Market Information Department
The Guy Carpenter Bermuda Composite‘s asset allocation did not change substantially from 2007 to 2008. An already conservative investment strategy left little room for more caution. Fixed income securities stayed at 75 percent from 2007 to 2008. Equity allocations were halved year-over-year, dropping from 4 percent of the aggregate portfolio in 2007 to 2 percent last year. Allocations to cash and short-term investments increased from 14 percent to 17 percent. While a “flight to quality” was not possible, a movement in that direction was discernable.
In the past, Bermuda-based carriers were able to anticipate a certain amount of insurance gains when setting return on equity (ROE) targets. These expectations will have to change this year — and for the foreseeable future. Underwriting will have to drive the growth strategy, as continued financial market volatility will frustrate efforts to supplement earnings with outsized investment returns.
Overall, asset allocations barely moved in 2008. Fixed income was and remains the predominant asset class for Bermuda Composite portfolios. The increase in cash and short-term investments came at the expense of equities and “other investments” — such as alternative portfolios — last year. However, this was a deliberate shift, as companies decided to keep more cash on hand given the volatility in financial markets and a lack of attractive investment returns. Equity allocations fell from 4 percent to 2 percent, and other investments accounted for only 6 percent of the Bermuda Composite’s aggregate portfolio last year, down from 7 percent in 2007.
While the changes to asset classes other than fixed income were drastic, they were small in the context of the USD141 billion in total investment assets held. The conservative investment strategy prevailing before the financial catastrophe of 2008 insulated the Bermuda Composite from the worst the market had to offer and consequently required little reason for drastic reallocations.
Nonetheless, Bermuda-based (re)insurers were not immune to the effects of financial market chaos last year. Aggregate realized and unrealized investment losses amounted to USD10 billion last year — compared to a more modest loss of USD248 million the year before. In 2008, this group of carriers lost 9 percent of its portfolio. Year-over-year, of course, this represents a profound change.
Yet, the situation is cast in a better light when compared to the broader market losses of 2008. The following chart shows how badly the equity markets were hit, especially during the fourth quarter.
The following chart shows the changes to the fixed income portfolio and equities during 2008. Realized and unrealized losses drove the change in each, although more pronounced for fixed income securities. The Bermuda Composite companies also disposed of these asset classes during the year, evidenced by a decline in net additions. The disposition of equities was nearly equal to the amount of capital losses, proving the earlier point of an allocation shift out of equities.
Inside the Fixed Income Portfolio
Like the broader Bermuda Composite portfolio, fixed income holdings did not change substantially from 2007 to 2008. More than half the companies’ aggregate portfolio in 2007 consisted of government and government agency bonds (U.S., foreign, and municipal).
Mortgage-backed securities (MBS) and asset-backed securities (ABS) constituted 40 percent of fixed income holdings in 2007 and 36 percent in 2008. Though the allocation fell year-over-year, four percentage points does not indicate a material change in investment strategy for the companies of the Bermuda Composite.
The slight change in MBS and ABS allocation was accompanied by a reduction in corporate bond holdings — from 31 percent in 2007 to 29 percent in 2008. These shifts were related to the financial market activity of last year. Though all asset classes were impacted severely, these two suffered most.
Traditionally safer fixed income securities, such as government-backed instruments, saw increases in allocation in 2008. Holdings in U.S. government and government agency (e.g., Treasury bills) bonds were increased from 14 percent to 17 percent, and municipal bond allocations grew from 6 percent to 7 percent. Bermuda-based carriers increased their allocations to foreign government bonds to 11 percent (from 9 percent in 2007).
The focus of the past year’s financial crisis has been on MBS and ABS related investments, since these were the most directly affected by the meltdown of the subprime mortgages. Even in this sub-category, as the above chart shows, the Bermuda Composite was relatively conservative with over half of the portfolio invested in agency MBS (e.g. Fannie Mae, Freddie Mac).
Investment Assets in 2009 and Beyond
Future changes to the Bermuda Composite’s portfolio are unlikely to be drastic, as the prevailing investment philosophy probably will not change. Continued turbulence in global credit and equity markets this year will underscore the need for cautious investments. Instead of pursuing outsized returns, Bermuda-based reinsurers will focus on preserving available capital (particularly given the cost to replace it) and turn their efforts to underwriting discipline.
The greatest impact of the financial crisis and its impact on investment returns will be for ROE targets. For the past five years, the companies in the Bermuda Composite have pursued ROEs of 15 percent. The five-year average (from 2004 to 2008) was only 8.7 percent, as a result of both catastrophe losses and the performance of investment assets. A mild catastrophe year in 2009 may alleviate some of the pressure, but only a broader stabilization of financial markets will make it possible for these carriers to attain aggressive ROE results.
The decline in ROE and volatility in financial markets will require a change in financial objectives for the near term, as lofty ROE targets will remain just that – lofty. Underwriting profitability will be the prevailing goal in 2009, with capital preservation the norm on the investment side. Limited capacity and an increase in the cost of capital will highlight the importance of effective risk selection and capital deployment, making modest ROE targets more appropriate this year.