Reducing volatility to surplus is fundamental in building a successful long-term investment program for an insurance company. A key objective of any successful investment program should be based upon generating an appropriate return while assuming the least amount of risk. Most investors are accustomed to comparing the total return of a portfolio to a benchmark. Many astute investors also consider the standard deviation (volatility) and use other measures that provide insight into performance on a risk adjusted basis such as alpha. While these concepts can be a very effective measure of performance and risk, care must be taken to ensure that the return measure, volatility measure and the benchmark are appropriate and focused on the actual needs. This article is designed to provide insight into aspects of these measures that differ significantly for an insurance company.
Return Measure: Investing insurance assets is unique in comparison to all other types of portfolios as the majority of the assets “entrusted” to the insurer are backing reserves. These funds must be invested in a way that provides for the future claims of the policy holders that have trusted the insurer. The capital and surplus represents the excess assets above that which is necessary to provide for the liabilities. Regulation, regulators and AM Best are concerned about both the stability of capital and the risk to capital for insurers. This is because they never wish to see asset levels fall to the extent that the ability to provide for future claims is in danger. The stability of capital is the basis of many of the statutory regulations of the NAIC including Risk Based Capital (RBC), cost accounting and reserves such as IMR/AVR. Amortized cost accounting is the foundation of statutory accounting and aimed at encouraging insurers to “buy and hold.” The desire is to encourage insurers to focus on how cash flow, book yield and surplus relate to the products that are sold by the company. This unique aspect places a high emphasis on the net investment income of the insurer. While total return includes the market value of an account at any given time, book yield is directly correlated to net investment income and provides for the ability to maintain surplus, pay growth rates on products, maintain RBC levels and provide for operations. This does not mean total return is of no importance. What is critical to understand, however, is that decisions made only to enhance total return often result in reduced surplus, lower net investment income and higher IMR/AVR levels due to the nature and purpose of an insurer and the application of accounting regulations. Net investment income, cash flow and book yield must be a part of any return measure emphasized by an insurer.
Volatility Measure: Standard deviation is a measure of volatility and very important; however, it is normally based upon total return when discussing investment performance. The problem with being focused on the standard deviation of total return is that it provides little insight into the real risk of an insurance company. What is most important to focus on is reducing risk. The two most important methods to reduce portfolio risk for an insurance company are: diversification by holding a small percentage of surplus or unassigned funds in any one investment and a focused strategy of having assets that are appropriate for the products that are sold to the public. If the assets of an insurance company produce cash flows that provide for the future claims, the policy holders are protected and risk is minimized. This is why an insurer does not report the market value of investment grade bonds. The market value of a bond will fluctuate with changes in interest rates. When the maturity of the bond is structured to provide for future cash needs, the company is secure as long as there is no credit event, regardless of what happens to interest rates between now and the date of the cash need or claim. Therefore, the volatility of total return is less of a concern than the volatility of book values or capital and surplus. This does not imply that one should never look at the standard deviation of total returns, but if focus is placed on reducing this volatility, it could inadvertently result in increases to the volatility of surplus and RBC levels. A low standard deviation of book yield is what separates an insurer over time. There are many ways to reduce the standard deviation of total returns on a bond portfolio. Unfortunately these methods are not correlated to providing cash flow around the liabilities of the company. Insurance companies sometimes make well intended decisions to reduce volatility only to experience later unintended declines in surplus. For these reasons, volatility measures must consider surplus and the book value of assets.
Benchmarks and Alpha: Alpha is one of five technical risk ratios used in modern portfolio theory (MPT) and is intended to help determine the risk-reward profile of a portfolio. Simply stated, alpha represents the value that a portfolio manager adds to or subtracts from a portfolio’s performance. Alpha can be very important as an investment tool; however, before applying it to an insurance portfolio a deeper understanding is critical. The alpha calculation plots the abnormal rate of return of a portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM). CAPM is a graph that draws a line between a “risk-free” investment and that of the “market.” The points of each are simply plotted by considering the standard deviation and the total return of each security. Typically the 90 day T-Bill is used as the risk free rate and the S&P 500 Index is used to represent the market. The return of the portfolio is then plotted and if it is above the line it has a positive alpha. Unfortunately, these measures have no basis for the assets of an insurance company. Of prime consideration is the fact that the risk-free rate must be appropriate. For most types of investors this may be the 90 day T-Bill as it reduces volatility and is backed by the Government. However, the risk free investment for an insurer is unique and very specific. The risk free portfolio for an insurer would be a series of US Treasury Strips “laddered” in a way where the maturities directly align with the future liability cash flows. This is also unique for each insurer as products and history differs for each company. The benchmark index used to replicate the market should be one with a duration that approximates that of the liabilities of the company and comprised of investments that are allowed by the insurance department of the state of domicile and appropriate for the insurance products sold by the insurer. If both of these are calculated, then the alpha of the portfolio will be a true reflection of the value added by the portfolio’s design. However, if the standard risk free rate is used, the results will not align to the unique characteristics of the company.
The purpose of this article is simply to point out some unique characteristics of an insurer that impact the return, volatility and benchmark measures used to gauge performance. As with any portfolio, it is important that all valuation tools are in line with the actual needs and objectives of the account. An insurance company is unique in comparison to all other types of portfolios. In summary, a focus on net investment income, surplus volatility, statutory accounting, IMR/AVR (if applicable), RBC and the liabilities can be accomplished while producing a good total return. However, the reverse is not necessarily true. A focus only on total return can have very negative consequences for an insurer, especially if the benchmark and volatility measures are not tied to the value of the insurer. It is for this reason that volatility of surplus is such a key factor for regulators and AM Best.
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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