Investment Intelligence - Bermuda
“Despite the difficult market conditions, Bermudian insurers have still produced positive investment returns.”
While at the time of writing full year figures were not yet available
for 2011, it is expected that returns will reflect these challenging times and are likely to be in the 1 to 3 percent range. Suddenly, the combined effect of benign investment markets and changing regulations will dramatically shift the focus of attention to the investment portfolio.
How can the current conservative investment strategy of most in
the Bermudian market yield a meaningful investment return that will meet shareholder and market expectations? Increasing allocations to alternative assets is one option but this can lead to short-term volatility that may have undesirable balance sheet implications.
Taking duration risk and moving down the credit curve can be
rewarding, if appropriately qualified investment managers are appointed. But the proposed Solvency II equivalence regime requires a much greater asset analysis than the BSCR regulation. Duration and credit risk require greater capital than the current rules and where there is insufficient transparency in the investment vehicle or instrument, the Solvency II regulation requires 49 percent of capital to be allocated—effectively ruling out many beneficial investment options (some of which are perceived as relatively low risk, eg, low volatility hedge funds). This compares to only 20 percent under the BSCR formula for Other Equity and Other Tangible Assets.
The use of an internal model for risk and capital calculation will
continue to allow some more sophisticated players to calibrate the underlying risks of the investment correctly and, as such, reflect a more appropriate capital weighting. However, this is on the assumption that the insurer’s fund manager is able and willing to divulge this information—many of the best third party investment managers will opt to maintain a degree of opacity to protect their intellectual property.
Even if the data are available, whether internally or from third party
managers, will they be in a Solvency II-friendly form that allows the Pillar 3 reporting requirements to be fulfilled easily, and who will consolidate the asset risk data across multiple investment managers? It is doubtful that the skills and knowledge exist today in insurance companies which have traditionally focused on liability modelling rather than asset modelling at the detailed security level and below.
For those who choose to remain tied to their conservative investment
approach, the data and reporting challenges are not hugely significant given that the majority of securities held will be relatively easy to price and value but, as suggested above, those assets may not return meaningful risk-adjusted returns relative to other, harder to value, securities. Another option could be using longer dated government
28 | INTELLIGENT INSURER | Spring 2012
debt and derivatives to hedge the duration risk which could prove a less onerous charge on capital than a commitment to corporate debt, but with an undesirable loss of investment income.
Many investors are already planning an increased allocation to
alternative assets such as real estate and absolute return strategies to enhance returns and take advantage of the diversification benefit that Solvency II offers, but investments here will raise the issue of look-through, transparency and data consolidation. The increased volatility and significant drawdowns seen in 2011 may also present a challenge in getting new investment ideas past traditionally conservative investment committees.
As mentioned above, the risk from more volatile assets must now
be fully reflected in the capital allocated to the investment portfolio under Solvency II.
While every Class 4 insurer is required to hold in excess of 120
percent of its enhanced capital requirement (ECR) / minimum solvency margin, the greater the surplus in the business, the greater the ability to take on board investment assets where the risk-adjusted return on capital (RAROC) invested is most attractive. Board level decisions on where to invest that surplus will become even more important if current market conditions prevail while Solvency II equivalence is being adopted.
In considering any new investment strategies, the board will have to
understand which asset class is the most effective vehicle to take that risk and will need to be convinced that they fully understand the asset risk the company is undertaking, and that the investment return on capital is worth the corresponding volatility and risk of loss.
But it is not only Solvency II equivalence which has to be factored
into the investment strategy. Changes in the type of business being underwritten in Bermuda could place further pressure on reporting
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