Research

Low Interest Rate Strategy

This article focuses on an insurance investment strategy that is unique in a low interest rate environment. The focus of this strategy is based on insurance specific methods to enhance surplus, improve Risk-based Capital (RBC) levels or reduce risk and build upon the concepts of other diversification topics. For related articles regarding risk for an insurer, please search our Insurance Investment Research section. These simple concepts are the premise behind statutory accounting and insurance reserves such as IMR and AVR. Unfortunately, misapplication of these principles is often the reason behind surplus issues. Proper application protected surplus even during the most recent financial crisis. These principles must be addressed in order to demonstrate why performance objectives must go beyond total return and be based upon net investment income, surplus and RBC targets. Investment decisions for an insurance company must consider the impact to the statutory financial statements prior to any transaction.

Understanding these unique insurance characteristics allows the prudent investor the tools necessary to find opportunities in different economic environments. Current interest rates are near their all-time lows. Insurance companies work on a spread basis and live off of net investment income. Over the last several years, the downward drift of interest rates has reduced the book yield of new investments. In turn this has decreased the growth rates offered on products and placed added pressure on company surplus levels. As a result of these features, most insurance companies are complaining about current interest rates and typical rate discussions are inherently negative. The prudent insurance investor understands that unique opportunities are often available in trying times and a low interest rate environment is no exception to this rule. Identifying these “opportunities” requires a comprehensive knowledge of insurance accounting. As a result of the recent financial crisis many insurance companies experienced downgrades within their bond portfolios. With the Treasury curve near all-time low levels this may be an opportune time to reduce the lower rated securities within the portfolio. Not only are yields at low levels, but the spread on credit issues has contracted as many investors are searching for yield. While this opportunity is an obvious one, there are more profound justifications for initiating current liquidations based upon credit quality. Many of the securities downgraded during the financial crisis remain viable “going-concern” institutions. Therefore, an insurance company often has the tendency to hold on to these securities. Other insurers choose to hold lower rated securities in an attempt not to realize a loss as the security accounting treatment is based upon amortized cost. However, for insurance companies reporting an asset valuation reserve (AVR) and looking to enhance Risk Based Capital (RBC), liquidation of these securities could improve the overall financial picture for the insurer. AVR is a reserve that simply removes funds from surplus ahead of time in order to buffer the portfolio in case of a credit event. Higher risk securities require a higher AVR and thus a lower reported surplus. The calculation for AVR is comprised of a basic contribution, a reserve objective and a max reserve. The reserve objective is the targeted annual reserve and the max reserve represents the highest level the AVR can reach. The lower the rating of a security, the closer the reserve objective factor is to the maximum reserve factor. One of our many services to the industry is performing comprehensive portfolio consulting reviews for use by insurance officers in making decisions. In many of our more recent reviews we have pointed out to several internal portfolio managers examples similar to the following: A company has 90% of its investments rated in the NAIC 1 (highest category), 5% in NAIC 2 (still investment grade) and 5% below an NAIC 2 rating. In this hypothetical example the 5% that is non-investment grade is responsible for 45% of the AVR reserve. A swap aimed at reducing this 5% can have a dramatic impact on enhancing surplus even when the liquidation results in a loss. Not only is the loss buffered by the AVR reserve, but the future AVR is lowered due to the quality improvement of the portfolio. This reduces the “January effect” and improves stability of surplus. In addition to AVR, RBC can sometimes improve dramatically as the securities identified as the highest concentration risk always begins with the lowest rated issues for RBC.

The current environment also offers the liquidity to diversify the portfolio. As discussed in other articles, the amount invested in any one security should be a small percentage of surplus and any applicable AVR. Should an unfortunate credit event occur, like Lehman Brothers, the surplus of the company would not be impacted in the base year under this strategy. However, in addition to surplus protection, RBC has the potential for additional improvements as the number of holdings increases.

In applying either of these strategies, it is important to consider the impact to book yield and to reinvest in issues that enhance the relationship of the assets to the liabilities. Slow and methodical is typically the most effective course of action and statutory “what-if” analysis should be performed.

Disclosures

Parkway Advisors, L.P. is an investment advisor registered with the Securities and Exchange Commission offering investment management, consulting, and accounting and reporting services. This material is for your use only and has not been independently verified and thus we do not represent that it is complete and should not be relied upon as such. The opinions expressed are our opinions only. Past performance is no guarantee of future performance and no guarantee is made.

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