Roger Crombie

Interest rates are at their lowest level in 40 years. Given the impact on earnings, a hard market, which is always welcome in the property and casualty sector, could not have come at a better time. On the life side, however, U.S. dollar rates below two percent make product pricing difficult. For companies using insurance to offer financial management to high net-worth individuals, low rates signify a soft market.

Interest rates lie beyond the power of individual companies and industries. Many companies' internal budgets and forecasting use a five-percent standard, the "natural rate" at which interest is considered by classic financial analysis to accrue over the long-term. Five percent remains manageable with the right spread, but risk rises sharply with even small excursions beyond that point.

Insurance is among the most conservative of industries, and its investment tactics more so. High-grade fixed-income securities take most of the risk out of investing other people's money. Holding a lesser parcel of blue-chip stocks has traditionally added spice, at no great danger, to the mix.

Hedge Funds

A number of Bermuda companies that were formed on or relocated to the island in the second half of the 1990s have added a new approach to the investment mix: the controlled use of hedge funds. Established at a time of boundless optimism in the stock markets, but now operating in a much more somber environment, the companies have experienced mixed results.

PXRE Group Ltd. has structured its portfolio in the past two years by blending traditional fixed-income investments with a hedge fund element. The move has been followed in the last 12 months by a new focus that saw the company exit the Lloyd's market in the second half of 2001. After September 11, 2001, PXRE management saw that significant growth opportunities existed in the worldwide property catastrophe market and the best way to capitalize was by dedicating all of its capital and efforts to expanding its franchise. Accordingly, the company focused on its core broker-market property catastrophe reinsurance business. Record earnings have followed.

"In addition to strong premium growth in our core lines, our strategy of investing in high-quality bonds and a well-diversified hedge fund portfolio has enabled PXRE to produce attractive investment returns despite the current turmoil in the financial markets," says Gerald L. Radke, chairman and chief executive officer.

In the first quarter of 2002, PXRE's hedge funds produced an annualized return of 9.9 percent, and in the second an annualized return of 3.1 percent. The comparable figures for 2001 were 14.3 percent and 9.2 percent, respectively.

Also in Hamilton, low interest rates have driven Max Re out of the life and annuity reinsurance business. The company wrote none in the second quarter of 2002. (Through six months, Max Re's net premiums written were $414.7 million.) "We buy, essentially, closed blocks of annuity business and discount the cash flows over a lengthy event horizon," says Robert J. Cooney, Max Re's chairman, president, chief executive officer and founder. "Life companies are not so motivated to sell their portfolios when interest rates are low."

Max Re has added recent earnings from the property and casualty side to fixed-income investments. The company's invested assets were $1.8 billion as of June 30,2002, with an allocation of 65 percent to cash and fixed maturities and 35 percent to alternative investments. Six months earlier, assets of $1.5 billion were split 58 percent and 42 percent, respectively.

The majority of the company's alternative investments comprise a "fund of funds" portfolio owned by a subsidiary, Max Re Diversified Strategies (MDS), and managed by Moore Capital Management, a major shareholder in Max Re.

MDS pursues eight different strategies for alternative investments. Six are specific hedge fund strategies, each with a different focus and style. "Our goal is equity-like returns with bond-like stability," Cooney says. The two non-hedge fund strategies are Japanese depressed loans and private equity insurance, including the company's stakes in two Bermuda re/insurers new in the past 12 months, Grand Central Re and DaVinci Re.

Max Re employs more than 40 fund managers, of whom only a handful has more than five percent of the portfolio. None have more than 10 percent. Max Re achieved a return of 6.7 percent last year. This year has proven tougher: for the six months ended June 30, 2002, alternative investments have returned 0.85 percent, compared with 4.85 percent for the same period in 2001.

Cooney, however, is not to be sidetracked by the markets' recent dreary performance. Looking ahead, he says: "If equities achieve six or seven percent, we should make our long-term target of 12 percent. Last year's return puts us behind a little, but this is still the first or second inning."

Interest Rates

Other Bermuda re/insurance executives are less keen to be quoted on the subject of interest rates or hedge funds. This unusual reticence is summed up in the words of a senior executive at one of the major Bermuda companies, who asked not to be identified:

"There are three reasons not to talk about interest rates," he says. "First, no one can do anything about them, short of crossing their fingers and hoping for the best. People I know in P/C are just hugely thankful that the present appalling rate atmosphere didn't coincide with the worst of the soft market, because if that had happened, the companies would have had nothing going on at all. Undisciplined underwriting and rotten investment returns do not simultaneously produce contented shareholders.

"Second, there is no real alternative for most insurers. While it might be OK for a company like Max (Re Capital) to operate a sophisticated hedge fund strategy, you have to recall that Max's major shareholder is a hedge fund manager. This is not a case of a group of insurance people entering a hedge fund office and saying 'Make us rich.' This is a new model for managing balance sheet risk, carefully thought out and operated by one of the best. There's every chance Max will work, in the long run, but almost zero chance that your average 100-year-old insurer can play catchup by handing over half its assets to a hedge fund manager and hoping for the best."

Finally, he said: "The current level of interest rates causes a kind of blind, dull pain behind the eyes of every insurance manager. No matter how good you are, no matter how many years you have spent racking up respectable profits and acceptable dividends, lousy interest rates leave you completely naked in terms of investment options. Your underwriting has to be first-class, or you start to ship red ink and then the death spiral begins. Of course no one will talk to you; what are they going to say?"

The consensus is that interest rates might go lower before they start to rise. Experienced hands will sit still and at tempt to ride out the storm, noting A.M. Best's comments that the current hard property and casualty market is expected to continue for two years. Lloyd's will need that time to find a meaningful way forward, and the condition of North American and European markets suggests that Bermuda will remain a buoyant environment. Life re/insurers have already battened down the hatches and may also be expected to follow a sensible, "wait and see" approach, absolutely the Bermudian way, when storm clouds gather.

The danger is that the pressure exerted by low interest rates might force less experienced re/insurance managers into adopting unusual and perhaps ill-considered strategies in a bid to inch ahead of the curve. As far as interest rates are concerned, patience is what the doctor ordered, and time the test.

Roger Crombie can be reached at crombie@northrock.bm.

COPYRIGHT 2002 Axon Group

COPYRIGHT 2002 Gale Group