As discussed in other research, risk for an insurer must focus on diversification as it pertains to capital and surplus (unassigned funds) and how the assets relate to the products that are sold to policy holders (members). The following discussion will utilize a few of these concepts to explain why performance objectives must go beyond total return and be based upon net investment income and the surplus of the insurer.
A key factor in the success of an insurer is the performance of the investment portfolio; unfortunately, the valuation tools used to measure insurance performance are often inappropriate. As an insurer, it is easy to be conditioned to view investment success by comparing the total return of our portfolio to that of a benchmark index of similar securities. This approach is extremely appropriate for most investment portfolios. Consider for example the equity portion of your personal IRA or 401-k account. If the total return on the portfolio over time exceeds that of the S&P 500 Index you are probably excited about your portfolio. The appropriate asset allocation of your retirement account is based upon the risk that is appropriate considering your personal needs and objectives. The expected time until retirement is normally the greatest factor in assessing the appropriate portfolio risk that can be assumed. The objective is essentially to generate the largest pile of money possible considering the risk profile appropriate for your needs.
When insurance assets are managed to optimize total return there are several unintended consequences that often adversely impact the insurer. Furthermore, decisions that a prudent investor would make in order to optimize total return may actually reduce surplus or the net investment income of an insurer. A key to understanding these potential issues is centered on the ultimate objective of the insurer. An insurance company is entrusted with funds that represent future payments to members or policy holders. This simple concept is the basis for statutory accounting principles and the majority of regulations developed by the NAIC or various state departments.
A large component of total return is the unrealized position of a portfolio at any given time. However, insurance companies carry the majority of assets at amortized cost. The basis for cost accounting is that fixed income investments are to be held to maturity in a manner where the cash flows are sufficient to provide for the future expected claims of the insurer. This reduces the concern related to decreasing market prices and places the focus on net investment income. This focus is appropriate and actually reduces risk. Securities purchased should support the future cash flows of the representative product and provide sufficient book yield (spread) to support product growth rates and operations. This is true regardless of the direction of interest rates. Insurance investing should not focus on speculation or “bets” on interest rates, but work to ensure that surplus and net investment income are appropriate in any economic environment.
Additionally, there are circumstances where a focus on total return would dictate the sale of a security in order to realize a gain and reinvest in another security with a better appreciation profile. If an insurer files an Interest Maintenance Reserve (IMR), then the gain on a disposal would not be realized initially, but amortized into income over the remaining life of the security that was sold. When a gain is considered, reinvestment would typically occur at a lower current yield; therefore reducing the overall book yield of the portfolio and negatively impacting net investment income. If taxes come in to play, the impact to income is amplified by the tax rate.
Another tool that is often used in an attempt to generate positive return versus an index is shifting between asset classes or qualities. This reduces diversification and has significant impacts to Risk Based Capital (RBC) in addition to creating volatility in the AVR. This in turn can place downward pressure on surplus in addition to the trading impacts to IMR. More importantly, if the amount invested in any single security is large in relation to surplus, the risk to the insurer is enhanced. This would not be the case for other types of investors as diversification is considered based upon total assets.
One final total return concept that is impracticable to apply to insurance investing is the typical strategy of a total return benchmark. As an insurance company your products, members, marketplace, liabilities, statutory reports, surplus and history are unique. Appropriate investing must consider the liabilities and surplus; therefore, every insurance portfolio should be unique. This makes the common benchmarks that are applied to all portfolios meaningless even when total return is the objective. Each benchmark would need to be custom designed, which reduces the ease of market understanding. Regardless, a total return benchmark could never quantify the specifics of investing to match liabilities, enhance surplus or better position IMR/AVR. Better benchmarks for insurers are: ALM objectives, book yield comparison to competition, surplus enhancements or anything that more efficiently ties performance to the true needs of the insurer.
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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