Where to turn: stocks, bonds, cash--no investment option seems certain for insurers these days.

Insurance companies are among the world's biggest and most influential investors, taking those tens of billions of dollars in premiums they collect and putting them to work in capital markets to earn a return before the dollars can escape as claims paid.

Historically, many insurers have enjoyed long periods of investment success--witness Berkshire Hathaway's Warren Buffett, the Sage of Omaha, whose legendary investment decisions were largely bankrolled by Berkshire's successful insurers and reinsurers.

Life insurance has essentially a long-term investment strategy, while property/casualty companies had been known in soft markets to cover underwriting losses with investment gains.

Then came the bursting of the dot.com bubble on Wall Street in 2000, followed by huge corporate scandals that brought down the likes of Enron, WorldCom and many others--and suddenly, stocks and certain bonds could no longer be relied upon to shore up an insurer's balance sheet.

Where does an insurer's investment strategist turn? Insurers began to dump the equities in their portfolios by the bucketful in 2000 and 2001, moving much of those assets into bonds. Then by 2002, the mammoth bankruptcies of Enron, WorldCom, Parmalat in Europe and others roiled the bond markets. At the same time, the freefall of the U.S. dollar against most other major currencies rocked cash positions.

But cooler heads have quietly pointed out that, no matter the current turmoil among strategists, investments are still an integral part of an insurer's risk management approach--something's got to be done with all that premium cash before it's lost to claims.

Balancing Act

The conundrum for property/casualty insurers was summed up well by Thomas S. Gayner, chief investment officer for Markel Corp., in a recent specialty insurance panel discussion hosted by investment banker Ferris Baker Watts. Gayner said that, in an uncertain investment environment, insurers have to keep in mind that there is an important interplay between the underwriting and the investment sides of the business. "I think the insurance business and the investment business are joined at the hip," he said. "The way in which disciplined people operate in both markets is the same, and from time to time, the investment and insurance markets move in the same direction."

But in many instances, when you look at the property/casualty insurance cycle historically, there is a counter-movement on the investment side. "For instance, I don't think it was any coincidence that during the 1990s, when we had the softest insurance market that we all lived through, it was a bull market in both the equity and the bond worlds," said Gayner. "As the investment returns were out there and easy for the picking, insurance markets got softer and softer."

Looking back into industry records, Gayner said that probably the best period for underwriting profitability was the 1930s, "which clearly weren't good times for the investment world."

"You had to keep underwriting profits up to keep the doors open," he said.

"Looking at those two extremes as a backdrop, I think it's reasonable to say that if you're going to have some predictions or top-down thoughts about the insurance cycle and where you are, it's important to have some context from the investment world."

Over the past five years, when leading equity indicators have been running in negative territory, the investment department was not going to make money, said Gayner. "The underwriting department is going to have to make money," he said.

"I don't think we can look at the stock market or bond market at any time and say clearly, this is overvalued and this is undervalued" said Gayner. "What we're doing is muddling through and correcting the financial excesses of the late 1990s. The implications for the insurance cycle is that we'll have a milder cycle. We're not going to have a real hard market like we had the last couple of years, but neither do I think the bottom is going to drop out, as in the 1990s, since the investment world isn't there to support that"

Modeling Allocation

John Robison, treasurer of property/casualty specialty underwriter RLI Corp., said his company has been moving away from what he calls a "simple investment allocation model," in which the company would allocate a certain percentage of its portfolio to bonds and to stocks. Instead, RLI is pursuing a dynamic financial analysis structure.

"That's where we review our investment risk in the context of our overall enterprise risk," he said.

Using dynamic financial analysis, the company looks at its underwriting, capital and investment structures in an effort to identify where risks may appear. "We determine what we call the optimal risk allocation, based on our risk tolerances and return objectives," said Robison.

Robison said dynamic financial analysis is a fairly new approach, which requires constant review and refinement, but "thus far we've been really pleased with it." The basic principles behind dynamic financial analysis go back a number of years, as insurers have always been interested in balancing their underwriting and investment risks, he said. In the past few years, new methods and products have been developed to make dynamic financial analysis a more sophisticated tool.

Based on this model, RLI has been adjusting its investment approach. Since 2000, the company has steadily reduced its exposure to equities, from about 40% five years ago to about 22% today, said Robison. "You don't want to maintain high-risk positions in both underwriting and investments at the same time," he said.

For a publicly traded company such as RLI, investment strategy is tested by the tug between regulatory requirements to protect policyholder interests and the desire to satisfy shareholders. "We take a long-term approach to our investment," said Robison. "We don't try to be market timers."

Robison added that RLI has avoided a trend among property/casualty companies to move into cash positions, which he said has hurt other companies in the short run. "If you think interest rates are going to move up relatively quickly, companies will hold cash and try to time the market as to when those rates go up," he said. "What I've found is that if you try to predict interest rates, you won't be very successful in investments over the long term."

Instead, RLI tries to match its assets with liabilities, invest at current rates and rely on its cash flow to react to a rising interest-rate environment, he said.

The goal is to tie investment strategies as closely as possible to underwriting strategies. "We'll look at the context of our underwriting risks, and what kind of capital we need to support those risks," said Robison. Whether premiums are growing or contracting, RLI's reinsurance position and the positions of its reinsurers, all add to the picture of RLI's liabilities, which then determines the matching asset position, and whether the company should take more or less risk on the investment side.

Recent regulatory changes, particularly the 2002 passage of the Sarbanes-Oxley Act, didn't have an appreciable impact on how RLI approaches its investment strategy in terms of risk assessment, but it did have an indirect effect, said Robison. "We like it in that the companies that we buy are complying with Sarbanes-Oxley," he said. "We think it may have enhanced investor confidence somewhat."

Constrained by regulatory requirements governing reserves and solvency, and buffeted by volatile risk factors, property/casualty insurers have more of a struggle to dovetail investment strategy with underwriting than life insurers, said Alan Levin, head of the insurance and reinsurance department at the law firm Edwards & Angell.

"Some of it is dictated by National Association of Insurance Commissioners' rules about accounting, and what baskets you can put your investments in," said Levin. "Certainly, P&C companies are struggling because of the poor performance of the market, which is not bolstering the underwriting."

Anemic investment performance is aggravated by a market with too much underwriting capacity, pressuring premium rates while the underwriting risks remain, he said.

"One of the market cycle trends right now is consolidation, meaning that if you have the assets you can dictate a lot of things," said Levin. "There is a fair amount of consolidation in both the life and property/casualty industries, and we'll see over our lifetimes if those consolidations pay off. But I'm somewhat skeptical of consolidating purely for asset management purposes and better returns."

Bond Performance

For life insurers, turmoil on the investment front has ruffled fewer feathers, given the long-term outlook that prevails in that segment, said Michael J. O'Connor, an actuary with consulting firm Tillinghast Towers-Perrin. Most life insurers have much of their investment positions in fixed-income instruments, such as bonds and mortgages, he said.

In 2001 and 2002, there were a number of distressed bonds that caused some credit losses for insurers, who had to sell some high-yield bonds in the wake of a wave of corporate failures. Since then, credit losses and defaults have "moderated pretty significantly" as part of a normal cycle of credit losses rising and receding, he said.

"The trend in interest rates in the last couple of years is that credit spreads have narrowed, so life insurers have had to react to that in terms of pricing their products, such as rates on fixed annuities," said O'Connor.

Over the past year and a half, yields on Treasury bonds have gone up somewhat for the short-term bonds, but remained moderate in the long term. Since life insurers tend to invest in bonds with five or six-year maturities, they haven't been affected much. "Life insurers haven't made many adjustments in the maturity length of their investments, because they tend to invest in securities with maturities roughly comparable to the length of their liabilities," said O'Connor.

Actions by the Federal Reserve in terms of raising or lowering interest rates affect life insurers indirectly in certain markets, such as bank channels. "If life insurers are selling products like annuities through banks, those banks have alternative investment products to sell," said O'Connor. "Bank certificates of deposit are off the short end of the yield curve, so if the short-term rates come up, the banks can offer more competitive short-term CDs."

Other than such changes in the short-term competitiveness of products, life insurers are more interested in implications for long-term investments, such as inflationary outlook or the outlook for corporate spreads, he said.

That long-term outlook keeps the investment strategies of life insurers "pretty consistent," said O'Connor.

Secondary Considerations

A challenge facing life insurers, accustomed as they have been to a long-term view, is growth in the secondary market of life products, said Levin. The life settlement business has affected life insurers because it affects lapse rates, which has an impact on pricing, he said.

One investment option that had fallen out of favor with many life insurers, but may be returning to favor through the current sustained period of low interest rates and equity prices, is real estate, said Levin. "As markets change and equities remain low, many companies have begun to look at real estate again, which they were heavily into and then out of in the 1980s and early 1990s," he said. "Private placements in real estate and those sorts of investments have become more favorable in the last few years."

Life insurers do tend to seek ways to diversify their investment portfolios, mainly with instruments such as corporate bonds, asset-backed securities and collateralized mortgage obligations, mortgage-backed securities and commercial mortgages. "Most life companies focus on those asset classes," said O'Connor.

With easier access to international markets, many of the larger life insurers have diversified their bond holdings over a greater number of regions or countries. "But even there, I believe a lot of those companies would buy dollar-denominated foreign investments," said O'Connor. "Some would buy foreign bonds in local currency, then evaluate whether they want to put it in their local currency."

Dollar-denominated foreign investments would neutralize the risk of exchange-rate fluctuations, he said.

On the property/casualty side, RLI's Robison considers interest-rate moves by the Fed to be "moderately important," in that RLI keeps tabs on the Fed's outlook for economic conditions. "But we won't make big bets based on our interest-rate assumptions," such as holding onto large amounts of cash for long periods of time, he said.

RLI will "make smaller bets," such as shortening its positions in certain bonds "without giving up too much yield," if the move makes sense within the company's overall DFA profile, he added.

Looking ahead, Levin said he doesn't see the NAIC or state regulators significantly changing accounting or solvency rules in such a way that would allow insurers--both life and property/casualty--to significantly alter their investment approaches. One trend he sees is "a whole market springing up offshore in derivatives and hedges" that compete with the reinsurance market.

Secondary-market investment tools such as derivatives and hedges are becoming more popular at the high end of the life market, said Levin. "I do see larger life insurers and wealth individuals trying to do sophisticated private-placement life insurance with hedges," he said. "But it seems that's a limited basket of high net worth individuals that insurers are going to sell to."

Such exotic playthings for the rich aside, the margin for error in the meat-and-potatoes business of blending sensible investments with appropriate underwriting risks has become slimmer on both sides of the ledger for insurers.

Key Points

* Stocks, bonds and cash have all shown increased volatility as investment positions for insurers over the past five years.

* Property/casualty insurers must more closely match their underwriting and investment strategies, as the margin for error in both areas has narrowed.

* Life insurers have seen increased pressure to adjust their product offerings in response to a more volatile investment climate.

Life Insurers' Separate Account Assets Flourished

The U.S. life insurance industry continued to recover in 2003 from the
effect of several adverse investment factors, including tow interest
rates, weak equity market returns, worsening corporate credit,
declining fee income and large investment losses.

Separate accounts are established to fund variable life insurance,
variable annuities, and modified guaranteed annuities and life
insurance. The separate accounts also may be used to fund guaranteed
benefits. As a result of the improving equity markets and higher
allocation to equities by policyholders total separate account assets
rose by 23% to more than $1.186 trillion.

2003 ($ millions)

Real Estate                       $20,203
Preferred Stock                   $29,319
Common Stock                      $64,186
Cash & short-term investments     $79,436
Contract Loans                   $106,249
Other Assets                     $188,966
Mortgages                        $261,072

Source: A.M. Best Statistical Study (Published 6/28/2004)

Stock Rally Boosted Property/Casualty Portfolios

The U.S. property/casualty insurance industry recorded a nearly 13%
increase in total admitted assets in 2003, Much of that gain can be
attributed to improved stock market performance that enriched insurers'
stock portfolios.

In addition, the value of cash and short-term investments increased by
more than 20% over the previous year, making it the greatest margin
increase among all asset categories.

The performance of common stock investments and cash and short-term
investments was not matched by similar trends in the nonaffiliated bond
category. Although the value of this asset class increased by
approximately 13%, the percent to total admitted assets remained
virtually flat compared with last year.

2003 ($ millions)

Mortgages & invested real estate     $3,755
Nonaffiliated preferred stocks       $9,205
Agents' balances collected          $38,533
Affiliated bonds & stocks           $51,739
Other investments assets            $52,962
Agents balances deferred            $67,546
Cash & short-term investment        $89,298
All other assets                    $91,891
Nonaffiliated common stocks         $126,560

Source: A.M. Best Statistical Study (Published 6/28/2004)

Learn More

RLI Corp. (Member of RLI Group) A.M. Best Co. #03883 Distribution: Branch offices, wholesale Brokers, independent agents

Markel Insurance Co. (Member of Markel Group) A.M. Best Co. #02699 Distribution: Wholesale brokers, surplus lines general agents

For ratings and other financial strength information about these companies, visit www.ambest.com.