Navigating today's investment environment
Over the last half decade, the corporate nexus between Lloyd’s and Bermuda has steadily increased in a visible trend, with notable acquisitions and the capitalisation of new enterprises, and with Bermuda and London-based companies binding together. With a continued soft market cycle in the reinsurance market and growing capacity at Lloyd’s (despite a so-far benign Atlantic hurricane season), risk and financial market conditions will present challenges to maintaining high levels of profitability and return on capital.
The focus here will be specifically on the challenging investment climate. Lloyd’s Syndicates and Bermuda reinsurers writing significant levels of property insurance are typically forced to match their assets to fairly short-tail liabilities. The low interest rate environment that has persisted over the past 18 months serves to drive investment yields lower as portfolios turn over. At the same time, there are economic headwinds on the horizon that limit opportunities to add return without disproportionately increasing investment risk. Nonetheless, where those opportunities exist, they should be exploited.
Perceived economic weakness has caused the Federal Reserve to maintain essentially a zero interest rate policy, with many forecasters now expecting no increase in the Fed Funds rate until the second half of 2011, at the earliest. In addition, in reaction to continued weak employment and housing data, the Fed has suggested that it is looking to resume quantitative easing in the interest of keeping mortgage rates low. In response to renewed easy monetary policy and increased market volatility, two-year Treasury yields have fallen by over 50 basis points since April 2010, while 10-year Treasury yields have dropped by over 100 basis points over the same period. At the same time, corporate bond yield spreads have fallen to fairly narrow levels by historical measures.
"While the opportunity is certainly limited, reinsurers and Lloyd's managing agents could also seek to replace traditional cash management options (money market funds or fixed bank deposits) with high-quality, weparately managed liquidity portfolios."
Insurers seeking to maintain book yield might be tempted to extend out further along the yield curve or to add more credit. Both should be done cautiously. An inevitable increase in interest rates or widening of credit spreads could cause a significant loss in portfolio market value in even intermediate duration ranges. Increasing levels of cash on corporate balance sheets suggest that we may move into a period of less than creditor-friendly events (share buyback programmes or an increase in M&A activity, as corporations seek to deploy that non- performing asset), which could be a catalyst for spread widening, which would counsel in favour of taking a cautious approach in longer-term portfolios.
At the same time, US Treasury Inflation Protected Securities (TIPS) could present an opportunity to limit downside risk and preserve upside potential. Renewed concerns around persistent deflation and economic weakness have pushed TIPS’ relative values to historically attractive levels. Insurers have typically had limited exposure to this asset class, but in the event that economic indicators begin to improve, TIPS would appreciate while conventional Treasury securities would fall in value.
While the opportunity is certainly limited, reinsurers and Lloyd’s managing agents could also seek to replace traditional cash management options (money market funds or fixed bank deposits) with high-quality, separately managed liquidity portfolios. Changes to the regulatory environment that affect money market funds have caused rates to fall significantly in very short-term instruments. A customised liquidity portfolio could take advantage of slightly higher- yielding corporate securities and consumer asset-backed securities (ABS)—an approach that we favour. Given the higher constraints on money funds, a customised liquidity programme would provide the same types of exposures as a prime money fund at a higher yield.
One common constraint imposed on Bermuda-based companies’ portfolios is the regulatory rules applicable to collateral provided to US cedants (typically restricting assets to securities rated ‘A’ or higher). Unlike Bermuda market companies, Lloyd’s Syndicates are treated as admitted reinsurers in the US by virtue of a master trust fund for allUS policyholders. While less frequently used in Bermuda, US state insurance laws permit Bermuda companies to obtain accredited status with a similar mechanism (frequently known a ‘Reg 20’ or Master Reinsurance Trust). In addition to cost savings and improved operational efficiency, reserve assets held in a Reg 20 trust can participate in the full investment-grade opportunity set.
Reg 20 trusts carry with them additional regulatory requirements when compared to posting separate collateral. A ‘trusteed reinsurer’ must provide an abbreviated statutory account of its US-source liabilities and assets on a quarterly and annual basis; this mechanism thus acts more as an alternative to accreditation than as an alternative form of collateral (and, as mentioned, this is precisely the same format and procedure by which the Lloyd’s market receives accredited status in the US). There are numerous financial and operational advantages to this structure. The most significant investment impact is the ability to invest in the complete range of investment-grade fixed income securities (down to the rating level of ‘BBB’) and foreign investment- grade fixed income securities. A small weighting in ‘BBB’-rated securities can have a significant impact on the yield of a fixed income portfolio. In addition, ‘BBB’ provides an opportunity for diversification. Typically, single ‘A’-rated finance and consumer cyclical issuers trade with the same level of volatility as ‘BBB’-rated industrial names.
In addition, the National Association of Insurance Commissioners has passed model laws that provide certain reinsurers with relief from collateral rules based on the reinsurer’s credit rating. Until recently, Florida had been the only state to enact statutes and regulations based on the revised model law. In July, New York passed its version, an important milestone in gaining national acceptance with state insurance departments and legislatures.
Lloyd’s and Bermuda have shown themselves to be attractive and profitable platforms from an underwriting perspective. Given the underwriting risks that are assumed by participants on these platforms, the investment of the associated assets has usually been done in a conservative manner, with an emphasis on high-quality assets of relatively short duration. In ‘normal’ environments, this approach has often been able to generate a satisfactory return. However, in today’s environment of historically low investment yields, it requires innovative thinking to add return at the margin without unduly lowering investment risk standards. In our view, this is achievable through the consideration of additional products such as asset-backed securities and TIPS, as well as potentially evaluating alternate regulatory structures such as a Reg 20 trust.
Cameron Laird is a senior vice president and head of insurance asset management at Brown Brothers Harriman & Co. He can be contacted at: cameron.laird@bbh.com
Joseph LoPorto is a vice president and relationship manager, insurance asset management at Brown Brothers Harriman & Co. He can be contacted at: joseph.loporto@bbh.com
This article has been prepared by Brown Brothers Harriman & Co. (BBH) and is intended for informational purposes only. BBH advises you that this communication should not be relied upon as legal or tax advice, and cannot be used to avoid tax penalties. you should consult with your own professional legal or tax adviser before taking any action that relates to the subject matter of this communication. The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Any opinions expressed are subject to change without notice.
