14 September 2012

Risk.net: Reinsurers urged to expand equities allocation amid 'fixed-income bubble' fears

Reinsurers need to increase their investment in equities to hedge the interest rate and inflation risks on their large fixed-income portfolios, according to reinsurance broker Guy Carpenter.

In recent years, reinsurers have invested heavily in high-grade, low-yield fixed-income securities as a result of the crises in the financial markets and the eurozone. At the same time, their allocation to equities has shrunk.

Reinsurers typically hold less than 5 per cent in equities, while investments in fixed-income securities average around 60–65 per cent. Munich Re, for example, allocated only 2 per cent of its portfolio to equities in the second quarter of 2012. The reason for such a low level of equity holding is unclear, says Flandro, London-based head of global business intelligence at Guy Carpenter - although capital charges imposed by rating agencies and Solvency II on equities could be a factor, prompting insurers to take less risk on the investment portfolios. "There is a real tendency for risk-off trades rather than risk-on trades", he says.

"This is the great curse of the sector right now. Yields are low. You're not getting any return for the risks you're taking when you're buying US government bonds. It's gone from risk-free return to return-free risk", says Flandro.

Increasing allocation to equities could help to protect the sector, despite their potential volatility, Flandro argues. "Equities are a good inflation hedge over the long term, they're also a pretty good interest rate hedge, and they're a good diversifier away from fixed income", he says.

But rating agencies have warned that reinsurers should be cautious about taking unforeseen investment risk. "If you were to see a significant increase [in equities] to double-digits, then this potentially makes [reinsurers'] solvency position more volatile", says Martyn Street, a director in the insurance division at Fitch Ratings in London.

Guy Carpenter's Flandro argues that reinsurers need to invest more aggressively to protect future earnings. "People are concerned about interest rates and what effect interest rates will have on balance sheets if they did move. Equities can be volatile, but if you have a sensible long-term strategy for holding them, it can be a good hedge against those risks", he adds.

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