Investing in knowledge

Insurers are embarking on such poor investment strategies that they may have insufficient assets to pay claims. This startling conclusion comes from a Watson Wyatt report, which identifies that insurers' investment strategies lack appropriate asset diversity and show poor liability-matching characteristics.

Roger Boulton, senior investment consultant at Watson Wyatt, expresses concern at how insurers lack the ability to apply an appropriate investment process.

"Given general insurers are experts in risk diversification as applied to insurance principles, it is somewhat surprising that this skill has not been widely applied to their investment decision making," he says.

The Watson Wyatt report Risk budgeting for insurers says that the confidence to deliver out-performance, after fees, of these companies in low-risk active management could be misplaced.

According to the report, a typical insurance company that invests in UK gilts with some equities may be taking relatively high risk given the expected level of return. This is because the gilts are often a poor match for liabilities, while the big bet on equities ignores the possibilities of other return-seeking assets.

This, says Boulton, is historic in how insurers have traditionally approached investment.

"Historically, there has been little emphasis on investment arrangements. However, increased market complexity, more holistic regulation and common sense are focusing more insurance minds on good risk taking.

"But many are still ignoring fundamental investment principles, such as taking risk only where it is rewarded, diversifying sources of risk as much as possible and, if risk must be taken, taking it only where expected return is highest."

The report says insurance companies are not considering all aspects of investment risk and as a result, may underperform competitors taking a more sophisticated approach.

The report identifies risk factors, such as peer group, financial strength, premium flexibility and liability risk and the benefits of risk budgeting for quantifying and dynamically managing them.

"Because insurers do not always have a full understanding of investment risk, some are missing the opportunity of improving their profitability because they do not have the best professional investment arrangements," says Boulton.

Double-digit returns
The irony is that insurance companies in the past have benefited from investment returns from the market without much effort and because their underwriting discipline hasn't always been what it should be.

But the heady days of double digit returns, achieved before the technology stock boom and bust in the late 1990s, is no longer promised in the current relative bearish market.

"Some Lloyd's businesses and some Bermuda insurers have professional investment strategies that boost their profitability, but there are many insurers who are not aware of the diverse range of investment opportunities.

"And surely insurers, as professional managers of liability risk, should be willing either to outsource or buy in expert investment resources?

"Then, whatever investment risk they choose to take, can be applied skilfully, for a higher return or at a lower risk, in the interests of all stakeholders," says Boulton.

The investment risks being taken by an insurance company go by many names - equity risk, duration risk, currency risk - but all form part of an overarching risk: the risk that the company has insufficient assets to pay claims due to adverse investment returns.

"This context suggests that, in the same way a UK equity manager would be benchmarked against the FTSE All Share Index, the company should benchmark its investments against the growth in a measure of its liabilities," says Boulton.

Therefore, the key decision to make before proceeding is how to measure these liabilities. Any such measure should capture all the important investment characteristics of the liabilities, including expected time until payment and sensitivity to inflation.

"Reported claims will typically be settled within a few years by a general insurer so therefore a portfolio of short duration fixed and inflation linked bonds has merits as a liability measure," says Boulton.

He notes that a lower risk budget improves the ability of an insurer to pay claims, but higher risk budgets offer the potential for higher expected returns and correspondingly lower premiums in the long term.

"This observation has, in the past, led to some insurers setting their investment risk subject to some overall limit."

Risk tolerance
Boulton continues: "Some simple metrics can be used to put the risk budget in the context of a company and so help to establish its risk tolerance. One example would be to compare the value at risk with annual premium income."

Insurance companies, like all institutional investors, have to decide whether to invest in UK equities, creating equity risk, or fixed interest gilts, creating inflation risk, or even employ high-risk investment managers.

"One way of aiding this decision is to break down the total risk budget between the different asset classes or investment managers in the same way that a business will allocate costs between its different divisions.

"Some basic principles of investment can then be applied in the quest for an efficient investment policy.

"By adapting the principles of risk management used in investment management the investor can then draw up a risk budget that will guide all the investment decisions in a consistent manner.

"The degree of risk to take is the most important investment decision an institutional investor has to take." IT

' For further information contact Roger Boulton or Andy Hunt on 01737 241144 or email roger.boulton@eu.watsonwyatt.com or andy.hunt@watsonwyatt.com

Three principles of investment
As a basis to identify investment risk senior investment consultant at Watson Wyatt, Roger Boulton sets out three investment principles.

Principle 1
Investors should diversify their sources of risk as much as possible.

"The reason for this is that the riskiness of investments is far more predictable than their returns.

"If an investor spends all his risk budget in one place, then there is a chance that it will not be rewarded. For example, equity investors have experienced considerable volatility over the last four years, but this risk has not been rewarded by the returns expected.

"By spending the risk budget in different places, some of these 'bets' should be rewarded at each time, for example, property, corporate bonds or hedge funds in recent years.

"A further observation to make is that, although risk is more stable than returns, market conditions can and do change, as we have seen in the last few years. For this reason we would, therefore, recommend that investors look to reassess their risk budgets on an annual basis," says Boulton.

Principle 2
Investors should only take risk where it is rewarded.

"This sounds as obvious as not buying a corporate bond yielding 4% per annum, when an equivalent government bond yields 4%.

"However, unless risk and return are considered in the right framework, it is often not clear how much risk or return an individual investment is contributing to the total," says Boulton.

Principle 3
If an investor must take a given amount of risk, then he should take it where the expected return is highest.

"All things being equal, an investor is looking to maximise his expected return for a given amount of risk. This objective can be fulfilled by maximising the expected return for each unit of risk spent.

"We can measure this by a simple ratio: the information ratio is a measure of the overall efficiency of a fund's investment arrangements."