For many decades there was little reason to question the supposition that insurers could reliably transmute premium dollars into a profitable stream of investment income. Then came the financial crisis of 2008 that overturned many long-standing nostrums (efficient-market hypothesis, anyone?) and created a wave of economic and political uncertainty from which insurers are still struggling to cope.
While most insurance industry investment portfolios have rebounded in tandem with the burgeoning equity markets, it is unclear when the industry will be able to generate the levels of returns seen prior to the crisis. Moreover, given what we now know about the volatility of global finance, whether the improvement in the insurance industry's capital position is qualitative or merely quantitative, remains to be seen. Today's safe bet may well be tomorrow's toxic asset.
In addition to the direct impacts of the crisis, insurance investment managers must contend with a bevy of actions by legislators and regulators intended to remedy or ameliorate it. It is still too early to judge the impact of the Dodd-Frank Act (DFA), which was enacted to mitigate risk and create transparency in the financial markets. Although aimed at reigning in excesses elsewhere in the financial services sector, some fear the law may unintentionally complicate insurers' efforts to hedge risk by restricting access to credit.
QUANTIFIABLE UNEASE
If the hotly debated DFA received a great deal of attention for its long-term implications to the insurance industry, a more immediate impact has been felt stemming from the quasi-governmental Federal Reserve. Insurance investment managers are looking on with trepidation as the Fed's second round of quantitative easing, widely known as QE2, comes to an end in June.
Envisioned as a way to stimulate the economy and push down long-term interest rates, many harbor concerns about the $600 billion bond buying program's potential impact on the devaluation of the U.S. dollar. Coupled with the concerns surrounding the end of QE2, with rising oil and commodity prices and the ongoing sovereign debt crises in EU countries, you have a potent formula for financial risk. "There's a lot of dry wood in the forest-all we need is a match to light it," says Michael Mata, of head of global macro strategy for fixed income at ING.
Mata maintains that there already was a good amount of negative sentiment toward the dollar prior to QE2, as it has been losing ground to European and emerging market currencies. Indeed, the 2010 Emerging Risks Survey by the Society of Actuaries found that 49 % of corporate risk managers say the fall in value of the U.S. dollar is the top emerging risk that will have the greatest impact over the next few years. "The dollar has been depreciating steadily since QE2 started," Mata says. "QE2 was a fairly risky move from a Fed Chairman who is supposed to be protector of the world's reserve currency."
Moreover, the massive amount of money the Fed created to purchase the treasury bonds has stoked fears of inflation. While Federal Reserve Chairman Ben Bernanke is widely perceived as reluctant to raise interest rates in order to avoid dampening the tenuous economic expansion, Mata says Bernanke may have to strike a more hawkish stance on inflation to mollify the stock market. "If there's a perception that inflation is getting out of control, and that the Fed is not being responsive to it, you could see a fairly ugly unwinding in the market."
One camp of economists contends that higher rates within reason (4 - 4.25) would not be that much of a drag on the economy, while the other posits that anything above that is a psychological hurdle and would slow down the economy along with higher gas and food prices. Mata says the U.S. economy is now less sensitive to interest rate swings because the housing bubble has burst, and now accounts for a smaller percentage of GDP.
Bernanke's interest rate quandary is especially germane to life insurers, given their long reliance on interest rate-sensitive products such as fixed annuities. The persistence of the current low rate environment already has engendered problems for portfolio managers in the life insurance industry, who must be cognizant of the increasingly robust competition they face from other financial institutions for baby boomers' retirement savings funds.
"For the past few years we've had extremely low rates, and insurance companies have struggled with that," says Marc Altschull, vice-chairperson, investment section council, Society of Actuaries. "You offer guarantees to your customers but you are having a hard time making enough investment income to cover the promises you made when you priced those products."
Nonetheless, a rapid rise in rates would usher in a new set of challenges. Altschull says to hedge against higher rates, investment managers should consider adding more floating rate bonds to their portfolios in anticipation of rising rates.
FINANCIAL RISK MANAGEMENT
So how well prepared are insurers to deal with this bevy of challenges from a financial risk management perspective?
Altschull says one of the few mitigating factors of the financial crisis is that risk management is more integrated into the investment process at insurance companies.
"The events of 2008 woke everybody up," he says. "Many companies retrenched, and we are seeing a lot more focus on risk management. You are seeing insurers build out their risk management staffs."
While one option for insurers is to entrust management of some of their assets to third-party investment managers, many choose to reinvest in technology to better manage assets and gain an overarching view of compliance, risk and financial performance.
Courtlandt Gates, CEO of Boise, Idaho-based Clearwater Analytics, says the company is seeing increased demand for its products from insurance companies anxious about their exposures to economic events. "Recently we're seeing a significant percentage of our growth coming from the insurance vertical," he says. "With regard to the actual technology itself, the majority of our resources right now are going into functionality for that vertical, just making sure that we have the scalable architecture and code to meet the needs of our insurance clients."
Gates says despite the fact that the worst of the financial crisis is receding from the minds of the general public, the need for vigilance among financial managers is as keen as ever. "Given the ongoing turmoil in the financial markets, I think there's an increasing need among insurers to really understand the assets that they hold that are so important for meeting their business objectives."
Mata agrees that the overall risk culture in the industry has improved in the wake of the crisis, but does express concern that some tools in the financial portfolio managers' toolbox are beginning to show their age. "It has been somewhat disappointing to me that there hasn't been much new math employed by the major software vendors," he says. "It's really just the same old models and frameworks that were developed in the 1970s. We now know that the financial markets don't always work in the manner described in these models."
Equity Rebound Buoys Insurance Investment Income
Property/casualty investment portfolio managers face the same array of challenges as their peers in the life insurance industry. Numbers released in January by the Property Casualty Insurers Association of America (PCI) and Jersey City, N.J.-based ISO Inc. revealed that insurers have been able to purge their portfolios of underperforming assets and capitalize on Wall Street's ongoing upswing.
"Insurers' overall capital gains for nine-months in 2010 reflect developments in financial markets," says PCI's David Sampson. "The S&P 500 rose 2.3% from year-end 2009 to Sept. 30, 2010, the Dow Jones Industrial Average increased 3.5%, and the NASDAQ composite climbed 4.4%. Insurers' investment results also benefited from a decline in realized capital losses on impaired investments, which dropped to $3.1 billion through nine-months 2010 from $13.6 billion through nine-months 2009."
