Insights. Property & Casualty Insurance CFO Survey #3. Investment Strategies

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1 Insights September 2012 Property & Casualty Insurance CFO Survey #3 Investment Strategies The third installment of Towers Watson s Property & Casualty Insurance CFO Survey examines CFO perspectives on investment strategies. The survey looks at how companies approach investment management and the rationale for their current investment policy. It also asks how current investment strategy is likely to change in the near future, how portfolio performance is evaluated and how interest rates affect investment strategies. Key Findings CFOs indicate principal preservation is the most important objective for overall portfolio management, closely followed by total return. CFOs satisfaction with their portfolios ability to meet total return targets and book income is mixed, while satisfaction with principal preservation and liquidity is strong. CFOs are with their companies performance in a number of areas, in particular, investment management governance and risk management. Only one-third of CFOs report their assets and liabilities are matched within one year, with about 30% shorter and 38% longer. Generally, respondents have not moved away from core fixed-income, equity and cash investments that have traditionally been the basis for insurers portfolios, although almost a third of respondents plan on taking some additional investment risk over the coming year. CFOs use multiple metrics to define investment strategy success, including total return (72%), performance against a specified benchmark return (66%) and investment income (50%). CFOs satisfaction with their portfolios ability to meet total return targets and book income is mixed.

2 Portfolio Objectives Participants ranked principal preservation and total return as the most important elements of their companies portfolio management, but their satisfaction with these two objectives varied. Three-quarters of respondents said that principal preservation was the most important objective for their companies, and an equal percentage was very with the outcome. Total return was ranked most important by 69% of CFOs, but only 23% were very with it (Figures 1 and 2). Property & casualty (P&C) companies need to maintain a conservative posture that ensures they are sound enough to withstand adverse market conditions and meet the expectations of investors, rating agencies and regulators. This may explain why respondents said principal preservation is the most important overall portfolio objective. It may also at least partially answer why the satisfaction rate in meeting total return objectives was not higher. In a volatile and, at times, weak market, the capital appreciation and investment income components of total return may not sufficiently contribute to a desired financial cushion or the return needed to please investors. Liquidity and the ability to pay claims ranked third among CFOs overall portfolio management objectives, with a 63% response rate, but ranked high in satisfaction, with 85% saying they are very with how their companies met this objective. All in all, CFOs are confident their companies investment management governance is strong: 78% said they are very, and 22% were somewhat. Similarly, respondents are that adequate risk control such as asset/liability management and liquidity are in place (Figure 3). With the industry recently tested during the financial crisis of 2008, the high level of satisfaction and comfort with risk controls are well founded. While dissatisfaction levels are generally very low, neutral responses for the portfolio construction process suggest that more effort may be needed to raise satisfaction in this area. Figure 1. Which of the following objectives are most important for your overall portfolio management? Principal preservation 75% Total return 69% Liquidity and ability to pay claims 63% Book income 53% Capitalization targets 9% Other (liability consideration) 3% Figure 2. How are you with your company s portfolio in terms of meeting these objectives? Principal preservation Total return Liquidity and ability to pay claims Book income Capitalization targets Other (liability consideration) Neutral Figure 3. How are you with your company s performance in each of these areas? Investment management governance Adequate risk control/management (e.g., ALM, liquidity) Investment management costs Portfolio construction process (whether managed in-house or outsourced) Asset allocation Investment diversification (beta diversity) Neutral 2 towerswatson.com

3 Asset/Liability Matching Surprisingly, only a third of CFOs surveyed said their companies asset and liability durations are matched within one year of each other. In fact, 19% were shorter on assets by more than two years, and another 19% were longer on assets by more than two years (Figure 4). The current yield curve structure appears to be leading different companies in different directions. On one hand, the current yield curve and the Fed s indication that it will not be raising interest rates in the near term have led some P&C insurers to extend out the duration to pick up incremental return. Other companies, however, have positioned their duration short in order to wait for yields to rise to avoid locking their assets into today s relatively low yields. Even though insurers are taking diverse approaches to asset/liability matching, all have the majority of their portfolios (ranging from 59% to 99%) invested in cash equivalents and core fixed income. As has historically been the case, they are also invested in common stock, but the percentage of investment varies more by individual respondents. On average, the participating companies allocate just over 5% of their investment portfolios to asset classes outside of these traditional investments, with high-yield debt and real estate the most prominent. Whether companies outsource management of general account assets largely depends on how difficult it is to manage a particular asset class (Figure 5). For instance, 83% of the respondents that listed hedge fund assets as an investment also outsource that part of their portfolios. But for core fixed-income investments, only 63% of the 32 CFOs who responded said their companies completely outsource the responsibility for managing that sector of their portfolios. Surprisingly, real estate has a relatively low outsourced representation across the respondents; however, much of this exposure is likely to be in owner-occupied buildings. Figure 4. How closely matched are your assets and liabilities? 19% 19% 19% 33% 11% Note: Due to base size, percentages do not total 100%. 19% Shorter by more than two years 11% Shorter by more than one year and less than two years 33% Matched within one year 19% Longer by more than one year and less than two years 19% Longer by more than two years Figure 5. To what degree was investment management outsourced last year for each of your general account invested assets? Hedge funds High-yield fixed income Bank loans Common stock Core fixed income Private equity Preferred stock Real estate Cash and equivalents Other All outsourced Some outsourced Not outsourced towerswatson.com

4 Two-thirds of CFOs said their companies next asset allocation analysis will be done in a full liabilityintegrated framework, leaving a significant 34% with an asset-only (limited liability information) analysis planned. It can be argued that an asset/liability approach can result in a higher investment in fixedincome investments than an asset-only approach. If an insurer needs higher returns or greater investment flexibility, an asset-only approach might be a way to help meet that objective. Regulators and rating agencies are giving more credence to enterprise risk management and Own Risk and Solvency Assessment concepts, where risk is evaluated across risk types. Insurer interest in those analytics may be driving respondents intentions to use a liability-integrated framework. As companies begin to comply with these new requirements, more may be interested in completing their asset allocation analysis using a framework reflecting both assets and liabilities. In the coming year, 31% of CFOs expect that their companies investment strategies over the next year will become slightly more aggressive, while none expect their strategies to become more conservative. This investment posture reflects a low interest rate environment that necessitates more risk taking to improve portfolio returns. None of the respondents, however, indicated that they expect to take on a significantly more aggressive investment posture. CFO Concerns Over the next three years, all respondents expect low interest rates to be among their companies biggest challenges. Interestingly, half of respondents indicated that the risk of rapidly rising rates would also be one of their biggest challenges. This dual interest rate risk reflects two extreme cases: historically low yields and the potential for rapid rate increases if the Fed and fiscal policymakers don t steer the economy carefully. The current situation of very low yields whittles away investment income, while a rapidly rising interest rate environment pressures asset values, capital levels and, if driven by inflation, adverse development in reserves. Half of the CFOs surveyed also responded that market volatility remains a top concern. The response reflects the continuing financial crisis, which promises to remain a part of the investment landscape due to financial weakness in the European Union and the possibility that the global economy could face a new recession. Risk Tolerance CFOs also described the primary metric their companies use to express investment risk tolerance. The majority, just over half (52%), use percentage of surplus as the primary risk tolerance measure with the remaining responses spread evenly across five other metrics. Respondents also described how their company s investment risk profile/position compares to its stated investment risk tolerance limit (Figure 6). While no respondents were over the limit, 53% were at or near their limit. Only 47% were significantly under their stated risk tolerance. That such a large percentage of companies may be willing to come so close to their limit may be related to our finding that 31% of respondents expect their investment strategy to become slightly more aggressive. That is, they see a need to generate better return in a low interest rate environment. The fact that just over half of respondents say their companies are near or at the limit reflects just how challenging it is to generate respectable returns and still stay within guidelines that are acceptable to stockholders and rating agencies. In fact, 60% of respondents indicated that there will be an increase in their allocation to credit risk assets such as high-yield bonds, bank loans and emerging market debt. Their intention reinforces the need among many in the P&C industry to improve total return. Conclusion CFOs need to both preserve principal and generate solid total returns from investment portfolios. Survey results suggest they are that the goal of Figure 6. How does your company s investment risk profile/position compare to its stated investment risk tolerance limit? 44% 9% 47% Note: Respondents did not select over limit. 47% Significantly under limit 44% Near limit 9% At limit In the coming year, 31% of CFOs expect that their companies investment strategies will become slightly more aggressive. 4 towerswatson.com

5 principal preservation is being met, but are less with total return. The responses illustrate the dilemma that CFOs face. Principal preservation is necessary to ensure companies withstand adverse market conditions while still meeting the expectations of rating agencies and regulators. Yet volatile and uneven financial markets and a low interest rate environment have made it difficult to generate a sufficient total return on companies portfolios that can add to existing financial cushions and satisfy investors. Lower investment returns are making it necessary for companies to write their insurance business at higher returns, a reality that requires more discipline in insurance product pricing. To cope with these market sensitivities, CFOs indicate that their companies are developing varied strategies to navigate these risks that include different asset and liability matching choices, a slightly more aggressive investment strategy, and outsourcing management of asset classes to benefit from specialized strategies and expertise. These strategies are being developed with a dual goal of targeting higher returns and maintaining appropriate levels of risk that will satisfy a broad constituency that includes investors, rating agencies and regulators. For more information about survey results, contact: Stuart Hayes stuart.hayes@towerswatson.com Bruce Fell bruce.fell@towerswatson.com Karen Wells karen.wells@towerswatson.com 5 towerswatson.com

6 Participant Profile Towers Watson s third North American Property & Casualty CFO Survey included participation of 32 of 73 registered program members (44%). Respondents represent a cross section of businesses, sizes and distribution systems as well as locales. Survey respondents represent a variety of types of business Which of the following best describes your company s core business? 0% 10% 20% 30% 40% Personal and commercial insurance 35 Commercial lines insurance Personal lines insurance 13 P&C insurance and reinsurance 6 P&C reinsurance 6 Multiline reinsurer 3 31 Respondents represent a cross section of companies of all sizes What was your company s total direct written P&C insurance premium for 2011? 0% 10% 20% 30% 40% Over $5 billion 4 $2 billion to less than $5 billion 7 $1 billion to less than $2 billion 18 $500 million to less than $1 billion 21 $100 million to less than $500 million 29 Less than $100 million 21 Respondents represent a variety of distribution systems What is your company s primary method of P&C insurance distribution? 0% 20% 40% 60% 80% Independent agents/brokers 59 Multiple distribution channels 25 Direct (e.g., direct response, Internet) 13 Exclusive/Captive agency 3 Other 6 Workers compensation insurance Medical malpractice specialty About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of employee benefits, talent management, rewards, and risk and capital management. Copyright 2012 Towers Watson. All rights reserved. TW-NA towerswatson.com