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(Re)insurers fixed on bonds despite diminishing returns

Despite dreary investment conditions that have stoked industry debate about how and where to find yield, insurers have not significantly changed their strategy in terms of the types of assets they find attractive, according to the National Association of Insurance Commissioners (NAIC).

In its latest research report, the organisation's Capital Markets Bureau (CMB) also found that insurers are not prepared to compromise the credit quality of their investment portfolios by "noticeably investing in riskier assets with higher yields".

The study reported that in the eight quarters to 31 December 2011, carriers continued to net invest in investment grade bonds, especially in corporate fixed-income securities.

"They have also net disposed of below-investment grade bonds, thereby reducing credit risk," it noted.

The findings may seem surprising given the challenge insurers face to generate adequate investment returns and the unappealing rates in many classes.

Historic low interest rates have created a low yield climate that has squeezed carriers' ability to generate investment income on their conservative portfolios and had a debilitating impact on the sector's return on equity.

The situation has led to much discussion on finding new asset classes that will substitute the safety of high-grade fixed-income products for the promise of yield that only riskier assets are capable of providing.

But the NAIC findings suggest that insurers have not actually been "reaching for yield" at the expense of introducing risk to investment portfolios, reflecting the uncertainty over the macroeconomic outlook.

The CMB had previously concluded that risk appetite tends to increase in a strong economy, while decreasing during weaker economic conditions.

And in its latest study it said: "Results from our asset mix study showed that bonds, particularly corporate bonds, were the largest industry investment - regardless of year or insurance company type.

"And banking/finance-related bonds were the largest corporate exposure. We concluded that despite changing economic conditions, the insurance industry's asset mix does not appear to have changed significantly."

In its examination of acquisitions and dispositions by asset managers in 2010 and 2011, the CMB found that bonds were the largest asset type acquired in all eight quarters by an overwhelming majority.

Corporate bonds accounted for the largest portion of overall bond volumes purchased by insurers.

Bonds were also the largest asset type sold in each quarter, but net acquisitions and dispositions data reveals that insurers were nevertheless still net buyers of bonds.

And the report noted that on a net basis, the industry typically bought investment grade securities in exchange for below-investment grade securities, "thereby lending comfort that insurers were not compromising the credit quality of the industry's portfolio to achieve higher yield".

Bond bubble?

But the continued migration of the industry towards high-grade fixed-income investment has led to fears of a bubble for the asset class.

"This is typical of the (re)insurance sector. It's herd mentality where everyone is piling into the same asset class," a leading industry analyst told this publication. He highlighted that for

(re)insurers with heavy exposures to high-grade bond assets like US Treasuries, such as those based in Bermuda, there is the potential for significant unrealised losses in the event of an interest rate rise.

As the graph below from Guy Carpenter demonstrates, portfolio yields have been on the slide for the last few years.

"If you look at the yield on US 10-year bonds, for example, it's down to around 1.6 percent and it's been in that ballpark since 2009. With average duration of three to four years that means that most of Bermudians' bond portfolios have been turned over and are now offering those lower yields.

"If prevailing interest rates in the secondary markets pick up quickly then those bonds will all go down in value for three years," the analyst explained.

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