Property-catastrophe underwriters have the most clearly identified need to align their investment strategy with the potential for a severe loss of unpredictable timing, but there is also likely to be an element of catastrophe exposure that needs to be considered in the asset mix and duration of most non-life insurers.
Maddi Forrester, head of insurance asset management at Threadneedle Investments in London, explains: "All our insurance clients, who include Lloyd's syndicates, European insurance companies and captive insurers, will have an element of catastrophe risk in their portfolios."
She says that the catastrophe exposures have to be seen in the context of the whole portfolio. "The make up of any portfolio will depend on a number of things including the aims of the capital provider who is funding the business and their attitude to risk, as well as the nature of the liabilities, and expected cashflow. Catastrophe is an element that we need to consider with the client."
Catastrophe underwriters hold large amounts of capital to ensure their solvency in case of a major loss. Few of them are able to hold tax-free equalisation reserves. Assets also need to be sufficiently liquid that they do not have to make distress sales of securities when there is a loss, and they want to maximise their investment returns without adding too much risk through the asset portfolio.
These complex relationships are increasingly amenable to analysis. In the past, says Ugur Koyluoglu, a director of Mercer Oliver Wyman in New York, relationships across the balance sheet were not well considered and they were certainly not measured using the same yardstick. About five years ago, techniques developed to link aggregate risk profile to earnings volatility, capital needs and value created, known as dynamic financial analysis (DFA), asset liability modelling (ALM) or enterprise risk management systems such as economic capital and risk adjusted return on capital (RAROC).
Conceptual at the time, they are now in use in many insurance and reinsurance companies, says Mr Koyluoglu, who adds: "In more advanced implementations, senior managers use the output of such systems in limit setting, capital attribution, performance measurement, reinsurance purchase, asset allocation, communication with rating agencies and investors, and portfolio level optimisation."
Asset selection
Since the most critical aspects of asset selection to meet catastrophe losses are low volatility and high liquidity, property-catastrophe reinsurers like IPC Re and Renaissance Re, hold a high proportion of their assets in short dated, highly rated fixed income paper, such as AAA and AA rated US government and other sovereign debt. As a result, there is little or no correlation between their assets and liabilities.
For more diversified companies, Mr. Koyluoglu points out that many have some element of enterprise risk, often starting with the risk of accumulations across the balance sheet that does need to be managed. "For example, they are not only trying to avoid too much concentration on one industry sector in their liabilities, but also whether that extends to the asset side.
If an insurer underwrites a lot of airline business, for example, it doesn't want to find that it has too much in the way of aviation company bonds," he explains.
John Wheal, CFO of Bermuda property-catastrophe reinsurer IPC Re, sums up his company's philosophy: "Our whole investment strategy is based on the fact that given the risk that we are running on our underwriting, we don't want to augment it by adding risk on the asset side. Our first priority is preservation of value/capital. The second issue is that because we could be faced with needing to pay large amounts in relatively short periods of time, liquidity is very important. Therefore, we have a very conservative strategy aimed at reducing risk."
Being able to pay claims without having to make disadvantageous asset sales is an essential part of asset management for the catastrophe underwriter.
"Liquidity is critical," confirms Todd Fonner, Renaissance Re's vice president and treasurer.
For its first four years, John Wheal says, IPC Re used only fixed income securities, but actually found that there was more volatility than the investment committee had imagined. "We asked the asset manager to come up with a different allocation to reduce the volatility. They determined that adding some equities would do that and so today we have about 85% fixed income and 15% equities. The volatility deceased dramatically. The important thing is that both parts don't suffer at the same time."
At the end of 2003, IPC Re's investment portfolio consisted of nearly 40% corporate bonds, virtually all rated A or above, 20 % equities and the balance in government and government agency bonds.
Maddi Forrester appreciates clients' concern for liquidity in the face of a low probability, high severity event, but says that it is still possible to enhance returns. "We recommend that everyone has a proportion of liquid government instruments linked to their catastrophe exposures but there is a tendency to be over-cautious. You very rarely see even urgent claims without several weeks' notice. Most people do not need cash in less than seven days because of the logistics involved, and the difference between over-night money and seven days can be significant. It is partly about education."
Timing
Even once a loss event has occurred, the speed at which claims develop and have to be settled varies considerably with the event, its location and with distance in the reinsurance chain from the original insured.
The tables above taken from an extensive loss development study of the development of World Trade Center (WTC) and other catastrophic losses published by the Reinsurance Association of American (RAA) shows that the losses from four major hurricanes, including Hurricane Andrew in 1992, emerged more quickly than those from two California earthquakes, Loma Prieta in 1989 and Northridge in 1994.
Incurred losses for three of the hurricanes reached 90% of ultimate losses less than a year after the event, while for the Northridge earthquake it took two years and four years for Loma Prieta. Similar comparisons can be made for the payment patterns, the RAA says.
Two man-made events, the Los Angeles riots in 1992 and Oakland fires in 1991, both in California, showed comparatively rapid development patterns to hurricanes but the WTC property losses are taking somewhat more time to pay than expected, says John Whelan at IRP Re, which Todd Fonner confirms.
It may be partly because documentation was lost in the event or that business interruption claims are time consuming to adjust.
Property underwriters tend not to suffer the time bomb effect of long tail liability losses, as asbestos related claims, but they still need provisions for incurred but not reported (IBNR). Says John Whelan: "It's not as small as you might expect. Some lines like aviation are still there, and we still have IBNR for the Northridge earthquake in 1984. Many years after the event, the California courts decided to re-open claims so buildings could be updated to the latest building codes."
In case of a big loss in the United States, non-domestic reinsurers face an even more immediate pressure for liquidity - the US requirement that they collateralise 100% of their US claims reserves. It put great pressure on Lloyd's in the immediate aftermath of the September 11 attacks, and the US authorities had to allow the market to put up its collateral in two tranches. Bermuda companies are subject to the same requirement.
Alternative asset classes
The need for liquidity and short duration constrains investment returns in a low interest rate environment, so property underwriters have been looking at alternative asset classes as possible ways of enhancing those returns. At the end of 2003, Renaissance Re's portfolio was made up of:
- 21% short term securities
- 62% longer dated investment grade issues
- 11 % in domestic high yield and sovereign debt of emerging market borrowers
- 6% in alternative investments, principally a diversified portfolio of hedge funds.
The attraction of the alternatives is clear. The portfolio as a whole returned 6.2%, but of this the non-investment grade portfolio returned 28.2% and the alternative portfolio 17.4%. "We will certainly accept investment risk," says the annual report, "but we do seek to be adequately compensated for taking investment risk."
The use of notoriously volatile hedge funds may be a surprise, but if held in a fund of funds, they are seen as a way of enhancing returns for companies with large bond portfolios and stabilising results where there is a large equity element. A number of insurers and reinsurers are now using them. IPCRe, for example, has also invested modestly in hedge funds, putting $75,000 in the AIG Select Hedge Fund in January 2004.
Roger Boulton, senior investment consultant with Watson Wyatt in the UK, explains that held in a fund of funds, hedge funds have, in fact, been less volatile than equities, although they may not give the same return when equities are soaring. "They can be a stabilising influence when added to an insurer's current investment portfolio because they behave in a different way to equities and bonds. A meaningful allocation, say of around 5 %, in a fund of funds can usefully improve diversification."
Another type of alternative investment is asset backed securities (ABS), bonds that represent pools of loans of similar types, such as mortgages and car loans. They have grown dramatically as an asset class and offer an alternative investment to government paper for catastrophe underwriters.
Dennis Kraft, head of credit research at Conning Asset Management, says ABS are high quality investments that historically have provided excellent returns and that they add quality and diversity to core fixed income portfolios.
Catastrophe bonds are a form of asset backed securities, and so far this year, there have been at least four deals with a total value of about $650 million, according to ARTEMIS, the alternative risk transfer portal.
The catastrophe bond usually, but not always, has a parametric trigger, some measurable physical phenomenon, such as earthquake intensity or storm wind speed, which acts as a proxy for a certain level of traditional losses in an extreme event, explains David Bresch, head of atmospheric perils at Swiss Re. He says that it is now possible to model the payout pattern of as many as 500,000 randomly generated possible events to design the cat bond to best match the traditional portfolio and to more precisely assess the risk involved. It is also possible to model the probable loss potential of two catastrophic events in one year.
Although in 2003, Moodys reported a 50 % increase in the value of issued cat bonds, from about $1 billion to around $1.5 billion, there seems little evidence of their becoming a main stream asset class, even though there has yet to be a loss on any of the more than 40 cat bonds issued since 1996. The use of cat bonds, according to Mr Bresch, is more related to the cost of conventional reinsurance or retrocession than directly to interest rates, so evidence of falling property reinsurance rates suggests the issuance may even contract this year, especially since property catastrophe underwriters will be the beneficiaries of rising interest rates.
