Follow the money: a look at how U.S. life/health insurers' investment strategies have fared since 1995.
Underwriting cycles roil P/C financial performance with discontinuities in premium rates, terms and conditions, revenues and underwriting results. By contrast, developments in L/H tend to be secular and gradual. Some have compared life insurers' financial results with grass growing. Examining investment practices for the past 11 years, however, shows changes in several areas, including some that are contrary to popular assumptions.
Except as otherwise indicated, all data is from Best's Financial Statement Product, as A.M. Best has published it for calendar years 1995 through 2005. All figures are for the total L/H industry. Some charts display shorter time periods, which reflect changes in statutory reporting and classifications and, therefore, the data A.M. Best can capture.
All financial enterprises have operated in a difficult investment environment for several years. As Chart 1 indicates, interest rates were at year-end 2005 near 40-year lows. Yield on 10-year constant maturity Treasuries at June 30, 2005, was 4.0%, a level last common under former President Eisenhower. It has climbed since then, but remains close to that level. In an ill-timed coincidence, total returns from public equities have recovered from losses in 2001-2003, but continue to be constrained.
Continued gradual increases in interest rates would be welcome and support reinvestment at higher yields without abruptly decreasing bond valuations and the consequent deterioration in Generally Accepted Accounting Principles (GAAP) surplus. Conviction that rates will continue to increase (along with uncertainty about how quickly) has piqued insurers' interest in structured securities that preserve value and diversify risk.
Chart 2 looks at the primary elements of L/H financial results. Assessing performance by net operating gain before net investment income is common in assessing P/C, but not L/H. The National Association of Insurance Commissioners' form for L/H Summary of Operations includes Net Investment Income in Underwriting Results, but not in the Statement of Income for P/C insurers. The point is, simply, to highlight the centrality to L/H financial performance of investment income, which tends to receive slight attention in securities and ratings analysts' discussion of insurer valuations.
Barring a problem, analysts tend to view investments as a commodity, and yields and returns as a given. Often heard is the idea that, if one wished to invest in investments, it would be into a hedge or mutual fund. Remarkably, all insurers are profitable only from investments, begging the question why investors fail to attribute much if any premium to investment expertise.
Since 1996, L/H investments have accumulated consistently. Chart 3 shows that Cash + Short Term has been essentially constant by dollar amount, occupying therefore a gradually diminishing share of total invested assets.
As a first look into the investment portfolio, Chart 4 displays the gradually increasing concentration in fixed income. Despite declining interest rates (and with the sum of bonds, mortgages and cash having increased consistently), the industry appears not to have reached for returns by moving into nominally riskier asset classes.
Doing so would have been a rational move to support pricing assumptions for life products. Over the past several years insurers have expressed increasing interest in alternative investment classes (such as hedge funds and owned real estate). Nonetheless, an increasing portion of new funds has gone into bonds. Investment portfolios look much as they did 10 years ago, probably a reassurance to policyholders if not to stockholders.
A closer look (Chart 5) reinforces this, with declining allocations to common stock and real estate, balancing a slight increase in Schedule BA (other long-term invested assets) investments. Deutsche Asset Management's experience is that interest in alternative investments has increased considerably, though actual investment activity has yet to keep pace.
If insurers are not moving into alternatives in search of returns, a related question is whether they have, instead, accepted increased risk in their bond portfolios. Perhaps unexpectedly, however, credit quality has actuary increased since 2001. Since then, allocation to the NAIC's Securities Valuation Office Class 1 has increased, that to Class 2 has decreased, with essentially no change in lower rated securities. A countervailing trend has been, however, a gradual decline in allocations to Treasuries. (Chart 6) This suggests the industry has migrated toward higher yielding of similarly rated securities, such as corporates and asset backed securities. If rating agencies are on top of things, however, this has been a wash as far as credit quality is concerned.
Taking a different perspective, Weighted Average Bond Ratings have decreased slightly, to levels last seen in the late 1990s. Publicly traded securities have dipped more than privates. It is curious that ratings peaked around 2003, about the time of the nadir of equity prices. (Chart 7)
Another dimension for assessing fixed income risk is duration. Statutory reporting does not, unfortunately, capture duration, though it does disclose bond maturities. Changes in distribution (Chart 8) were:
1 year or less flat 1-5 years up 5-10 years up noticeably 10-20 years down slightly >20 years up
By itself, this is uninformative.
Chart 9 suggests weighted average maturities have lengthened slightly since 2002, from 8.7 to 8.9 years, bringing weighted average maturities to about as high as since 1995. Life insurers maintain they invest to match their insurance liabilities. Product mix unlikely changes sufficiently, however, year over year to drive these changes. They may instead reflect an attempt over the past few years to maintain yields in the face of the lingering trough in interest rates.
Riskier and less liquid investments as a percentage of adjusted surplus (surplus plus asset valuation reserve and interest maintenance reserve) is a simple measure of investment risk that rating agencies follow closely. Consistent with earlier comments on the general reduction in risk of the industry's balance sheet, Chart 10 indicates these percentages have been flat to declining, with the exception of that for Schedule BA. A related ratio is the relationship between total investments and adjusted surplus. That figure has also declined, by 6% over the past two years.
Altogether, this is an unexpected profile and contradicts conversation that insurers are accepting increased risk in pursuit of returns.
Chart 11 outlines changes in the ratio (not simply the ratio) of investments to adjusted capital. In the early 2000s, substantial changes in equity valuations (though equities were a minor allocation) may help explain the change.
L/H insurers' risks (and therefore policyholders' and, to a lesser extent, stockholders') vary with the relative proportion of investment exposure borne by insurers and clients. The general trend, not surprisingly, has been a migration from general to separate account. (Chart 12)A pick-up at year-end 2002 likely reflects the decline in equity prices and policyholders' consequent attempt to push back investment risk to their insurers through a shift to guaranteed and fixed contracts.
As expected, yields on bonds and mortgages declined over the covered period. Yield (dividends) on common stocks also increased slightly, possibly reflecting a decline in book value of stocks, which statutory accounting carries at market value. Apart from real estate, yield on Schedule BA investments has been the most erratic. Real estate yields were distorted from exceptional figures from the Metropolitan Life Insurance Co., which had produced as much as 58% of real estate yield among the five largest life insurers. (Chart 13)
Despite the decline in bond yield, the proportion of investment income from bonds has actually materially increased. Income from "Other" has remained low, as "Other" investments generally seek capital gains, not income. (Chart 14)Again, the picture suggests increasing conservatism, contrary to a shared perception of increased risk in search of returns and insurers' interest in alternatives in search of them.
As expected, investment yields and returns have declined since the 1990s. (Chart 15) The trough for total returns likely reflects the reversal in equity prices. Barring that, the decline in both has been consistent and smooth. This is not surprising, given the high proportion of bond investments, proportion of fixed income returns that derive from investment income and, finally, continuing low interest rates.
Investment expense ratios have declined, likely reflecting a combination of insurers' well publicized drive for efficiency, along with the scalability of investment operations. "Investment Expenses" comprises the direct cost of managing investments. "Total Investment Expenses" adds the expense of carrying investments, such as depreciation on real estate. (Chart 16)
Owned real estate has long been an investment specialty of life insurers. For instance, Connecticut General Life (a predecessor to Cigna) was a significant investor and participant in the development of Columbia, Md., a premier planned community. Over the past five years, life insurers have continued to invest in real estate but have divested more than acquired. Real estate sales have been a consistent, if not significant, source of realized gains. (Chart 17)
Real estate in all forms has in fact increased with the growth of the market for mortgage-backed securities and commercial mortgage-backed securities. (Chart 18) MBS look to the residential real-estate market, which is generally less cyclical than the market for commercial real estate. CMBS performance looks to the principal and interest that corporate borrowers pay. Regardless of payment dynamics, insurers have expanded their participation in real estate financing, whether through ownership or debt.
Investments outside the United States have accumulated steadily. At year-end 2005, international investments were 98% bonds and 2% common stock, which (according to Schedule D--Summary by Country) exclude investments in affiliates. (Chart 19)
Committee on Uniform Securities Identification Procedures (CUSIP) inventories permit identifying foreign investments by country. A question beyond the scope of this article is the extent to which these investments are held to fund insurance liabilities in the same currency, versus serving as diversifying investment vehicles. For example, 78% of Aflac's bonds and preferred stock at year-end 2005 were of issuers outside the United States or Canada and likely funds Yen-denominated liabilities of its Japanese branch. A portion might also, however, reflect investment strategy of an enterprise with the expertise to consider foreign investments on their own merits.
Statutory reports disclose the share of insurance premiums produced outside the United States, though not the currencies in which they are denominated. Consequently, we cannot match foreign investments with insurance liabilities in corresponding currencies. Still, anecdotal evidence suggests U.S. insurers are increasingly active in international sectors for returns and diversification.
Siren songs of extraordinary returns make "Other" investments interesting to many financial investors. A.M. Best can now provide Schedule BA data, which Chart 20 presents at year-end 2005. Oil and gas comprises the largest share, followed by Transportation Equipment. Given the increase in energy prices and concerns over supply, oil and gas is a logical diversification. Life insurers have, however, long been active in the area, suggesting these positions predate recent activity in such commodities. Similarly, transportation is another long standing class of investment, dating to the 19th century.
The NAIC has recently increased the requirements for Schedule BA disclosure, so it will be possible to track changes among categories of BA investments. Hedge funds have attracted interest across institutional investors. Still, there is no category that separates them from, for instance, private equity funds and their potentially radically different performance characteristics.
Realized capital gains have been, as expected, erratic. (Chart 21) Ratings and securities analysts react by assigning greater value to recurring investment income than to capital gains. Declining interest rates generated substantial realized gains from bonds in 2003 and 2004. By contrast, the reassertion of increased interest rates lay behind realized capital losses in bonds in 2005 and will likely recur in 2006.
U.S. life insurers invest mostly in fixed income and generally look for income--not returns--which reliably funds policy benefits and expenses. Given the proportion of fixed income returns that reflects yield, not price return, it is unsurprising most returns comprise yield (Chart 22).
Derivatives play a smaller role in portfolios for insurers than for other institutions, reflecting restrictions on their use. (Chart 23) U.S. states generally permit insurers to use derivatives only for hedging investment and insurance exposures.
Statutory returns do not separate the use of derivatives for hedging investments versus insurance liabilities (such as guarantees under variable policies). The significant increase in derivatives lagged the decline in equity prices and preceded the limited increases in interest rates, suggesting their primary role was to hedge guaranteed liabilities under variable policies.
Betraying suspicion, life/health insurers seem to have resisted the temptation to increase returns at the expense of risk. Maturities, credit quality and asset allocations all remained constant to more conservative. Observers may well conclude management chose policyholders over stockholders. Another article might examine how this affected insurers' cost of capital.
* Since 1995, life/health insurers' net investment income has increased steadily.
* Conviction that interest rates will continue to increase has piqued insurers' interest in structured securities that preserve value and diversify risk.
* Life/health insurers seem to have resisted the temptation to increase returns at the expense of risk.
Contributor Richard Major is director and insurance strategist with Global Insurance Asset Management, Deutsche Bank, Philadelphia. He can be reached at email@example.com. Text and data analysis provided by Major
Chart 20 Schedule BA Investments ($ Millions) Other 3.0 JV/LLP/LLC * like Common Stock 2.4 JV/LLP/LLC * like Fixed Income 4.3 Fixed/Variable like other Fixed Income 5.9 Fixed/Variable like Mortgages 9.0 Fixed/Variable like Common Stock 13.0 Mineral Rights 20.8 Transportation Equipment 22.6 Oil and gas 27.2 Note: Table made from bar graph. * Joint Venture/Limited Liability Partnership/Limited Liability Corporation.
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|Title Annotation:||Reinsurance/Capital Markets: Life/Health Investments|
|Comment:||Follow the money: a look at how U.S. life/health insurers' investment strategies have fared since 1995.(Reinsurance/Capital Markets: Life/Health Investments)|
|Date:||Oct 1, 2006|
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