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Vanilla investing with a twist

AS ARGUABLY THE GREATEST investor of his time, it is worth listening to the advice of Warren Buffett when it comes to the art of investment. Having amassed a personal fortune of $53.5bn (£34.4bn) through a series of shrewd investments, Buffett has created in Berkshire Hathaway a financial heavyweight that is part investment vehicle, part industrial conglomerate and one of the largest insurance and reinsurance companies in the world.

Any finance director with an interest in their investment portfolio should take note. Though probably his most well-known nugget of wisdom relates specifically to how insurance companies should manage their investment strategy: the concept of the free cash float.

In Berkshire Hathaway’s 2010 report, Buffett wrote that its insurance float – money that the company temporarily holds in its insurance operations but that does not belong to it – funds $66bn of its investments.

“That float is ‘free’ as long as insurance underwriting breaks even, meaning that the premiums we receive equal the losses and expenses we incur,” Buffett wrote. Essentially, he is able to use this kitty to make investments.

Investment portfolios are an important component of any company’s finances. They have the ability to boost profits when returns are good, but when the market suffers a systemic shock – as it did when Lehman Brothers collapsed – they have the capacity to bring a company to its knees. The balance of risk versus reward is never far from the finance director’s mind.

For FDs plying their trade in the insurance industry the balance between generating sufficient yield – the income return on an investment – and protecting the balance sheet is more acute than most. The aftermath of the financial crisis, which nearly toppled American International Group, exposed the industry’s over-reliance on investment income. However, insurers have long struggled to make any money from underwriting.

According to data from the Insurance Information Institute, not a single underwriting profit was recorded in the 25 years from 1979 to 2003. In the eight years from 2004 to 2011, only three had underwriting returns in the plus column. That’s a cumulative underwriting deficit of $479bn from 1975 to 2011.

Clearly, insurers had put too much faith in their underwriting returns. Yet, given today’s low pricing environment for underwriting risks, investment income remains an important component. But how are natural cautious insurance finance directors approaching the low-yield investment environment? And what can other FDs learn from their approach?

Risk taking is the order of the day, says Rick van de Kamp, director of insurance solutions at ING. “Insurers are looking to raise risk, they want yield in their portfolios,” he says. “There was a period of de-risking, moving to domestic bonds and scaling down equities, but there has to come a time when you stop de-risking. Government bonds are so terribly low – they need to get more yield.”

This change started last year. Third-quarter results from Zurich Insurance Group and reinsurance giants Swiss Re and Munich Re showed they were willing to increase risk in their investment portfolios to compensate for low interest rates. Zurich increased its equity allocation from 2.3% to 2.9%, Munich Re increased its exposure from 2.2% to 2.9%, and Swiss Re increased its allocation from 2% to 3%.

A prudent move
The move proved to be a prudent one. The past few months have seen stock markets around the world bulling forward. London’s FTSE 100 index is trading at its highest level for more than five years, while New York’s Dow Jones index burst through the 15,000 market for the first time.

“The value we see in equity markets has come as a surprise,” says Luke Savage, finance director of the Lloyd’s of London insurance market. “People may have got lucky with the rally in the equity market. It is unsustainable but whether it falls back, we will have to see.”

Shares and assets have risen in popularity because of the depression in bond yields. A combination of artificially low interest rates and aggressive stimulus packages from central banks in the form of bond purchases has driven down returns of government debt. With some sovereign yields below 2%, insurers have started to look for higher rates elsewhere.

High-yield indexThey will find no joy in European investment-grade corporate bonds, where yields hit record lows in April. The situation appears unlikely to change any time soon. Insurance FDs will need to get used to the historically low interest rate environment.

“I would hate to wager a guess as to when we’ll return to a more normal-yield environment; it’s at least a few years away,” Michael McGuire, CFO of insurance and reinsurance group Endurance Speciality Holdings, said at a Standard & Poor’s conference in Bermuda.

Insurers have long played it safe by building portfolios that are dominated by fixed income investments like government or corporate bonds, though 20 years ago most insurers carried more equities on their balance sheets than fixed income.

In the US, there has been a stampede into junk bonds as corporate high-yield bonds fell to a record low. Insurance companies are the not the stampeding type when it comes to their investments – nevertheless, there has been some rebalancing taking place.

In the third quarter of 2012, Swiss Re increased its holdings of sub-investment grade corporate bonds from 4% to 5%, while Zurich boosted its BBB-rated corporates from 24% to 25%. To many, these might seem like minor tweaks, but to insurers small changes can be pronounced.

“They had gone into the fixed income world and got good returns. They hit that sweet spot but yields and spreads have become compressed,” says Shazia Azim, insurance partner at PwC. “Insurers are looking for investment decisions where they can tweak. Because they were over-cautious in the past, they are still not taking enormous risks.”

Inherent conservatism
That inherent conservatism is perhaps the most salient point. Yes, insurers are entering into more risky asset classes, whether in commodities, lower-rated bonds or equities, but they are starting from a very low base.

Although some very big industry names – AIG, Swiss Re and XL Capital – were left in a tangle over their financial instrument strategies, the majority of market players were well insulated from the fierce heat of the banking collapse. Why? They have always been a cautious bunch when it comes to investments.

“We are not here to chase yield. I want to be able to sleep at night,” says Stuart Bridges, CFO of Hiscox. “We keep our investment strategy straight forward – we’re not in a large number of complex structured products.”

Asset allocation graphBridges goes on to add that Hiscox aims to grow the maximum return it can from its portfolio without taking too much risk. The strategy appears to be working. In addition to Bridges’ undisturbed sleep, Hiscox increased its total investment return to £92.7m in 2012, from £25.9m in 2011, equating to a yield of 3.1%, up from 0.9% the year before. Not bad for keeping risks to a minimum.

The investment result, which accounted for more than 40% of Hiscox’s profits, exceeded expectation and was derived from an asset portfolio that changed little during the year. In the bond portfolios, duration was kept short and a healthy weighting towards non-government bonds was maintained. Some alterations to the selection of equity and hedge fund managers were made, but overall exposure remained constant at around 6% of assets.

Bond credit graphLikewise, Beazley was able to grow investment income to $86.2m from $39.3m and increase investment returns to 2% from 1% by maintaining a conservatively positioned portfolio, though the company did increase its allocation to credit and the duration of its fixed income portfolio.

The decision to further increase the allocation to investment-grade credit improved the overall investment return for the year as yields continued to come down, spreads tightened, and the interest rate curve flattened further.

“It doubled from a small number. We moved from being very cautious in 2011 to just cautious in 2012,” says Martin Bride, group FD at Beazley. “We have about 80% invested in fixed income. We do have investments in hedge funds but these are carefully selected to be low risk and low return.”

Still, reinsurers have been able to earn returns on their investment portfolios – it’s just a matter of how much. Savage, who has been Lloyd’s finance director for nine years, agrees that the industry has diversified globally and through asset class. Small changes in asset allocation may well represent the beginning of a move towards a more balanced mix of assets, but with macroeconomic uncertainty still the order of the day, insurers are unlikely to take on too much investment risk.

Bridge admits that the temptation is there to add risk to improve yield. But it is a temptation that must be resisted. “We make slower investment returns. It is important to accept the environment – it is the same for everyone. Everyone has to invest in the same asset markets and it is difficult for everyone,” he says. “There is no free lunch in the investment markets.” ?

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