A never-ending education

In a financial world that appears to be constantly changing, the challenges currently facing chief investment officers (CIOs) are probably unlike any they have experienced in their careers.

Worldwide monetary policies are making it difficult to ascertain the real value of investments and are helping to keep interest rates very low, with no sign that they will rise significantly in the short and medium terms.

For Mark Silverstein, the CIO for Endurance Specialty, the current economic climate is a very unusual one, with monetary policy that “has never really played out like this before”.

“There are lots of opinions about whether it has been successful or not. It has not created high inflation as some thought it would, but it has created other issues. The primary drawback is that because central banks have lowered interest rates so far, it has distorted the price of many investment assets,” says Silverstein.

“With fixed income prices distorted upwards and the yields down, investors are migrating into other assets such as equities, which drive up their prices. One of the biggest challenges is figuring out the true value of assets if the central banks’ actions were not distorting markets.

“It has definitely been a challenge. If you think back 10 years, a typical reinsurance company would probably have had a portfolio yield of around 5 percent. Now that yield is more like 2 percent.”

Investing skill

Silverstein joined Endurance as its CIO in August 2005 and is responsible for management of the company’s investment portfolio, valued in excess of $6 billion.

He has more than 29 years of professional experience in investments, with a focus on fixed income securities, including managing US and global core fixed income portfolios for re/insurance companies, pension funds, endowments and mutual funds.

“Investing is constantly challenging and a never-ending education, as there are so many moving parts in markets and economics. When managing investments for an insurance company, you have the added complexity of figuring out how those investments match the strategic business needs and objectives of the company.

“If you were investing your own money and seeking to maximise yield at a particular level of risk, then the focus can be largely on return,” says Silverstein.

“But with insurance, there are other priorities that must factor into your investment strategy, mainly that you are overseeing the bulk of the capital of the company. The first priority is preserving that capital and ensuring that the company is well positioned to pursue its core operating business.

“This has an impact on the investment strategy. You are, on one hand, preserving capital and, on the other hand, trying to use that capital to help build more value for the portfolio and for the company itself.”

“With insurance, there are other priorities that must factor into your investment strategy, mainly that you are overseeing the bulk of the capital of the company.”

Investment strategy has also been driven by the low interest rates and the lower returns on fixed income assets.

“We have adjusted our expectations, acknowledging that our portfolio will likely earn less than in the past. We continually update our assessment of how much risk we are willing to take and within the context of current market conditions, construct what we think is the best portfolio to suit that environment,” says Silverstein.

“In the past you could get fairly attractive returns from fixed income and it was less necessary to delve into other markets. However, with current rates so low, you are not going to earn a lot in fixed income. Also there is more risk than there used to be because rates cannot really fall much lower from where they are today.”

About seven years ago, more than 90 percent of Endurance’s investments were in fixed income, but now that level has dropped to the mid to low 80 percent range.

Silverstein says Endurance was not alone, as many companies have reduced their fixed income exposure and increased exposure to equities and other investments such as hedge funds and private equity.

“We believe the returns from fixed income will be lower than from other asset classes, so like many of our peers, we have shifted a portion of our portfolio from fixed income into other classes that we think will perform better.”

He adds: “It does involve risk—there will probably be more volatility in the pricing of those assets but I think over time, we will have higher returns. Consider that fixed income is only yielding about 2 percent, while equity returns over the next number of years will probably be more in the 5 to 10 percent range.

“If we are having 2 or 3 percent growth in the US plus a little bit of inflation and you assume that companies can keep up with that inflation and earn profits, then you should have returns from equity above 5 percent unless there is meaningful multiple compression.

“There could be a year when equities are down 10 or 20 percent—it is entirely possible—and that is where having a risk budget comes into play. To avoid undesirable losses, a portfolio downside limit is utilised, which translates into an exposure limit for equities.

How much risk?

In terms of risk, Silverstein says investment strategy was driven by how much risk is deemed acceptable.

“In my opinion, building an investment portfolio and an underwriting portfolio have a lot of similarities in terms of understanding how much and which risks you want to take. If you believe that you are getting paid appropriately for those risks, then putting them together in a portfolio should create a more efficient business.

“Then the question is how much risk do you take? Shareholders in our business know we are taking insurance and reinsurance risks, but they don’t expect us to be taking much risk on the investment side.

For most insurance companies, someone becomes a shareholder because of their attraction to the underwriting side of the business. We are an underwriting business. That is our primary activity,” he says.

“The investment side of the business should be part of the strategy for safeguarding the capital of the company and producing an attractive and steady level of income, which contributes to book value growth. So on the investment side we take less risk and our goal is to meet the objectives of capital preservation and sufficient liquidity to pay claims.”

On what lies ahead, Silverstein says: “Our belief is that interest rates will continue to stay very low. I believe they will drift up but not very fast and of course, the moment this is printed, rates will go up very quickly.

“Overall, it is very difficult to predict interest rates and therefore it’s not an easy way to make a living. We must accept the interest rate that is in the market.”