Asset strategies

One of the biggest challenges facing insurers is the management of their assets in the volatile equity markets and low interest rate environment following the World Trade Centre (WTC) catastrophe. The reason: investment income generated by these assets has been critical, because the industry rarely makes an underwriting profit.

Although two Lloyd's agencies have declared that they are liquidating their portfolios, insurers have been cautious about signalling any change in their investment strategies while world markets are so unsettled.

Traditionally, insurers' investment of choice was a government or municipal bond, secure and predictable, but not too exciting for shareholders in soaring equity markets. Today, P/C insurers use a range of asset allocation strategies, which aim to balance the shareholders' search for returns with the need to meet solvency requirements and pay claims as they arise.

Chris Hitchings of Commerzbank Securities in London says the source of the funds generally dictates the risk profile the insurer is prepared to take. He says most of the equities and property investments are allocated to shareholders' funds, while technical reserves, the money to meet future liabilities, are still invested in public or investment-grade fixed income securities. The cash flow of the business, when positive, is likely to go into a variety of money market instruments.

According to Chris Klein of Benfield Greig's counterparty risk team, security analysts pay particular attention to the quality of reinsurers' asset management. "In the reinsurance industry, people don't generally make money on underwriting, so the investment income is very important." He also says reinsurance debtors are one of the most important asset classes for many insurers.

CGNU says in 2000, it allocated 61% of its general insurance and other non-life investments in fixed income securities and 29% to equities and properties. Royal & SunAlliance noted that investors' sentiments toward equity markets suffered as 2000 progressed and that within its general insurance investment portfolios, the group continued to reduce its exposure to ordinary shares as part of its risk-based capital management programme.

Large insurers, particularly those in long-term business, are among Europe's largest fund managers and handle their own asset management. Merrill Lynch's Roman Cizdyn says continental European insurers such as Allianz, AXA and Zurich Financial have substantial funds under management, the bulk of which come from their financial services businesses.

In the UK, CGNU has its asset management subsidiary Morley Fund Management and Royal & SunAlliance Investments is the UK-based hub of the group's worldwide asset management operations.

Smaller insurers and Lloyd's vehicles are likely to use third-party fund managers and they mandate more or less active management of their portfolios, says Geoff Lunt, fixed income fund manager for Investec in London. Another source of investment advice are actuaries, brokers and reinsurers, who offer their now extensive modelling capabilities so their clients can integrate the management of their assets with their liabilities and business objectives. These processes are variously known as asset-liability modelling, dynamic financial analysis and holistic risk management. A main imperative for an insurer is to match the duration and currency of assets to its liabilities so it can pay future claims on time without having to liquidate assets prematurely. Therefore, fixed income, fixed maturity securities dominate investment strategies for technical reserves. The duration of the bonds will reflect the balance of the insurer's portfolio toward long- or short-tail business.

Lunt, says Lloyd's syndicates tend to have a short profile for their funds because of the "annual venture", which means that, technically, the syndicate is dissolved and reconstituted each year. However, integrated Lloyd's vehicles (ILVs), where the managing agency provides all the capacity for the syndicate it runs and the funds of the managing agencies them-selves, have been investing in equities, but mainly in a passive way, tracking the FTSE index.

Lunt says the mandate from insurance clients is often an unspecified outperformance of the index of a basket of bonds. But he adds: "Specific targets will become more widespread."

Another feature in insurers' investment strategy is pressure for socially responsible investment (SRI).

Many insurers have signed the commitment by the insurance industry to the United Nations Environmental Programme. This acknowledges the important role insurance plays in managing and reducing environmental risk through their investment portfolios.

CGNU's Morley Investment Management says it believes companies most likely to grow consistently in the future will be those that are promoting, or benefiting from, sustainable economic development. Morley will not invest in any company until it is approved by its team of socially responsible investment (SRI) research analysts. The fund managers look for "growth at a reasonable price" - companies that are characterised by superior long-term growth in earnings per share where this is not fully reflected in the stock price. Only stocks that clear both the environmental/social and the financial hurdles are selected for inclusion in the portfolios.

In addition, CGNU has a policy of positive engagement to promote improvement in corporate behaviour

In a study on European insurers, the "Clash of the Titans", published in November 2000, Hitchings of Commerzbank Securities remarks it would be helpful if it were possible to show that the stock-picking ability of one major insurance group was consistently better than that of another. "However, the reality is that each of the companies has investment portfolios of a size at which aggregate returns cannot be expected to deviate much or for very long from the asset classes which they choose. And the broad asset classes represented are not really chosen - they result from the application of prudential requirements to the geographic and business mix of the group."

He says differences in the investment return have been a significant factor in the relative financial performance of insurance companies and while such differences are "certain to be a feature of the future", we cannot know by how much.

What we do know is that when investments perform well, insurers' capital tends to expand more quickly than the natural growth of the underlying business requires, thus fuelling price competition, says Hitchings. As investment income falls, insurers concentrate more on technical rating, which is one reason why industry leaders are predicting a sustained hard market, as insurers rebuild their capital bases after the WTC losses.