The Intelligent Quarterly from the publishers of The Insurance Insider

Summer 2013

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The financial services industry is experiencing trying times.

No one can predict for sure where markets are heading, or which asset class or product kind will emerge as the winner from this troubled period.

Some of the outstanding issues are: weak nominal yields and even negative real yields; volatility spikes induced by the risk-on risk-off behaviour of market participants, to which even bond markets are not immune; uncertainty about the credit quality of the corporate issuers as well as sovereign; and a debt crisis which increases substantially the level of expected inflation.

In addition to the burning issues affecting the financial industry as a whole, the (re)insurance industry has always had one difficult structural issue to deal with: the cyclicality of the (re)insurance business. Click to enlarge

In this context, the countercyclical investment - in other words, the asset class that would react positively when the (re)insurance industry is affected - is the holy grail as far as allocation of capital and surplus is concerned.

Commodities & (re)insurance
Intuitively, although it is difficult to express in a very precise way, one can guess a rather direct relationship between the insurance and commodities markets - and not only because commodities can be insured (for example, with crop insurance).

A deeper look reveals a new possible correlation between (re)insurance as a business and commodities as an asset class. For example, what about the impact of a major natural catastrophe affecting an oil production area? Couldn't a reinsurer heavily exposed to property catastrophe risks in a specific oil-producing area (like the Gulf of Mexico) seek a long exposure to oil price as a way to offset some its losses?

Also, some of the marine insurance premium is linked to freight rates and freight rates are linked to commodity prices - and so maybe is the loss ratio, above a certain level of freight rates.

The nature of the asset class
In such unpredictable times one is tempted to take a serious look back at the fundamentals, which can mean longstanding asset classes, simple products, transparent structures, or simply tangible assets.

Commodities fit the bill rather well. True, they are a relatively new asset class, and are even sometimes classified in the alternative space. But they are the archetype of tangible liquid financial assets, their dynamics are easy to understand, and they are available to invest through mostly transparent and simple structures. The asset class is rather scarce, compared to equities or fixed income, but very diversified.

Nowadays, satisfying liquidity is offered by: energy - the sector trading the largest volumes, represented by the major oil benchmarks (West Texas Intermediate and Brent Crude Oil), and their distillates, whose dynamics are highly dependant on the global economic outlook; base metals - namely copper, aluminium, zinc, nickel and lead, whose behaviour is closely linked to infrastructure development; and precious metals - namely gold, silver, platinum and palladium, a sector which itself comprises high diversification.

Commodities are not usually directly investable, meaning that investors have to resort to more or less indirect approaches to the asset. The market standard is to gain exposure through futures, themselves tracked by indices, which may be wrapped as funds, ETCs, ETNs or ETFs.

Whatever the wrapper, and whether the investment is physically backed or not, one has to be aware of the impact of the shape of the forward curve. The converging nature of the delivery date of commodity futures and, as a consequence, the necessity to roll the positions, makes this aspect critical, even though it is usually implicit and embedded in an index.

Let us be clear: contango or backwardation per se does not mean it is correct or not to enter commodity futures markets, anymore than the variable nature of dividend levels makes stocks a bad or a good investment, but such impacts have to be considered before investing.

Commodity markets are often said to exhibit very high volatility, and a high risk of sudden drops. Click to enlarge

These perceptions are mostly flawed: over long-term horizons, the distribution of returns of equities and commodities are very similar. In other terms, their risk/return profile is quite close, as shown in the tables.

One might even consider that commodities embed an implicit protection against default, insofar as commodity futures can only drop to zero if the physical underlying commodity they represent loses all interest for consumption or transformation. Such an event could only be triggered by major technological changes, which do not happen in the short or medium term.

Inflation hedge
Any investor concerned with long-term liabilities linked to inflation has to consider the claimed inflation-hedging power of commodities. It is another regularly debated topic, and it is not easy to reach a conclusion with absolute certainty.

The reason for this is that inflation itself is not a perfectly defined concept: there are many different kinds of inflation and many different definitions of inflation. With this in mind, an investor cannot expect commodity prices, which are global by nature, to be a very good hedge against all kinds of inflation.

When the terms of the equation are so fuzzy, the fundamentals are the only reliable ground. These fundamentals tell us that if the prices of raw materials increase, then the prices of transformed goods will be impacted.

In other terms, there is a contagion of higher commodity prices, caused in the long time by scarcity, to many sectors of the economy, be it power in all its forms through the energy sector, transformed goods, or the building industry, namely through the metals sector.

Commodity indices
As far as the allocation to various commodities is concerned, things are trickier.

It is a full-time task to analyse markets in order to achieve effective commodity picking and timing of investment.

This is probably the reason behind the success of the dynamic allocation strategies offered by many market participants, be they asset managers, commodity boutiques, hedge funds or investment banks.

From a (re)insurer's perspective, an amount of commodity exposure makes sense in terms of portfolio diversification as well as inflation concerns. In addition, more precise and tailor-made solutions can be developed to capture specific risks (corps, property cat risks and so on).

The opportunity to access such an interesting asset class has to be included in the enterprise risk management process, especially because it embeds some of the characteristics that the countercyclical investment has to have.

In order to make it a viable option though, risks have to be controlled, and in that respect, the strategies mentioned above offer the simplest route when they are offered with a volatility control layer, and are wrapped in a capital-guaranteed product.

With such an investment, an insurer may benefit from the potential upside of commodity markets, invest in commodities in the most cost-efficient way and be protected from any downside, if the contract is held to maturity.

In the current circumstances, this could be a very effective way to gain that little bit of extra yield and enhance the management of the risk and capital through the (re)insurance cycle.

Laurent Dignat is managing director at BNP Paribas, Global Equity & Commodity Derivatives

Dominique Geffroy is part of the Commodity Investor Derivatives Group at BNP Paribas, Global Equity and Commodity Derivatives