Insurers take on more risk to offer investments

Insurers are finding a profit bonanza in wealth management, but a global study by State Street outlines they are also taking on more risk in their own investment portfolios to provide investment products.

In a global phenomenon, insurers have enjoyed terrific success selling investment products, as they are in a unique position to offer guarantees and risk management options on investment vehicles that are not available through traditional security providers. Variable annuities, such as guaranteed minimum withdrawal products, and segregated funds have proven to be popular product solutions, as the boomer market seeks risk protection combined with investment growth as they near retirement.

But great success has brought its own set of challenges. Insurers have had to reorient their internal risk management strategies to ensure they can actually guarantee the principal protection on investment products.

State Street’s Vision Report on the Insurance Industry notes that insurance companies have been slowly moving away from internal portfolios that were heavily allocated to traditional fixed income assets. Instead, insurers are increasingly turning to alternative investments such as hedge funds, private equity placements and fixed income derivatives to attain higher risk-adjusted returns to cover the spread on investment products.

The allocation to alternative assets remains fairly small, however. Using estimates from Swiss Re, State Street says only $10 billion to $15 billion of worldwide insurer assets are in hedge funds, and $25 billion to $35 billion are in private equity. This number is expected to increase by about 10% a year.

Before sub-prime issues started to hit the market, insurers were increasing their allocation to synthetic assets, such as credit-linked notes and collateralized debt obligations. Due to the association of these products with sub-prime exposure, State Street doesn’t expect these instruments to increase in popularity anytime soon.

In Canada, insurers seem to be firmly in line with this global trend, gradually reorienting their assets, since the majority of their growth is coming from selling investment products.

Denis Berthiaume, senior vice-president of retail markets for Standard Life, says the wealth management space is a natural growth area for Canada’s insurers because of their unique ability to guarantee risk protection on investment products. He says that in the case of Standard Life, which is positioning itself as a “strong retirement company,” the majority of its sales are coming from investment products.

“In our retail operations, 90% of sales are coming from money products. We cannot say that we are strictly a traditional life insurer,” he says. “Insurers have one clear advantage, and that is the risk reduction component that we can wrap around products to cover specific needs of boomers. People are willing to assume some risk on their investment or retirement products, but there are some risks they don’t want to assume, whether that’s market risk or longevity risk. In terms of financial planning, the insurer is best able to manage the risk component for the retail investor.”

Berthiaume says there have been some changes made in their own investment portfolio to account for volatility of guaranteeing investment products, but very strict risk management controls are imposed both internally by Standard Life and externally by the Office of the Superintendent of Financial Institutions. He says Standard Life never held any asset-backed commercial paper that failed their risk assessment.

“OSFI follows us very closely. When we assume more risk from an investment perspective, we are required to keep more capital in our reserves,” he says. “On seg funds for example, if we provide insurance on funds with higher variability, we are required to have more cash reserves on board. If you are providing protection on seg funds, you need to have enough money in reserve to back up the protection on the seg funds. If you get into riskier investments, the level provisioning should be adjusted accordingly.”

Their increased presence in wealth management has meant a growing number of actuaries specializing in enterprise risk management, according to Doug Brooks, senior vice-president and CFO of Equitable Life.

Brooks, a recognized authority in enterprise risk management, says actuaries must become more adept at taking a broader view of the company’s total risk liabilities, rather than just monitoring specific liabilities related to certain areas.

“There is certainly more risk with some products. The variable annuity product in the U.S. and the expansion of forms of segregated funds involve risk; even some types of more traditional life insurance products now involve different types of risk,” Brooks says. “Over the last 10 or 20 years, products have become much more complex, and the tools to deal with risk are more complex.”

He adds, “Certainly, insurers have had to look very closely at what risks they’re taking on by issuing segregated funds that have the market-related guarantees associated with them. That has required a lot of activity to hedge those risks using derivatives products, put options and those sorts of things.”

Brooks says one challenge for Canadian insurers is trying to find higher-yield investments, particularly in the domestic Canadian market, that are appropriate for their risk management strategies.

“In the Canadian market, the pool of available assets isn’t that large. There is a lot of demand for higher-yielding-type assets. There are only so many mortgages and what-not to go around, so there is a lot of competition in Canada for those types of assets,” he says.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(12/03/07)