The fall in stock market returns has created a devastating hole in insurers' accounts. As a result, capital for underwriting expansion is now being held in cash.

THE WORLDWIDE collapse in investment returns could hardly have come at a worse time for insurance companies.

Throughout the 1990s stock markets across the globe boomed and insurers were, of course, keen not to miss out on the chance to earn anything up to 10% on their investments.

The gains were so lucrative that the profits they generated fuelled the soft market slump. Insurers could afford to chase market share by slashing rates for their products.

But now it's all over. The market for risk protection was already hardening when 2001 brought record losses. But the losses from falling stock markets could amount to twice the $40bn to $50bn (£25.8bn to £32.3bn) cost to insurers of the 11 September catastrophe.

Reinsurance giant Swiss Re estimates that non-US insurers alone lost $60bn (£38.7bn) as a result of falling equities last year, with this year set for another decline. Worldwide, the figure rose to $90bn (£58bn).

Insurers have been desperately cutting back their investments in equities, and the same Swiss Re Sigma study estimates the proportion of UK insurers' portfolios to be held in shares has fallen from a peak of around 30% in 1998 and to less than 20% in 2001.

Equity investments are now so uncertain - and non-life rates have hardened so much - that insurers can make more money from underwriting or the credit markets than the stock markets.

Insurers have been furiously raising money for extra capacity, so they can continue to make good underwriting profits for as long as the hard market last.

The volatile investment environment means much of the new capital is currently being held in cash. This not only avoids potential losses but also keeps liquidity high.

A case in point is Lloyd's insurer Hardy, which set out in April to raise £25m and even now has kept the bulk of the proceeds in cash.

Equities account for about £8m of its total £45m holdings. The equity portfolio is held in two sections - a UK fund run by Newton fund managers and a US fund run by Ruane Cunnif. The UK fund has produced a negative return, but outperformed its peers. The US fund produced a positive return.

As for the overall strategy, Hardy chief executive Barbara Merry said the group was sitting tight on its equity holdings.

"The conclusion we've come to is that this isn't the right time to sell," she said.

Low growth
Swiss Re warns that it could be some time before equities pick up again.

"There is a risk that stock markets will go through a period of overshooting on the downside before reverting to normal growth, which is 3% to 4% over risk-free returns, compared to 7% to10% during the 1990s.

"Consequently, investment returns for the insurance industry may remain low for a long period of time."

Steve Umpelby, chief administrative officer at Barclays Global Investors (BGI) says: "We believe equities will outperform bonds by 3.75% a year in the UK - but that is over the next ten years."

And, in a note of caution to anyone thinking that a strategy could be built on buying now while share prices are low, he adds: "We don't try to pick the top or the bottom of the market. "Lots of people have tried it and they don't tend to succeed. That's not how we manage money."

Given the increasing importance of cash holdings to insurers, and the fact that it is crucial to insurance brokers, Umpelby says companies would do well to pay more attention to their cash holdings.

"It's an important asset class, but one that everyone forgets about."

Leaving cash sitting in a current account at the bank could be costly.

Umpelby says good cash funds can return 0.3% more than the open market rate.

"It's massively significant," he says. "If you've got £100m sitting there with a number of different banks, by putting it into the top performing cash fund you'd get another £300,000 over the course of the year.

"That goes straight to the bottom line, straight into profit."

Not only can a cash fund offer a better return, but it can offer diversified risk, lots of flexibility and the ability to take it out at the drop of a hat. This is crucial for an insurer that may need the flexibility

One of the top considerations for a general insurer is to make sure its assets match liabilities. So many of the industry's investment decisions are heavily influenced by the risks being written.

When picking an investment portfolio, an insurer needs to accommodate its book, which may have short or long tail risks. So its portfolio will consist of short and long duration investments. For example, an insurer selling long tail cover, on which it will need to pay out in US dollars, will pick a long duration dollar-denominated fixed income fund.

Furthermore, the shock of massive bankruptcies such as Enron and WorldCom has raised the prospect of insurers losing money through exposure to corporate bonds.

Munich Re's exposure to WorldCom totalled about $80m (£52m) through shares and bonds, and AXA's exposure amounted to about E40m (£26m), mainly in fixed income securities.

Fears of further high-profile collapses make clear the importance of diversification so that if one issuer fails it doesn't bring the whole portfolio crashing down.

Umpelby says another factor frequently overlooked was to ensure the best allocation of investments, not just between equities, fixed income and cash but, within a portfolio, to geographical or sector areas.

Credit derivatives
An average fund invested in Japan may have outperformed a good fund invested in the UK or US, for example.

Swiss Re forecasts that although credit derivatives have lost some of their appeal due to high-profile bankruptcies, they could begin to regain their attraction particularly to insurers with experience of underwriting credit risks.

It says: "In the long run, it is likely that insurers with the expertise to manage credit risks will resume greater participation in the credit derivative market."