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Key Investment Issues Facing the Insurance Industry Roundtable Discussion September 2013

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Introduction

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When Shakespeare wrote “Whether ‘tis nobler in the mind to suffer, the slings and arrows of outrageous fortune, or to take arms against a sea of troubles” it’s reasonable to assume he wasn’t thinking about institutional investments. However, his words are extremely relevant to the challenges facing the insurance industry today. Insurers continue to face many issues with their investment portfolios in the current economic environment of low-interest rates and financial market volatility. Key questions that need to be addressed include: •

Do insurers know - and can they measure - their risk appetite?

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How much volatility can insurers tolerate?

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How can credit quality be evaluated and maintained and what is the right level of risk?

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Is asset liability matching a big deal?

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Should alternative investment strategies be considered?

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Should insurers be using derivatives to manage and mitigate the risks that are inherent in their investment portfolios?

In early September 2013 CAMRADATA hosted an industry roundtable discussion to shed some light on these and other issues to discover how insurers should “take arms against asea of troubles” to avoid the “slings and arrows of outrageous fortune”. The following article captures the participants views and observations. It has been written by independent, freelance journalist Brendan Maton, who chaired the debate.

How insurers should “take arms against a sea of troubles” to avoid the “slings and arrows of outrageous fortune”

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Roundtable

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Participants Nigel Jenkins, ASIP Principal, Payden & Rygel Global Limited, London Nigel Jenkins is a Principal and heads the Global Fixed Income Group at Payden & Rygel. He is responsible for for the management of Global, UK and European benchmarked fixed-income portfolios. Prior to joining Payden & Rygel, Jenkins was a founding partner of Centric Capital LLP, a fixed-income and currency hedge fund focusing on quantitative methodologies. Previously he was Head of Global Fixed Income and Currency Hedge Fund at WestLB, and a Director of the Fixed Income & Currency Group at Rothschild Asset Management, both in London. Jenkins holds the ASIP designation of the UK Society of Investment Professionals, a member society of the CFA Institute. He earned a BA degree in Economics from the University of Cambridge.

Roy Sampson Finance Director, Groupama Insurances, Part of Ageas UK A qualified Chartered Accountant and Fellow of the Institute, Roy joined GAN in 1997 as Group Accountant. In 2003, he was promoted to the position of Finance Director, with responsibility for the implementation and delivery of certain strategic projects. Roy now has specific responsibility for all management, statutory and regulatory reporting. As the head of the finance teams, he is also responsible for Groupama Insurances’ investments and credit control. Previous to this he was Audit Manager for Ernst & Young and a Director of a London Market Agency covering Marine, Aviation and Treaty business.

Gilles Bonvarlet Non-Executive Director – Insurance industry Gilles has been involved in the insurance industry since the early 1990’s, firstly as a management consultant with Coopers and Lybrand where he advised the investment management divisions of two UK composite insurance companies. He then joined the Lloyd’s market where he held senior executive positions including Managing Director of Brockbank Syndicate Management, CFO of XL London Market Group and COO of Talbot Holdings. He has served on many Lloyd’s representative bodies including the Capital Committee of the LMA and Lloyd’s Market Board. Gilles currently serves as a Non-Executive Director of Amlin Underwriting Ltd and LAU Europe Ltd.

Nigel Bennett Outsourced CIO, IF Structuring Founded IF Structuring in 2003 to provide independent investment services to Insurance Companies and Family offices. Former CIO of Brit Insurance where he was responsible for over $5.5bln assets. Nigel operates as an outsourced CIO for a number of Insurance Companies, and the focus of his work is to assist companies in identifying and implementing required changes to their investment strategy, risk tolerances, asset allocation, manager selection and overall investment process. Nigel was Chairman of Lloyd’s Investment Working Group, a forum for the CIOs and Treasurers in the Lloyd’s market to resolve common investment issues.

Brendan Maton Freelance Journalist Jason Pratt Senior Vice President, Chief Investment Officer, Montpelier Group Jason joined the Montpelier Group on November 2009 after serving as Managing Director, Principal and Head of Portfolio Strategy and Risk Management at Peritus Asset Management. Previously, he was a Portfolio Manager and Head of Credit Derivatives and Structured Credit at Atlantic Asset Management. He held various positions at ARM Financial Group, an insurance holding company, the most recent of which was Director in the Portfolio Management Group overseeing private placements non-mortgage structured credit. He received a Bachelor of Science in Economics from the University of Louisville in Kentucky and has served as a guest lecturer in the Department of Economics at Harvard University.

A highly experienced financial journalist with an expansive network of contacts in the UK and across Europe. Has written about pension schemes and national welfare systems from Finland to Greece for 18 years and understands the retirement savings industry in each European country. Brendan has interviewed EU commissioners and national ministers; central bankers; pension scheme heads; insurance chief executives; chief investment officers; actuaries; union officials; professional and lay trustees. He worked at Financial Times Business for eight years, finally as Editor-in-Chief of all international pensions titles. Brendan has spent the last ten years as a freelancer for a number of publications, including Financial Times, Responsible Investor, Nordic region pensions news and IPE. Chief webcast host for IPE. Brendan has acted as conference chair for Financial News, the UK National Association of Pension Funds, Dutch Investment Professionals Association (VBA), Corestone, Insight Investment, Marcus Evans, Robeco Asset Management, Sustainable Asset Management (SAM), Towers Watson. And now CAMRADATA.

Marcus Johnson Chief Executive, NW Brown Group Limited Prior to joining NW Brown, Marcus was at Meridian Performance Services, a London based consultancy practice. Before that he was Managing Director of Credit Agricole Asset Management (UK) Ltd. He has spent over 30 years in the investment industry and has been an underwriting member of Lloyd’s for more than 20 years. His first five years in the city were spent at Hoare Govett where he was responsible for Gilt Edge research. He is also a Director of Anglian Archives plc (a document storage company) and of property and forestry.

Key Investment Issues

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Facing the Insurance Industry By tradition, general insurers have not used derivatives for investment purposes. In 2010 fewer than 100 – just over 3% - of US-based Property & Casualty insurers held synthetics within their portfolios. In the current environment of miserable yields, however, it is questionable whether reliance on ‘safe’ sovereign bonds and similar securities is a prudent investment strategy. Could the flexibility of derivatives aid the reduction of risk?

Any discussion on derivative hedging for general insurers has to begin by addressing the question of what is to be hedged

In London this month CAMRADATA hosted a roundtable to discuss the place of derivatives in the insurance world, both as hedges and sources of return. Key points to emerge from the discussion were:1. For many general insurers, hedging is not essential: their liabilities are short-term and even in the event of a spike in claims, revenues and reinsurance adequately cover obligations. 2. Record-low yields on sovereign debt, however, applies greater pressure on revenue margins, already squeezed by competition, increasing operating expenses and the rising cost of regulation. Insurers have to figure out how rising rates will affect their investment portfolio and overall operations. 3. The bigger picture is that decision-makers within insurance firms must be cognisant of the risks they are running and the appropriateness of the investment strategy used to rein in those risks. Derivatives may be a part of that process but there are many other elements to consider in a well-run company. Any discussion on derivative hedging for general insurers has to begin by addressing the question of what is to be hedged. There is no doubt that all sorts of institutions in financial markets want greater certainty about their cashflows and are using the likes of swaps and swaptions on interest rates, inflation and even mortality to that end. But much of the demand for such instruments is highly specialised, e.g. utility companies taking a view on inflation or oil companies hedging future energy prices. This century, new demand has come from occupational pension funds, especially those mature plans backed by companies with pension regulators, accountants and analysts (in some instances, all three) poring over their financial data.

But general insurers don’t resemble any of the above specialist users, not even occupational pension schemes. Life insurers do: both occupational pension payouts and annuities can last half a century. Motor insurance policies in the UK, on the other hand, expire every year – each side can walk away from the deal. This flexibility embeds all kinds of operational revenue risks into general commercial insurance as well as some capital management risks. But the “unwanted” risks of duration mismatch and equity overweighting found in the sphere of traditional pensions are not here. “I think it’s fair to say when considering hedging that general insurers do not know their liabilities precisely,” says Nigel Jenkins, a Principal at fixed income manager, Payden & Rygel. “There is a far greater number and spread of moving parts and attendant risks than at a pension scheme.” This point is taken up by Roy Sampson, Group Director of Finance at Groupama UK. “I think we have to be careful in setting the scene to determine why and when an insurer would need to hedge,” he says. “We can’t just begin with the precept that hedging per se is virtuous. The fact is that the duration of liabilities is so short that a well-run insurer will have both revenue streams and the buffer of reinsurance to cover even a spike in claims.” Of course no two organisations are identical and Gilles Bonvarlet, Non-Executive Director in the London Market, makes the point that an insurer writing big-ticket insurance on a few items will have far greater volatility than an insurer with premiums dispersed across tens of thousands of small, individual customers. Nevertheless, the sense that general insurers have less demand for popular interest-rate hedges than life insurers and pension schemes was shared among participants. “I would say that 75% of our pension fund clients use derivatives,” says Jenkins, “while 75% of our insurance clients don’t.” Evidence of the distinction was provided by Marcus Johnson, Chief Executive of insurance brokerage, NW Brown – at the end of 2012, the average duration of the fixed income portfolios among Lloyd’s syndicates was 2.6 years. This accords quite neatly with the rule-of-thumb for the duration of general insurers’ liabilities of 2.5 years (although at the roundtable there were no insurance actuaries, the people who calculate the liabilities, to explain themselves). In contrast, it has taken UK occupational pension schemes collectively a decade to achieve a similar degree of approximation between assets and liabilities.

The average duration of the fixed income portfolios among Lloyd’s syndicates was 2.6 years

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Le bon est l’ennemi du mieux But if there is no urgent need, why even raise the issue of hedging and derivatives? The answer lies in the fact that general insurers are commercial operations (as distinct from pension schemes which for some corporate sponsors – although they cannot say it publicly – are an unwanted risk in their entirety). Just because business has been good does not mean it cannot be done better. And so, participants further explored the matter of interest rate risk.

While there may not be a great mismatch between assets and liabilities in 2012, Johnson’s figures show that a year earlier, the average duration among Lloyd’s syndicates had been 1.7 years

While there may not be a great mismatch between assets and liabilities in 2012, Johnson’s figures show that a year earlier, the average duration among Lloyd’s syndicates had been 1.7 years. Evidently, insurers’ risk exposure is not quite as dull as first appears and does in fact change from year to year. As Johnson himself states: “Selecting the appropriate duration benchmark versus liabilities is an active decision.” “And so defining its risk appetite is where a company should start,” adds Bonvarlet. Nigel Bennett, chief executive of IF Structuring, then raised the matter of governance, or who is responsible for sizing this holistic risk appetite and any subsequent tactical variances. “The actuary will estimate the liability duration but the investment committee and or finance director might question the practicalities and risks of matching the asset/liability durations.” Participants with a career in investments agreed that actuarial predictions could appear rather too fixed. This is frequently the responsibility of the CIO to recommend a suitable level of risk. Bennett himself acts as an external CIO for a number of separate insurance companies. Another CIO, Jason Pratt of Montpelier Re, then brought the debate to a real dilemma regarding asset allocation, liabilities and interest rates: He asked about how comfortable insurers were with their existing duration profiles given the events of the summer given how much yields and risks had changed. “How much pain are you willing to take before you feel compelled to make a change.” Several participants were most fearful about insurers’ interest rate exposure – and the kind of regulation that interprets sovereign debt as low risk (Solvency II’s standard formula makes no capital charge on debt issued by the likes of Portugal, Greece and Italy). One possible, if not essential, remedy for those who believe yields are going to rise and stay above the recent record lows, would be to shorten their interest rate position. Jenkins said that Payden & Rygel had adopted this position, albeit moderately as the firm was not convinced yields are set to rise greatly. “This is not going to be a 1994-style bond rout,” he explained. “We haven’t seen enough evidence of inflation to convince us that yields are really going to take off.” A reduction in the average duration exposure of a portfolio can be achieved either by investing in lower duration bonds or by retaining longer maturity bonds and then hedging the interest rate risk by selling interest rate sensitive derivatives. Johnson agreed that traditionally Lloyd’s syndicates were not big users of derivatives. But derivatives are not the sole means to take advantage of a rising-rate environment. Pratt’s view is that investors have to be cognisant of all the means at their disposal. In this regard, hedging and derivatives become important tools for sound investment management: not because their use is essential but in the modern era, their consideration alongside physical assets and paper helps. Bennett agreed. He gave the simple example of buying futures to gain quick access to a market before refining the position with the subsequent purchase of real assets. “I have clients who, if they like an asset class, will make a bridgehead using derivatives,” said Bennett. “But if they don’t like an asset class they already own, they just sell assets.” On the negative side, Johnson warned that in his experience, hedges are always more cost expensive in practice than on the planning paper. The differences are not trivial: “At a previous company, we decided to buy up a big slice of sovereign debt from Ireland. We wanted an interest rate hedge that should have cost 0.5% but ended up more like 1%,” he

recalls. “You have to remember that the brokers have made the calculations and they want to make a profit too.” Is it merely a matter of experience or are there technical reasons as to why the use of derivatives might be more costly than expected? Bennett and Pratt had different views on the role of operational systems as a dissuasive factor in the adoption of derivatives. Bennett believes that some insurers’ internal systems struggle to cope with derivatives inputs, with all the unique characteristics they bring. Pratt countered that the adequacy of systems needs to be assessed to ensure that management and the board understand risk before entering into complex strategies. Good Governance Over Models The debate naturally led on to the importance of good governance in insurance companies – not for the sake of better derivatives management per se but the greater ultimate goal of improved performance for the business’s owners. “It’s incumbent on management to ensure organisations are carrying out their duties and analysing the risks properly,” says Pratt. He added that taking responsibility extended to any outsourcing of investment management as well. “Montpelier outsources because with $3bn assets under management, there aren’t the economies of scale for us to trade inhouse. But that doesn’t mean we just accept a glossy risk-report every three months. We work closely with our portfolio teams to understand what is happening in capital markets and communicating our needs and risks as an organisation.” As a simple example on asset allocation, Pratt said that while he had concerns about the threat of rising yields, they did not affect all asset classes equally. “Expertise is key in evaluating portfolio risks. For example high yield credit has not been especially sensitive to interest rate risk historically and more correlated with equity markets.” Conversely, with specific regard to derivatives he noted that insurers have to be clear about which risks can and cannot be hedged and the efficacy of any hedging program. Of course, the models with which insurers can analyse asset class returns and risks improve with every passing year. They are used more both by firms and their regulators. All participants warn, however, that myopic reliance on any data modelling carried risks all of its own. “What is often missing in risk management is common sense,” says Sampson, although he tempered this comment by adding that competence has improved greatly in recent years in no small part due to regulatory reforms. He felt that risk management was now in operation holistically throughout a business where before it had been an isolated

Bennett believes that some insurers’ systems struggle to cope with derivatives inputs

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department without necessarily the power to intervene in all aspects of a company’s running. Johnson, however, expressed reservations that regulations, not least forthcoming Solvency II, were more and more cyclical, and more damaging as a result. “If they see a negative return, then they will want some kind of response, which could mean selling quality assets at the wrong time,” he said.

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Risk and Return Under Pressure

Bonvarlet suggested that diversification of assets was a broader means of reducing the pressure

The $64bn dollar question is how far insurers risk making more illiquid investments in order to improve their balance sheets. Bonvarlet reminded everyone that margins are being squeezed because revenue has not been growing in the insurance world due to economic sluggishness. Concurrently extra costs, not least from regulation, continue to increase and competition from third-party vehicles such as insurance-linked securities (ILS) is developing. This pressure encompasses more than any discussion on hedging alone. Bonvarlet suggested that diversification of assets was a broader means of reducing the pressure. Panellists duly expanded on the kinds of investments they were looking at in the current environment. Johnson suggested direct property and loan funds. “The big issue or opportunity that we have not yet discussed is the retreat of banks from the lending market,” he noted. “In the UK alone, this retreat is in the order of £400bn.”

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Bennett agreed that there were good profits from financing small and medium enterprises, although for a typical insurer he reckoned it had to be done via third-party funds. There are lending strategies which yield over 8% but insurance companies will only consider investing a few percent of the total assets as they are highly illiquid. Johnson also mentioned catastrophe bonds, a growth market since 2004 where returns of 10% are possible. Following Bonvarlet’s observations on ILS, he added that it was ironic that reinsurers used to have this business to themselves until hedge funds started to muscle in. “Now the reinsurers have decided that if you can’t beat them, join them,” remarked Johnson.

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In the sphere of derivatives, Jenkins said that Payden & Rygel used a variety of derivatives as part of its exposure to credit. “We fundamentally believe in the attractiveness of credit right now,” he said. Pratt expressed concerns about equities. “For the economy to grow you would expect to see re-leveraging. We’ve seen record profitability from companies in the US but that is not the same thing as a growing economy.” In conclusion, pressures are in place that force general insurers to run their businesses better or face the ultimate loss: an end to their operating life. Some of those pressures come as a double whammy: an absence of economic growth hurts both policy revenues and returns on pure investments. Other trends, such as the phenomenal rise of insurancelinked securities, offer both threat and opportunity.

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Without doubt, insurers have to diversify their investment portfolio in order to help the business. With financial repression already exacting a high price on government bondholders for the errors of capital markets (or to be precise, certain major agents in capital markets), the traditional reliance on sovereign debt is a dangerous strategy. Participants at the roundtable were fearful of current interest rate exposures. The difficult part is which path to choose away from the subsidizing of national governments’ efforts to restore economic growth. Quantitative easing complicates rather than simplifies the choosing. Ultimately, participants placed great importance on the management model of insurers in controlling risks across the organisation and understanding the direction of returns.

Written by Brendan Maton, Freelance Journalist

© Copyright CAMRADATA Analytical Services September 2013. This marketing document has been prepared by CAMRADATA Analytical Services Limited (‘CAMRADATA’), a company registered in England & Wales with registration number 06651543. This document has been prepared for marketing purposes only. It contains expressions of opinion which cannot be taken as fact. CAMRADATA is not authorised by the Financial Services Authority under the Financial Services and Markets Act 2000.CAMRADATA Analytical Services and its logo are proprietary trademarks of CAMRADATA and are registered in the United Kingdom. Unauthorized copying of this document is prohibited.

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