Introduction to Investing in Insurance Risk

This article provides a brief overview of concepts that are fairly obvious to most professionals in the investment and insurance field but may be unfamiliar to other readers. In addition, insurance risk is
presented through an uncommon perspective that sheds light on its unique characteristics and corresponding investment considerations.

Investing in Risk

There are no truly riskless assets. We always invest in risk. We might do it
in the form of stocks, corporate bonds, real estate or treasuries, but ultimately
the investment performance of these securities is predicated on their
risks. We invest because we expect to earn a return commensurate with the
risk we take in investing. In fact, we want the return to be higher than what
the risk profile of an investment would imply.

Insurance Risk is good

It is too simplistic to say that “risk is bad”, and to think that it is something
we want to avoid or minimise. Investing is always about risk. In fact,
investors actively search for risk to invest in. As long as the compensation
for taking on the risk is appropriate, the investment usually makes sense.

A good investor is not the one who avoids risk; with excessive focus on
avoiding risk such an investor will also strip out his return. A good investor
is the one who invests in securities that together generate high risk-adjusted
return appropriate to the investor’s goals.

A good investor is certainly riskaverse, but only in the sense of not being willing to accept risk without proper compensation. As obvious as such statements may seem, the idea of
seeking risk makes some uncomfortable. An investor must recognise that
risk is good as long as it is the right kind of risk, the returns are commensurate
with it and the overall investment objectives are satisfied. The portfolio approach to investing is important to every investor.

A pension fund might have allocations to individual asset classes and benefit from the diversification it provides. The benefits of diversification explain why investments with low correlation to others are at a premium and being sought after. Certain types of insurance risk possess this desired quality of
having low correlation with other asset classes.

WHAT IS INSURANCE RISK

Insurance risk lacks a clear, unambiguous definition. It is generally defined
as the risk being taken on by insurance companies in selling insurance
protection. This could be interpreted in a very broad sense to include all
risks faced by an insurance company in the course of its operations.

So it could be said that investing in insurance risk is the same as investing in an
insurance company. Considered in this broad sense, insurance risk includes
all traditional investment risks – market, credit, operational and others – as
well as the insurance risk defined in a more narrow way – that of insurance
claims (obligations under insurance policies) being greater than expected, or
greater than a certain level that the insurance company wants or is
permitted to take.

Even this definition is imprecise, since all the risks are intermingled and cannot be fully decomposed into individual elements. The more narrowly defined type of insurance risk would apply in cases of
higher-than-anticipated losses due to factors such as random statistical fluctuations
in the number of insurance claims or their severity, natural
catastrophes or man-made disasters, spikes in mortality or fundamental
shifts in longevity, and many others.

Often such types of insurance risk either cannot be transferred to investors
purely through the traditional equity or debt instruments issued by insurance
companies, or are best transferred to capital markets in a different fashion.
Insurance-linked securities (ILS) are structured to transfer to investors this
type of risk, and are specifically designed to address unique issues of insurance
companies. Most have to do with the transfer of “pure” insurance risk
where other risks are excluded orminimised.

They afford investors exposure to risks that are different from those embedded in the traditional securities and that are often only weakly uncorrelated to the behaviour of the financial
markets.

INSURANCE MARKETS

Before considering securities that are in some way linked or related to insurance,
it is instructive to take a look at the insurance markets in general.
Insurance markets have many unique features not found in other industries.
Insurance companies are highly leveraged enterprises in the sense that their assets-to-shareholder equity ratio tends to be very high – particularly for life insurance companies and property-casualty companies in long-tail lines of business.

While the degree of leverage across the capital markets has been going down (in some cases considerably), the insurance industry remains an exception. The diverse offerings of insurance companies comprise two main categories: life and health insurance, and property-casualty insurance (referred to as general insurance in many parts of the world). Though these two categories
of insurance are quite distinct, some companies handle both life and
property-casualty insurance.

In describing insurance markets, it is also important to note that insurance
is one of the most heavily regulated industries, a fact that, by itself, introduces
a broad set of constraints and risks not found in other sectors.
Moreover, the regulation to which insurance companies are subject is not uniform among jurisdictions, contributing to the fragmented nature of the insurance marketplace.

Some jurisdictions impose price regulation and so insurance companies are not free to raise insurance rates on some of their products. In extreme cases, companies unable to raise rates for this reason
have decided to exit certain products lines, but have encountered additional
regulatory constraints, making this exit difficult. Few industries have to deal
with such issues.

Another phenomenon specific to the insurance industry is the underwriting
cycle; it pertains primarily to property-casualty insurance, and, to a
lesser degree, to health insurance. Insurance companies as a group go
through periods of charging customers rates that are too low, leading to
rates of return dropping below the required level (referred to as “soft”
markets); followed by periods when the companies are able to raise their
rates to the level where they generate rates of return in excess of the
minimum required (“hard” markets).

This cycle does not have a simple logical explanation and is seen by many as evidence of how inefficient the insurance markets are. Arguably, no other sector has such a clearly
pronounced profitability cycle, with the possible sad example of the airline
industry.

While many factors drive the underwriting cycle – changes in
macroeconomic conditions, shock events resulting from investment losses
or losses due to natural catastrophes, the fear of losing customer relationships,
and many others – it is also recognised that some of the factors are
purely psychological (such as the herd mentality).

Predicting the next turn in the insurance underwriting cycle is a favourite pastime of the sell-side
equity analysts who cover the insurance sector. The underwriting cycle To sum up, insurance markets are unique because of a variety of factors, including fragmentation, particularly strict regulatory requirements, unusual risk and a significant degree of inefficiency. Deep understanding of
such industry dynamics is a prerequisite to analysing many securities issued
by this industry.

SECURITIES ISSUED BY INSURANCE COMPANIES

Insurance companies issue some of the same types of securities as do most
companies in other industries. We can invest in insurance through common
stock, debt or preferred stock.

The analysis of the common stock of insurance
companies is based on the general principles of equity analysis, while
taking into account also the specific features of the insurance industry. Other
types of securities issued by insurance companies are not found in most
other sectors.

An example would be surplus notes, which are securities
similar to the trust-preferreds issued by banks. The securities issued by
insurance companies are a relatively small part of the global capital markets,
reaching at most 3% of their total size. In the US, insurance companies provide two types of financial statements: traditional statements based on the Generally Accepted Accounting Principles (GAAP), and statutory statements mandated by insurance regulators.

The volume of information contained in these statements is greater
than what would typically be available for a company in another industry.
Detailed exhibits provide a wealth of additional information. Both the
GAAP and the statutory statements, along with other data released by
insurance companies, help investors analyse the companies and value the
securities they issue. The availability of the additional information,
however, does not make the analysis easier and the uncertainty lower.

There are too many industry-specific issues that make the analysis different from
that of other companies, and these issues present unique challenges. In the
simplified analytical framework, we may often wonder why price-to-book
ratios of insurance companies exhibit idiosyncratic behaviour, and what
drives the difference in the price-to-book and other ratios between companies
that appear to be rather similar based on their balance sheets, income
statements and the business they conduct. Only a deeper level of analysis
can answer such questions.

We may think that diversification can be achieved simply by investing in
stocks or bonds issued by insurance companies, since they contain the
“pure” insurance risk such as that of losses related to natural catastrophes or
changes in mortality rates. However, these risks are rarely the main drivers
of insurance stock performance. For most insurance companies, the main
component of their profits stems not from underwriting income but from the investment returns on their asset portfolios.

This explains why insurance companies, with their huge balance sheets and assets invested mostly in
bonds and stocks, are heavily exposed to market risk. Life insurance stocks
are seen by many as a beta play, as opposed to an uncorrelated asset.
Figure 1.1 overleaf illustrates the performance of the Dow Jones US
Insurance Index relative to the S&P 500 Index and the Dow Jones Industrial
Average.

Correlation of the insurance index returns with the markets for the
time period illustrated in Figure 1.1 was 80%, showing that investing in
insurance stocks in and of itself does not necessarily provide diversification,
because insurance companies are, to a significant degree, leveraged investment
vehicles.

Warren Buffett puts it in slightly different terms by using the concept of
float: “Float is money we hold but don’t own. In an insurance operation, float
arises because premiums are received before losses are paid, an interval that
sometimes extends over many years.During that time, the insurer invests the
money.”

This statement, repeated with minor variations in numerous annual
letters by Buffett to the shareholders of Berkshire Hathaway, explains both
the concept of leverage in insurance and why many insurance stocks have a
high degree of correlation with the financial markets.

INSURANCE-LINKED SECURITIES

ILS are defined as financial instruments, other than traditional equity and
debt securities issued by insurance companies, which carry insurance risk or
a type of risk that is closely related to it. Examples of the risks included in
insurance-linked securities are property-catastrophe risk, mortality,
longevity and insurance loss reserve adequacy. ILS can also include many of the traditional risks such as market, credit and interest rate risks, but it is the inclusion of the significant degree of insurance risk that defines them.

The seemingly irrelevant question of what asset category ILS belong to is
important. ILSs are normally classified as alternatives, but they come in many shapes and forms even for the same type of risk. These securities can be structured as fixed income instruments or as equities. Some ILS come in the form of derivatives while others most closely resemble private equity
investments. A dedicated ILS fund can be limited to investing in only catastrophe
bonds or have a broader mandate of investing in various types of insurance-linked securities and types of insurance risks they contain.

The fund mandate determines how an investment in the fund itself is classified – whether it necessarily falls in the category of alternatives and, if the answer
is positive, where it is placed within that category. The uncertainty as to the
appropriate allocation bucket exists even in the cases of direct investment
rather than that through a fund.

The classification may affect the flow of funds to ILS and insurance linked
strategies since they are relatively new and have not earned standard
allocations afforded to the more traditional asset classes and investment
strategies. The size of the insurance-linked securities markets is very small relative to that of the global financial markets, and even relative to the total value of
securities issued by insurance-related entities.

While exact figures are not available, the total size of the traded insurance risk (ILS), even when broadly defined and including both property-casualty- and mortality/longevity linked
securities, does not exceed US$70 billion. The following figure shows estimates
of the insurance-linked securities markets in relation to the broader financial
markets.

Notes: Derivatives, whose total notional amount is a multiple of the stock and bond markets
combined, are not included. Estimates are as of 2009 and are based on data from the Bank for
International Settlements, SIFMA, World Federation of Exchanges, World Bank, Milken
Institute, World Economic Forum, LISA, Conning, and McKinsey. Only publicly traded
securities are considered in estimating the size of the global financial markets. 

There are no adjustments for the cases of one public company owning stock of another publicly traded company. Securities that have connection to the insurance industry are broadly defined and
include those issued by companies involved in other businesses in addition to insurance. A
broad definition of insurance-linked securities is used to include such types of ILS as life
settlements and industry loss warranties. Most private deals that can be reasonably character -
ised as ILS-type transactions are also included.

standard investment analysis used for most other industry sectors. The
specialised expertise is a significant source of competitive advantage in the
investment analysis of insurance equities and debt.
 
Investing in securities issued by insurance companies does not provide
the diversification that might be expected from exposure to the risks of
insurance losses being greater than expected due to the fluctuations in the
frequency or severity of insurance claims, changes in mortality rates, or
other risks unique to the insurance industry. 

In investing in corporate securities issued by insurance companies, most of the risks are not “pure”
insurance risks but risks common to the financial markets. This explains the
high degree of correlation between the investment performance of the insurance
sector and the markets as a whole.

Search for uncorrelated return

Investors never stop their search for assets that improve the performance of
their investment portfolios, either through extra yield or through exposure
to uncorrelated assets. The value of truly low correlation with the markets
became painfully obvious during the financial crisis that started in 2007. By the end of 2008 all correlation assumptions broke down, and assets with historically low correlation all of a sudden started moving in sync. They were all moving in the same direction – down – and so were the supposedly diversified investment portfolios. Having investments with low beta generally
improves portfolio risk-adjusted returns and contributes to the goal of
capital preservation.

Insurance-linked securities as a portfolio diversifier

While insurance-linked securities are not zero-beta assets, they do represent
a valuable and effective form of diversification. Many of them provide exposure
to risks that have a low degree of correlation with the rest of the
financial markets, while still generating a very competitive yield. 

Securities such as cat bonds issued after 2008, designed with an express intent to strip
away, as much as possible, all risks besides the true insurance risk of natural
catastrophes, provide a good illustration of this diversification.
 
A storm on Wall Street might shake the very foundation of financial
markets, but it is not going to lead to a hurricane in Florida or an earthquake
in California. A catastrophe bond is not going be triggered because of the
condition of the markets. The relatively low degree of correlation with
market risk is the greatest advantage of insurance-linked securities, and for this reason insurance-linked securities can be an important component of
most investment portfolios.

 

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