40.00% 30.00% 20.00% 10.00% 0.00% -10.00% -20.00%
Chaucer Catlin Cash & short-term duration Hiscox Bonds Equities Amlin Hedge funds Beazley Total return Looking into the causes of this disparity between investment results,
the impact of different asset allocations of five quoted insurers with very different risk profiles and risk appetites can be seen. Both Hiscox and Amlin had large allocations to bonds—a position that would have been held historically—and one that paid off in 2009 as corporate bond spreads tightened and the benefit continued to be reaped during 2010.
Chaucer and Catlin had a more conservative stance, whilst Beazley had
the largest hedge fund allocation but did not hold longer-duration bonds, indicating a risk appetite focused on hedge fund allocation.
The significant additional yield over Libor gained in 2009 and 2010 from holding bonds did not reflect historical trends and required a conscious decision to hold an asset class where the perceived risks had substantially increased in 2008. 100% 80% 60% 40% 20% 0%
Chaucer Catlin Cash & short-term duration Hiscox Bonds Equities Amlin Hedge funds Looking across the market as a whole, we can see that the assets
generally remain allocated on a conservative basis with only 4 percent allocated to equities and alternatives. Even the Lloyd’s Central Fund, which is protected from all but the most severe market scenarios, has only 22 percent invested in non-cash/bond assets.
2010 TOTAL INVESTED ASSETS 3% 1%
2010 CENTRAL FUND ASSETS 3%3%2%
3% 4% 28% 31% 7% 42% 37% 36% Beazley
If we look forward, it is hard to see how these investment strategies can
continue to generate positive returns. Cash is generating close to a zero return, government bond yields are expected to start rising soon and credit spreads are at much tighter levels than in recent years. So how can the investment strategy of most in the Lloyd’s market yield a meaningful investment return that will meet shareholder and market expectations?
Increasing allocations to alternative assets is one option but, as shown in
the two bar charts on the left, can lead to short-term volatility. The challenge of Solvency II, which requires a much greater asset
analysis than the current ICAS regulation and requires capital to be allocated relative to the degree of risk taken at the security level, is also looming. Where there is insufficient transparency in the investment vehicle or instrument, the regulation requires 49 percent capital charge to be allocated. This rules out many current investment options, some of which are perceived as relatively low risk, for example low-volatility hedge funds. The use of an internal model for risk and capital calculation will allow more sophisticated players to correctly calibrate the underlying risks of the investment and reflect a more appropriate capital weighting. However, this is based on the assumption that a fund manager is able and willing to divulge this information, and many of the best investment managers will opt to maintain a degree of opaqueness to protect their intellectual property.
Even if the data is made available, it may not be in a Solvency II-friendly
form (for example showing contribution to interest rate risk, credit spread risk and currency risk). Also, who will consolidate this asset risk data across multiple investment managers? It is doubtful whether the skills and knowledge exist in insurance companies that have traditionally focused on liability modelling rather than asset modelling at the detailed security level and below.
For most Lloyd’s market portfolios, the challenge is not as great given
that the majority of securities held will be relatively easy to price and value. But those assets may not return meaningful risk-adjusted returns. Many investors are already planning an increased allocation to alternative assets such as real estate, commodities and absolute return strategies to enhance returns and take advantage of the diversification benefit that Solvency II offers. But such investments will raise the issues of look- through, transparency and data consolidation.
The risk from higher-returning assets must now be fully reflected in
the capital allocated to the investment portfolio under Solvency II. In considering that potential downside, the board will have to understand which asset class is the most effective vehicle to take that risk.
The table below shows the ratio of investable assets to net tangible assets
for Lloyd’s listed insurers. As net tangible assets are a close approximation of solvency capital, those companies with the higher ratios will benefit disproportionately from small increases in investment returns. Conversely, if the return falls below expectations or turns negative, the potential to impact overall value and shareholders’ funds increases.
Cash and LOCs Corporate bonds Government bonds*
Alternative investments Equities
* Includes supra nationals and government agencies Source: Lloyd’s, Aon Benfield Market Analysis
Fixed income—government* Fixed income—corporate Global equity Hedge funds Cash
Emerging markets & high-yield bonds Property equity Emerging equity
INVESTMENT GEARING
TOTAL INVESTMENT ASSETS RATIO OF INVESTMENT TO NET TANGIBLE ASSETS
Chaucer Catlin Hiscox Amlin
Beazley
1,455 5,214 2,780 4,325 2,497
4.6 2.9 2.3 2.8 4.0
40 | INTELLIGENT INSURER | September 2011
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