valid for insurance companies. As Parenteau points out, investments in many of the tried-and-true investment options are no longer viable. Rather, insurance companies, including captives, must develop a strategy that aligns the risks with the returns. "When it comes to investing today, it is all about the yield," Parenteau notes. And today, low yielding investment vehicles do not warrant the risks associated with them.
Accordingly, insurers must be open to less traditional methods that are able to generate competitive interest rates. And as noted both in the Swiss Re study and information provided above, many times these specialty products are available only via third-party asset managers.