May 1, 2003 by Craig Harris
Of the three main levers insurance companies can use to generate profits – underwriting, claims and investments – the latter is often the least discussed and most misunderstood. Needless to say, insurers prefer not to air “dirty laundry” about how exposed their portfolios were to, say, Nortel or Enron or the so-called “dot.com companies”. Nor have most insurers marked their equity investments at what accountants now call “fair value”.
While individual company details are sometimes elusive, the broader investment picture for property and casualty insurance companies shows an industry sheltered in part from the difficult bear market. Of the Canadian industry’s investment holdings, about 75%, amounting to roughly $27 billion, is invested in bonds with the remaining amount of $9 billion held in equities.
The ratio roughly holds true for North America, with about two-thirds of the U.S. p&c industry’s investment portfolio held in bonds. In Europe, the parent company home of many branch operations in Canada, multi-line insurers have taken a more aggressive position on equities. As such, some commentators call the North American insurance investment strategy “boring” and “unadventurous,” but it has been prudent in recent times. Bonds have been by far the best performing asset class over the past three years in terms of returns. “The nature of the business we are in shapes the industry’s investment philosophy,” says Dr. Robert Hartwig, senior vice president and chief economist of the U.S.-based Insurance Information Institute (III). “Catastrophic events like 9/11 and Hurricane Andrew show that investments need to be highly liquid and conservative, often in the form of government bonds and blue-chip stocks.”
GOOD “OLD DAYS”
In the Canadian insurance environment, there is little in the way of complex asset/liability management issues or sophisticated hedging instruments, such as derivatives – which legendary investor Warren Buffett recently coined “financial weapons of mass destruction”. But, there is a pattern of change in investment strategies among some insurers.
Since 1992, when regulatory changes in Canada gave insurers more flexibility in their investment portfolios, some companies staked out bigger positions in equities. As a result, they benefited from the enormous surge in equity markets over the late 1990s. However, these same companies are now facing unrealized gains and investment write-downs for non-performing stocks and holdings. In fact, in 2002 all asset classes under-performed relative to their historical returns, especially common stocks. From 1997 to 2001, the industry’s portfolio of common stocks produced an annual return of 15.9%, including the best-ever annual return of more than 25% in 2000. In 2002, common stocks produced a loss of about 2.1%.
Paul Kovacs, the chief economist at the Insurance Bureau of Canada (IBC), notes that, had the portfolio of common stocks held by insurers even produced an “average return” for 2002 based on recent years’ performance, then the industry’s before tax income would have been about $750 million higher than current figures – thus increasing the return on equity (ROE) of companies by one to two percentage points.
The same holds true for bond yields. From 1997 to 2001, bond portfolios yielded a return of 7.2%. In 2002, bonds provided an average annual return of 6.4%. Kovacs says, “while this decline may seem minor, the drop had a major impact on the industry’s pre-tax profitability. If returns from the bond market had maintained their historical average, the industry’s pre-tax profits for 2002 would have been approximately $250 million higher.”
All this may seem like “would’ve, could’ve and should’ve” for an industry that clearly needs stronger profitability numbers. Interest rates are at 20-year lows, affecting returns from the most sizeable portion of insurer investments: bond yields.
There is little left in the kitty after operating expenses to “subsidize” the true cost of insurance. Underwriting and claims must figure into any discussion of ROE, but the investment climate has changed considerably in the past two years – a fact obvious to anyone who has opened a mutual fund statement recently.
For insurers, that climate may become even more difficult in the short-term, for several reasons. First, the Canadian Institute of Chartered Accountants (CICA) is pushing for a harmonized approach to accounting for investments. The new standards, which will likely be in place next year, propose that equity investments, such as common shares, and other financial instruments like derivatives be recognized and measured at “fair value,” or current market value. The standards also specify when gains and losses as a result of changes in equity values are to be recognized in financial statements. “What we are doing is attempting to bring about more transparent financial reporting,” says Paul Cherry, chair of the CICA’s “accounting standards board”.
These new standards will clearly affect insurers with significant equity investments. In some cases, companies have already moved to write-down certain holdings. Wawanesa Insurance Co., for example, wrote-down 25 securities and two mutual funds to market value at end December 2002 for a total charge of $77 million. Unrealized gains (losses) for Wawanesa amounted to $112 million. Notably, the company reported a net loss in 2002, its first since 1974.
Wawanesa president Gregg Hanson remarked on the “significant write-downs in our equity portfolio” in a commentary to the company’s annual report. “We performed an assessment of the appropriate carrying value of all our investments and considered all securities held where the book value was in excess of the market value, and where we believed the investments were other than temporarily impaired. This action on our part underlines our view of the current state of the capital markets. We do not believe that the ‘bear market’ will be ending any time soon and thus have chosen a prudent approach.”
On the flip side, Fairfax Financial Holdings, one of the biggest names in publicly traded insurance entities in Canada, showed the benefits of retreating into bonds. As of late last year, Fairfax had just 7% of its portfolio in stocks. Chairman Prem Watsa, the closest Canadian equivalent to Warren Buffett among investment watchers, has been bearish on equities since the late 1990s. He invested heavily in bonds and used several “puts” or “shorts” to hedge against poor returns in various indices, including the S&P 500 composite index. In 2002, that strategy paid off for Fairfax’s investment portfolio, achieving a total return of 11% and realized gains of $738 million.
The second reason for investment concerns for the insurance industry is the new minimum capital test (MCT), introduced by the Office of Superintendent of Financial Institutions (OSFI) in January of this year. The new test, which replaces the minimum asset test (MAT), measures both the risk profile of the insurance company (i.e. what kind of business it writes) and the risk weighting of its investment holdings. As Kovacs notes, “the test came in during a difficult period. There has been lots of discussion around it, particularly at the beginning of this year. Some companies have benefited, while others have not.”
Bruce Thompson, director of the financial institutions group for OSFI, says “some insurance companies have altered their portfolios to better meet capital requirements. There has been a further move away from equities into bonds.” But he also notes that, “OSFI does not monitor insurance investment policies on a prescriptive basis. There is something called the ‘prudent person’ rule, whereby a company’s investment strategy should reflect its risk profile.”
Thompson adds that two consecutive years of poor investment returns have caused some capital-related concerns at OSFI. “The short answer is that yes, we are concerned about capital levels in the insurance industry. But we look at this on a company-by-company basis. We monitor by individual company and the
re are some we require to submit detailed financial statements on a monthly basis.”
Hartwig echoes similar comments about capital levels, or policyholder surplus, in the U.S. market. “Are regulators concerned about dangerously low capital levels in the p&c insurance industry? No. But there are ‘spot concerns’ about capital among particular companies.”
And then there is “discounting of future liabilities”, which may throw another question mark into the investment equation for insurance companies. Discounting, which came into effect this year, essentially allows insurance companies to use projected rates of return on their investments to match future liabilities. It takes into account the fact that a company’s future investment portfolio will likely be worth more than what exists on its books today.
While actuaries in Canada first proposed using discounting practices, insurance companies were not convinced they wanted it. OSFI decided to introduce it, making Canada different from most other countries in its insurance accounting methods. It has been in practice for several years, but now discounting must be “embedded” in a company’s financial statements, not reported to regulators in a separate summary.
The key issue will be arriving at the “right” projected rates of return on investments. Will insurers shift investment portfolios to use more advantageous projections against future liabilities? “That is highly unlikely,” says Kovacs, who adds that most companies use stable investment instruments, such as bonds, for future projections. “This hasn’t caused a great deal of discussion among insurance companies,” he adds. Nevertheless, OSFI’s Thompson says the regulator will watch carefully what kind of projected rates of return are used for discounting and “intervene where necessary”.
Investment trends seem to vary by geography. While North American insurers are conservative, their counterparts in Europe have tended to be much more aggressive in terms of equity holdings. They have correspondingly taken a bigger hit in the bear market.
To compound the problem, several multi-line European insurers have cross holdings in other industries. In some cases, insurance investment portfolios had significant financial holdings in particular sectors, such as banking and airlines. This elevated their exposure to the stock market slide, and to catastrophic events like 9/11.
The Geneva Association, a European research group composed of top insurance CEOs, noted in a recent report that, “September 11 has revealed there is a stronger correlation between underwriting and investment risks than previously assumed. The investment risk absorption capacity is diminished.” The report went on to state “the problems in the insurance sector currently center principally on the behaviour of the stock markets, with the biggest risk being a further slump in stock market values [apart, of course, from renewed terrorist attacks].”
Future developments in investment income are also closely linked to the performance of the economy, especially the North American economy for Canadian insurers. In essence, there are two cycles at work – the insurance and general business cycle – and the two do not always correspond. There are some anomalies in North America, with a weak U.S. economy but a relatively buoyant Canadian economy. Equity markets have been stressed in both countries, while interest rates have remained low, only creeping up marginally in the past six months.
Kovacs sees some optimism in the fact that equity markets are “flattening out”. He adds that, “although they are just barely moving up or even moving sideways, at least they are not going down. We really need to get the stock markets going.” Hartwig’s notion of future investment returns is “shaped by a few basic expectations. First, the U.S. will have a colossal budget deficit this year and many economists believe there is a clear link between that and an eventual rise in interest rates. Second, an improving U.S. economy could also add pressure to increase interest rates. And, third, I expect improvement in overall stock market returns – by that I mean actual positive returns in the modest single digit range.”
Predictions on the economy, stock markets or interest rates usually amount to sheer speculation. This applies particularly to insurers, who generally realize that tighter underwriting, proper pricing and claims cost control are more likely to be the keys to future profitability. For the insurance industry, however, one thing is clear: the traditional pattern of relying on investment returns to subsidize the cost of insurance has been broken.