Investment Intelligence - Bermuda


BEWARE THE COST OF FUTURE RETURNS


The proposed implementation of Solvency II equivalence will force Bermudian insurers to be far more proactive in terms of how they analyse and forecast their investments, say John Townley and Matthew Hutchinson.


A


s Bermudian insurers prepare for the implementation of new regulations based on the proposed European Solvency II framework, it is timely to consider the implications for the


asset side of the balance sheet. While most insurers have sophisticated models with which to analyse and forecast their liabilities, such rigour has rarely been applied to insurers’ assets until the introduction of the Bermuda risk-based capital regime (Bermuda Solvency Capital Ratio—BSCR) in 2007-8.


The Solvency II rules will require an equally diligent assessment


of assets as well as liabilities and require an in-depth understanding of the risks in the asset portfolio both now and projected into the future—something that goes beyond the BSCR requirements.


Looking back at the success or failure of relative investment


strategies is not generally a great predictor of future risk and returns and to do so independently of liabilities is likely to be misleading. There are, however, clear indications that Bermuda’s insurers will face some genuine challenges under Solvency II equivalence, and failure to understand the risks associated with historic returns and an inability to forecast future asset risk effectively could lead to a competitive disadvantage.


The Bermudian insurance market is traditionally considered a


conservative investor with a short investment time horizon and cautious levels of risk assets. As shown in Chart 1, as of the end of 3Q2011, 88 percent of Bermuda’s insurance assets were in cash or fixed income instruments.


26 | INTELLIGENT INSURER | Spring 2012


CHART 1: INVESTMENT ALLOCATION IN THE BERMUDIAN MARKET (3Q2011)


FY 2010 Investment Allocation


Fixed Maturities 82% Equities 3%


Short-term investments 4% Other investments 4% Cash & Equivilants 7%


Source: A.M. Best Co. While this conservative asset allocation is predominantly liability-


driven, over the last 20 years asset-liability management (ALM) has generally been a rewarding investment approach. Government bonds have yielded relatively high rates of interest, cash rates have been high and declining bond yields have generated positive capital gains, producing a relatively high risk-adjusted return on investment.


These fruitful market conditions at low levels of risk created


an environment where investing heavily in asset risk systems and forecasting models was not a priority for most. The market turmoil of the last few years changed that as asset risk came to the top of the agenda of boards and senior management. Recent returns


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