Investments feel the pinch.

Yvonne Deeney explains why (re)insurers need to consider new asset classes as part of their revised approach to asset management in a low inflation environment.

The time has come for (re)insurance company chief executives and
chief financial officers to lower their expectations of returns on
investments and capital employed. The robust growth and moderate inflation
of the 1990s, which often produced double-digit returns, was far higher
than can be expected over the next decade.

Although policymakers tolerate 2% inflation in Europe and up to 3% in the
US, low inflation will naturally subdue investment rates. Bond yields of
5% and uncertain stock market gains will no longer compensate for
underwriting losses. If they are to ensure profitability, deliver the same
return on capital and fulfil the promises made to shareholders,
(re)insurers will require higher premiums from their underwriting and
better assessment of their risks.

Seeking a balance

At the same time, shareholders' expectations will also have to be

Risk and return balance is increasingly important. Shareholders need to be
aware of balance-sheet leverage, particularly in times of uncertainty when
a company's management is striving to maintain or increase return on
equity by higher gearing.

The analysis of risk tolerance is key to managing expectations and
producing the results required by the board for its shareholders.

The search for balance has led to a revaluation of insurance and
reinsurance risks, the price of which had been driven down prior to 2001.
Lower interest rates increased the amount of capital available and the
surplus of money drove down the cost of risk to unsustainable levels, both
in the general reinsurance market and in the pay-outs on life assurance
investment-related products in the core countries of the European

Unusually, poor equity market performance has coincided with falling
interests rates, leading to diminishing investment returns. This is
squeezing profits for shareholders in traditional life business, as well
as creating significant risk when minimum guarantees to policyholders are
in place.

After the adverse environment of 2000 and the terrorist attacks of
September 2001, companies had to dip into reserves as their investment
funds could no longer make up the shortfall with sufficient running (or
income) yield.

Higher yields

Investment managers are under pressure to increase yields towards the 8%
level often exceeded in the 1980s and 1990s, when growth and inflation
were regularly above average. With bond returns likely to average 5-6%
over the next three to five years, coupled with current equity market
uncertainty, traditional investors are being forced into alternative
markets where higher yields are available, albeit at higher levels of

Property and casualty liabilities typify short or medium-term risks of one
to three years. Therefore, matched assets would normally consist of short
and medium-term government bonds and, where reserves have accumulated,
additional time and a small portion of equities (up to 20%) would be
bought in the correlated currencies. Insurance asset management in the
current environment is challenging and techniques to add value at sector
and even bond selection levels will enhance returns and avoid managers
having to rely on big interest and/or currency bets.

Investment-grade corporate bonds (rated 'BBB' or higher) are now accepted
as reasonable diversification for a portion of the portfolio - perhaps
20-35%, depending on the company's appetite for risk.

The credit market in the US is highly developed, offering an extensive
choice of corporate bonds across different sectors so that diversification
is easily achievable.

Although the European corporate debt market is still developing and
suffers a scarcity of transparent benchmarks, both liquidity and expertise
are growing rapidly. Here diversification across sectors is more difficult
to achieve as the telecoms market has dominated issuance over the past two

A niche sector and a unique asset class is the convertible bond: a hybrid
investment that gives the investor the option to convert into the
underlying equity of the issuer, while having the advantage of a coupon
(usually below prevailing market rates) and a finite redemption value and
end date similar to a bond.

These equity-linked debt instruments can benefit from the upturn of stock
while protecting the investor during any downturn. They are ideal for
medium-term portfolios where higher volatility than fixed-rate bonds is

New asset classes

Non-correlated asset classes are becoming more popular due to the quest
for higher performance. These include structured products, hedge funds,
fund of funds and private equity.

- Structured products are tailor-made private placements, linked to the
performance of an agreed index or number of indices or stocks. They
usually involve a gearing factor on that index or basket of stocks. The
potential returns are usually considerably higher than market rates to
reflect the correspondingly higher risk inherent in this investment class.
However, careful analysis of each structure is needed, with proper,
on-going risk management.

- Hedge funds and funds of funds are a significant departure from
conventional (re)insurance asset class investment categories. This
much-maligned sector can offer lucrative returns, especially when equity
markets are in negative territory. Sound advice and a thorough
understanding of the manager's risk management techniques are
prerequisites when considering this alternative asset class.

- Private equity funds form another specialist sector, which represents a
leveraged capital investment in a public or private company. Private
equity is therefore akin to venture capital investment and requires common
understanding between the chief executive and chief information officer of
the risk and return balance.

Acceptance of structural changes as part of investors' realistic
expectations of lower rates of return is now of paramount importance. A
more objective balance of risk versus reward is required. Chief
executives, their underwriters and investment strategists need to
acknowledge the challenges of repricing reinsurance risks because of lower
investment performance It is the ones who do that will be the
(re)insurance winners of the future.

Yvonne Deeney is managing director of Dublin-based GE Re Management
Services (formerly ERC Management Services).
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