A.M. Best Special Report: Investment Management -- Risks Are Developing Beneath the Surface.

OLDWICK, N.J. -- On the surface, many of the fundamentals influencing the investment-management landscape within the insurance industry are showing signs of improvement after a historically turbulent period. Credit markets have improved. Equity markets have stabilized somewhat. The industry's investment portfolio in aggregate remains well diversified, and asset allocations are in line with traditional industry norms, according to the A.M. Best Co.

However, A.M. Best believes these results in aggregate are masking increasing risk within individual companies' investment portfolios. The continued downward pressure on investment yields, combined with the ongoing emergence of more complicated spread-based and equity-based products, are stretching the limits of traditional investment risk-management processes.

Over the past two years, the industry has been recovering slowly from the ill effects of low interest rates, volatile equity markets and a weakened corporate credit environment that prevailed from 2000 into early 2003. The macroeconomic environment continued to improve in 2004, particularly within the credit market; however, interest rates remain low, pressuring spreads and the equity markets remain somewhat volatile.

The realities of today's economic environment and the continued evolution of the industry's liability product mix are influencing investment strategies. However, if the characteristics of the aggregate industry portfolio are reviewed, not much has changed.

When looking beneath the surface at individual companies' portfolios, however, A.M. Best has observed a number of different strategies being employed by insurance companies to generate the yield needed to support their liabilities in the sustained low interest-rate environment. These strategies include: "waiting it out" by maintaining higher-than-normal cash and short-term balances; "going long" by extending the maturity of the fixed-income portfolio to reach for higher yields on longer-duration issues; "dropping down the credit ladder" and purchasing lower-credit-quality bonds with more credit risk but higher yields; or "searching the horizon for yield" by looking at alternative investments such as mortgage loans, private placement or convertible bonds, and even more esoteric classes such as hedge funds and private equities.

These various dynamics are placing increasing pressure on the traditional investment risk-management disciplines within the life industry and have brought about the need for a more thorough analysis of companies' overall investment and asset/liability management processes when assessing insurers' financial strength.

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A.M. Best Co., established in 1899, is the world's oldest and most authoritative insurance rating and information source. For more information, visit A.M. Best's Web site at http://www.ambest.com.