Deutsche on navigating troubled investment waters

Bermuda:Re spoke with Deutsche Asset and Wealth Management about the challenges of the current investment environment and strategies re/insurers can explore to maximise their investment returns.

What investment strategies would you recommend reinsurers pursue in the current troubled investment environment?

Bart Holl, global head of insurance relations, Deutsche Asset & Wealth Management

This can be broken out in three categories - yield-enhancing, equity, and alternatives.   
Yield enhanced strategies:
- bank loans
- infrastructure debt
- convertibles
- emerging markets debt
- enhanced cash
- real estate mezzanine debt

Equity:
- dividend enhanced
- real estate income producing equity
- infrastructure public securities

Alternatives:
- secondary PE
- liquid hedge funds
- commodities

Are reinsurers considering going further out on the risk curve to pep up their investment returns or are they pursuing conservatism in order to deploy capital in products with better returns when the markets strengthen? What are the challenges associated with both approaches?

A combination of holding some "dry powder" and shorter duration securities for a better entry point into fixed income. It is also relevant to expand asset allocation models and strategies using more sophisticated modeling and analysis. Risk metrics should be focused on traditional sharpe ratio-type analysis (efficient frontier) and VaR measurements. At the end of the day, it is all about capital, and the investment side would not want asset risk to derail an insurance company's underwriting ability/capacity.  Underwriting results are trending better, but there is still glut of capital that is keeping pricing tame.

The challenges of traditional fixed investing are low nominal rates and compressed spreads. Reinvestment opportunities are pretty unattractive in the Barclays Aggregate Index space. Moving out of the BarCap index, this becomes a liquidity trade and insurers need to feel they are getting paid for less liquid fixed investments.  From an economic perspective, economic growth is tepid and spreads are tight given global uncertainties, therefore there seems to be more downside risk exposure than up.

Specialty and alternative investments, either in other parts of fixed income, equity, or alternatives, all have benefited from Central Bank easing and risk assets performing well. Concern, however, is the impact of central banks withdrawing that easing. Delivery vehicles of specialty and alternative investments are very important as well from a capital, accounting and scheduling view.  If capital risk adjusted returns not attractive then insurance companies will take position...why bother.

What can reinsurers do to protect against interest rate shock?

Steve Doire, co-head of client solutions, Deutsche Asset & Wealth Management

Options for dealing with interest rate shocks include reducing duration, reallocating fixed income from more interest rate sensitive sectors to higher spread sectors, hedging, and diversifying into asset classes that tend to perform better when rates are rising.

Many companies have been conservative in their duration positioning of their bond portfolios -- fortunately for most reinsurers, they have short duration liabilities and like duration asset portfolios to start with. Of course, reducing duration costs yield, so while reinsurers have been conservative most have not made drastic reductions. Based on our own research, average duration for Bermuda reinsurers moved marginally from 3.2 in 2007 to 3.0 in 2012.

Many companies have dealt with low yields by increasing allocations to BBB/High Yield bonds and away from Government/MBS.  Allocations to BBB bonds and High Yield bonds have increased over 75 percent and 300 percent respectively since 2007.

The hedging topic is getting more attention, but given the low durations of reinsurance bond portfolios, as well as the costs and administrative overhead involved, reinsurers have thus far opted for other alternatives to protect against rising rates. However, there are some innovate hedging approaches that can be cost effective -- and we've seen interest with some clients.

Diversification is probably getting the most attention. Reinsurers are looking at asset classes that tend to perform better in rising rate environments.  The best example is equities.  Average Bermuda reinsurance equity allocations have increased over 40 percent since the crisis lows.  If rates are rising due to a strengthening economy, than equity values should also be increasing.

What are the implications of such shock events for the portfolios of reinsurers?

The biggest implication is the resulting impact on capital that a loss in fixed income portfolio value has.

Most analyses are based on an instantaneous shock.  For example, if rates rise 200bps (2 percent) on a 3 year duration portfolio, the portfolio loses 6 percent of its value. Since reinsurers have inherent leverage in their balance sheet with bond holdings generally about two times the level of their capital, this would mean a reduction in capital of 12 percent. Rating agencies have cited a capital loss of 10 percent as a reason for ratings review.

That said, a 200 basis point shock is an extreme scenario, especially given the Fed position of keeping rates low for the medium term. Additionally, when rates do rise, they typically rise gradually. This gives investors the benefit of reinvesting coupons and maturities at the higher rates, thereby dampening the impact of the of the rate increase over time. We often do "horizon" analyses for clients that take this into account and we find that modest duration (3-4 year) portfolios actually benefit from gradual rising rates.

What will be the major challenges for the reinsurance industry in the coming eighteen months?

Holl:

1. Investment income run-off
2. Will specialty and alternative investments become mainstream for insurance companies and if so, what are proper allocations
3. Underwriting results or writing at a profit
4. Too much capital chasing reinsurance risks
5. Regulatory developments and potential to dampen book value growth  and/or ROE results
6. Liquidity management, how much is to much given low yields, liquidity is very expensive
7. Building knowledge of alternative investments, avoiding allocations to asset classes or structures that have abnormal risk behavior