Insurers Taking On Less Investment Risk

To assist our clients in understanding important emerging asset allocation trends, Brown Brothers Harriman conducts an Annual Insurance Asset Allocation Study that investigates and analyzes the investment trends of U.S. insurance companies over the prior five years, from 1998 to 2002. We analyze investment strategies separately for both property-casualty and life-health companies, grouping them by size, type and line of business. The asset allocation results are also weighted by market value, premium or leverage (surplus-to-total assets ratio).

The data for the current study are aggregated and analyzed from the National Association of Insurance Commission filings, as of May 2003. A summary of the findings for the p-c industry is presented below.

The year 2002 represents a marked shift in the investment philosophy for insurance industry as a whole. The current trends signal a reluctance to incorporate more credit and market risk, and a preference to invest in short-term paper while awaiting more attractive opportunities.

As seen in the Figure 1, after four years of steady increases in allocation to corporate bonds, investments to this sector stabilized after peaking at 22 percent of their portfolio (weighted by market value). Not surprisingly, the allocation to equities dropped for a fourth year in a row–down 25 percent last year (compared to a 23 percent drop in the S&P 500)–and is now at only 12 percent. Still, we find that those p-c insurers with larger books of business continue to hold twice as much in equities (27 percent in 2002, when weighted by premium) than companies writing smaller amounts of premium.

Meanwhile, despite the low interest rates, insurers have dramatically increased their holdings of cash, rising 50 percent last year to almost a tenth of their portfolio. Allocations to government bonds at 14 percent are higher than equities for the first time in five years, reflecting the defensive nature of the investments. With a robust growth in written premiums, allocations to municipal bonds are also on the increase, sheltering projected underwriting gains from increasing tax liabilities during more profitable years ahead.

Examining allocations by size of company, we find that small insurance companies–with less than $250 million in total net admitted assets–continue to invest more conservatively than their larger counterparts. They consistently held fewer equities and other alternative investments (such as mortgage loans and real estate), totaling less than 10 percent collectively. They prefer instead to invest in government bonds (23 percent in 2002) and have aggressively increased their allocation to cash to 15 percent, signifying higher liquidity requirements.

Next, we studied the impact that the type of company has on the choice of investment strategy. We divided all p-c insurance companies into stock, mutual, Lloyd's, reciprocal, risk retention group and U.S. branch groupings, and discovered that asset allocations do vary by type of company.

As expected, our study confirms that mutual companies tend to be the more aggressive investor, allocating twice as much to equities (25 percent in 2002) with only half as much cash (5 percent in 2002) compared to stock companies.

Stock companies exhibit investment patterns consistent with those of the industry as a whole.

Over the last five years, Lloyd's companies rapidly reduced their allocation to municipal bonds–from 48 percent in 1998 to 30 percent in 2002–and doubled their allocation to cash to 20 percent reflecting the turmoil within the industry. They also consistently held extremely low levels of equities amounting to less than one percent of their portfolio.

A grouping of the p-c insurance industry according to their lines of business revealed the impact company liabilities had on investment allocation decisions. A snapshot of year-end 2002 allocations, comparing equity and government bonds for the various lines of business, can be seen in Figure 2.

Homeowners, commercial multi-peril and reinsurance companies allocate a greater proportion to equities than the industry, exhibiting an ability to better withstand short-term volatility. On the other hand, commercial auto, private passenger auto and other liability lines hardly invest in equities. Instead they take a conservative stance and allocate their monies to government securities.

Fidelity-surety companies increased their allocation to municipal bonds by 50 percent over the last two years. Medical malpractice companies, on the other hand, faced with the strains of higher claim payments and a lack of quick legislative reform, decreased their allocation to municipal bonds steadily (28 percent in 2002).

In summary, the trend toward taking more investment risk–both credit and liquidity risk–came to an abrupt halt in 2002. And under the threat of a prospective rise in interest rates, insurance companies prefer to invest in short-term paper and wait for better investment opportunities ahead.

With premiums rising and an expectation of higher profits, we are seeing a clear trend towards an increased exposure to municipal bonds. And because of a strong showing in the equity market in the first half of 2003 and signs of a strengthening economy, insurers might also be tempted to invest more of their surplus in this asset class and ride the bull equity market.

Stay tuned to see how–or if–insurance companies alter their allocations further once the clouds clear over these unusual set of economic conditions.

An online version of the Annual Insurance Asset Allocation Study is available at http://snapshot.bbh.com/aastudy.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, July 21, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.