The following article first appeared in the February 2008 edition of AsianInvestor magazine. Each month we offer a feature from the magazine. To subscribe, please email us at [email protected]

Disaster seems to follow JapanÆs insurance industry. At the beginning of the decade, it was zero interest rates, negative spreads and a bombed-out stock market that made asset management a near-impossible task. The nadir came in 2003 when the Nikkei 225 Index bottomed at 7,600.

Since then, management at both life and non-life companies have had to juggle a different set of challenges, from accounting rules to, in 2007, an industry-wide scandal involving the non-payment of benefits.

But for these past several years, investing the general account was no longer problematic, as Japanese stocks recovered and benign global market conditions reigned, helping return balance sheets to the black and allowing firms to invest more aggressively. Strength in global conditions even allowed insurance companies to record investment profits despite Japanese equitiesÆ more recent, awful performance.

This comfortable situation is changing, however. JapanÆs insurance companies fear the impact of a recession in the United States. This could not only end JapanÆs tenuous economic recovery, which would hurt revenues, but is expected to keep global financial markets in turmoil. The first three weeks of January saw over $5 trillion of value in global stock markets erased, and volatility is likely to continue.

Meanwhile, insurance executives face likely changes to accounting rules. They expect the attitude taken toward banks is likely to apply to them as well.

JapanÆs regulators have strictly interpreted how banks should reserve capital against risk assets under its adoption of the so-called Basel II agreement. This spurred a number of city and regional banks to sell their hedge-fund holdings two years ago, lest they face punishing reserve requirements.

It is now widely expected the government will use Basel II as a model for the insurance industry. It may take five years or so to implement, but insurance companies are already preparing for the day when they must mark their liabilities to market, along with their assets, and provision against problems like duration mismatches or high levels of risk assets that could lead to volatility on corporate balance sheets.

This realization has sent a shudder through the hedge-fund industry in Tokyo. Insurance companies have been major buyers of hedge-fund products. They dedicate a far greater percentage of assets to alternative investments than insurers in America or Europe. Will the double whammy of market turmoil and incoming accounting-rule changes force these ultra-conservative insurers to slash their allocations to hedge funds, in order to seek shelter in the government bond market?

Subprime escape

No, actually. The insurance community is doing the reverse: gradually increasing its exposure to funds of hedge funds and other alternative asset classes, while holding steady their overall allocations to government bonds, cash and corporate loans (collectively viewed as low-risk investments).

Before detailing the hows and whys, it is useful to put this in context. Japanese insurance-company investments tend to be run prudently. They became huge investors in hedge funds out of desperation, although having now experienced the sector for almost a decade, these institutions are comfortable with it.

To get a sense of how they handle exotic instruments, consider the industryÆs exposures to AmericaÆs subprime-mortgage market. Or, rather, lack of exposures. So far the only insurer to announce substantial problems is Sompo Japan Insurance, a non-life company, which in November revealed it set aside Ñ34 billion in reserves due to subprime exposures via triple-A rated tranches of CDOs. Even so, it expects to announce a profit at the end of the fiscal year in March; moreover, this reserve is a small amount compared to its total asset size of Ñ5.6 trillion.

There have been a few even smaller exposures announced: the Ñ7.3 trillion Mitsui Life announced a Ñ3 billion exposure and Ñ1.6 billion ($15 million) related loss; the Ñ6.2 trillion Asahi Mutual Life has an exposure of Ñ500 million and a related loss of Ñ300 million ($2.8 million).

The industry is not yet in the clear. JapanÆs nine biggest insurance companies are estimated to have nearly $10 billion of reinsurance contracts written by monoline insurance companies, which are now teetering on the brink of insolvency. A crisis amongst monolines would haunt Japanese investors.

But overall, the insurance industry here has dodged the subprime bullet, thanks largely to experience. JapanÆs biggest insurers already learned to only invest in structured products in which they could trace the collateral.

Nippon Life Insurance, for example, once experimented with CDO2 (ie a CDO structured out of other CDOs). Then came the market turmoil in the wake of the September 11, 2001 terrorist attacks, and the company realized it couldnÆt follow the money.

Sumitomo Life Insurance reports a similar tale: it owned a triple-A rated tranche of a structured product that held credit from Xerox Corporation, which defaulted in 2002. Again, it realized that it couldnÆt follow the chain of credit.

These insurance companies realized that credit rating agencies are involved in potential conflicts of interest: they make money by issuing ratings, and if there isnÆt enough data about a type of product, they extrapolate statistics to generate hypothetical track records that donÆt hold up to reality. This realization led them to stop investing in highly leveraged structured products where the collateral proved difficult to trace.

ôThe subprime crisis happened just as many people expected,ö notes Hirofumi Miyahara, deputy general manager at the $216 billion Sumitomo LifeÆs investment department. ôMany hedge-fund credit investors were not surprised.ö

Keeping hedge funds

Given this history in mind, insurance companies are keen to remain invested in areas such as credit and hedge strategies that can take advantage of the current distress.
ôI see this as an investment opportunity,ö says Hiroshi Ohzeki, chief manager of the finance and investment-planning department at the $500 billion Nippon Life Insurance. Last year Nippon Life established an investment department dedicated to credit and alternative investments. This unit now runs around Ñ3 trillion ($28 billion) of investments into credit, hedge funds, private equity and emerging-market securities. The firm intends to steadily raise its allocation to this unit, adding around $1 billion each year for the foreseeable future.

Ohzeki explains when this unit was established a year ago, credit spreads were very tight. So from that perspective, the blowout in spreads since AmericaÆs subprime mortgage market collapsed means the firm has cash to spend on cheap assets (measured in yen terms, however; the firm does not intend to take currency risk).

So how can insurers expand their allocations to hedge funds if, at the same time, they need to reduce overall risk? Because the new accounting regulations are going to demand they provision more against risk assets, and market volatility means they have to at least maintain, if not boost, their allocations to Japanese government bonds.

It will come by trimming exposure to other risk assets, notably Japanese equities, which make up the lionÆs share of insurersÆ assets in the risk category.

This is a bit of problem because a large amount of these equity holdings are based on industrial relationships. Approval to sell would require approval from the board of directors.

But insurance companies can stop allocating new assets to these, or in some cases trim back, to favour funds of hedge funds and absolute-return funds, says an investment executive at a non-life company. ôSompo Japan, Mitsui Sumitomo and Tokio Marine [the leading non-life shops] are all the same,ö he says. ôOur headache is Japanese equity and we want to diversify by seeking alpha from alternative investments.ö

ItÆs the same story for the big life companies, which tend to use funds of hedge funds but may also directly invest in individual strategies. Japanese insurers like funds of hedge funds because of their low volatility: in 2007, for example, fund-of-hedge-funds volatility was only 2%, versus roughly 5% for JGBs and 15% for both Japanese and US equities, according to Sumitomo Life.

This is why Japanese insurers can increase hedge-fund exposures at a time when they need to cut their total risk profile: funds of funds are very low-vol products.

But the way they tap hedge funds may change: the insurance execs say they are unhappy with the volatility or poor performance of the single hedge fund managers they invest in directly, so these may be culled to put more into funds of funds.