Hidden Risks with Overweight Bond Portfolios?

(June 25, 2012) — Property and Casualty (P&C) insurance companies may be unaware of the inherent riskiness of bonds when they gravitated to overweight fixed income portfolios, a paper by consultancy Towers Watson contends.

The average P&C insurer’s asset allocation has shifted from 55% fixed income in 2000 to 73% in 2010, the paper notes. In that same time, equity allocations fell from 30% to 15%. A host of risks associated with fixed income investments, however, should give pause to P&C insurers that believe they have removed all risk from their portfolio by migrating to bonds from equities.

“There are still material investment risks remaining even in a portfolio invested wholly in bonds,” the paper contends. “As witnessed during the global financial crisis, risks that were considered low or negligible have become much more prominent and can no longer be ignored.”

In particular, the paper points to credit risk—stressing that bonds once considered sacrosanct like developed market debt should no longer be so. It also examines the risk that accompanies regulatory changes regarding interest rates, the need for liquidity, and the specter of inflation. The paper further details active management risk, which is based on the typical active bond mandate’s tracking error relative to the benchmark, currency risk, and the risk associated with leverage. The danger that continually low interest rates in coming years could prevent the rolling over at historical rates of corporate bond investments, what the paper calls re-investment risks, and governance and operational risk are considered as well.

To combat these challenges, the paper suggests that P&C insurers diversify allocation by country, credit quality, and credit type, match the interest rate and currency exposure in the liabilities, and ensure governance is consistent with the desired asset strategy.

“We believe potentially significant risks remain in a bond portfolio, and may be slowly increasing undetected, in particular the exposure to more extreme events,” the paper concludes. “An unmanaged break-up of the Eurozone is one such event that could have a materially detrimental impact on bond portfolios and we recommend that insurers consider the likelihood of, and their overall risk exposure to, such outcomes so that the asset strategy can be structured accordingly.”

To see the paper in its entirety, click here.