In today's challenging environment, which includes the scrutiny of Wall Street and equity analysts, insurance investment skills are crucial.
The domestic and global insurance industry, both life and property/casualty, is now in a period of prolonged consolidation and ownership change. Insurance executives are being forced by heightened competitive pressures, and slow growth, to face a new set of severe challenges, as they seek to position their companies for ongoing financial and marketing power. These challenges include successful initial public offerings (IPOs), avoiding hostile takeovers, maintaining adequate size-ranking for market credibility and economies of scale, and getting through sometimes painful mergers and downsizings. Good investment operations lie at the heart of necessary post-millennium survival skills. Superior return on assets is being recognized by all as a prime mover of bottom line return-on-equity performance and of sales vitality, and therefore of company surplus growth and share price strength.
Of course, the crucial linkage between investment strategy and overall corporate goals is nothing recent. Shareholders and policyholders, the board of directors, regulators, and rating agencies have demanded good investment results for years, from companies of all sizes and structures. But as more companies seek to demutualize, or plan to enter the mergers and acquisitions arena, they face the scrutiny of a new class of critics: Wall Street and buy-side equity analysts, who periodically forecast company earnings and publicly announce their stock picks. These analysts may sometimes be unsympathetic, even harsh, in their verdicts. As an outside audience they matter to all insurers and their stakeholders.
As a result, particular attention is being focused on a key criterion for measuring management acumen: a coherent and rigorous set of skills, procedures and systems for determining ideal asset allocations and proper investment styles relative to company goals. If correctly deployed, the asset management function should generate optimal risk adjusted results over each measurement period.
So what should a management team do? The answer lies in three basics, all of which form an integral part of what Scudder Insurance Asset Management (SIAM) offers every one of its clients.
• Forge a strategic partnership with an outside entity who can be held accountable for producing outstanding investment results, an entity possessing mass and momentum in the insurance industry, savvy in the ways of Wall Street, thoroughly objective and independent research, adequate staff size to give each client individual attention, and above all a deserved reputation for defining state-of-the-art portfolio management and risk management practices.
• Seek order and completeness in choosing asset allocations through a decision/direction loop framework. The first step is to articulate investment objectives and guidelines, which includes benchmarks, constraints, and other risk management considerations. How the company intends to keep score also needs to be defined at this early stage in order to provide meaningful performance evaluation and manager direction. Finally, once overall risk strategy has been determined, acceptable asset classes, sectors, and unique securities can be selected for building the optimal portfolio structure. This order and completeness counts in choosing asset allocations - only in this way can investment policy best meet corporate objectives.
• The decision/direction loop of strategy updating and implementation, reconciling results to objectives, and setting guidelines for the next accounting period, is a never ending process. Asset/liability management (ALM) is not something you do once - it is a constant responsibility of your investment professionals, an integral tool of the holistic investment process.
It is wise to look in more detail at the requisite moving parts of a vigorous and seasoned insurance asset management operation. For reasons elaborated below, more and more insurers are turning to outsourcing to gain a “virtual investment department”. Essentially, an investment capacity and magnitude of capabilities beyond what the insurer can achieve internally.
What makes insurance investing unique?
Insurance companies assume many and varied risks from their policyholders. Investable funds accumulate from the collection of premiums, and those funds must be liquefied as needed to pay claims. In the interim the funds can earn investment income. But this simple-sounding process faces many complexities, due to fluctuating claims behavior, capital market volatility, and the dictates of various regulatory bodies.
Insurance claim payments represent negative cash flows whose level and timing can be challenging to predict, yet it is the guaranteed payment of these claims when due which is the ultimate promise behind every contract. Demographic and inflationary trends must be accounted for carefully in planning. Movements in interest rates and stock markets can also impact claims incidence and consumer cash withdrawals. Thus, the insurance investment process poses both opportunity and risk. The opportunity is for superior returns and a strong contribution to surplus. The risk is that asset quality, liquidity and cash flows, and/or market price volatility, may prove unsuitable to the liabilities assumed. But other constraints apply to an insurance company too. Some of these pertain to financial reporting procedures. Results, once published, tend to assume a reality of their own, so these sometimes-artificial scorekeeping rules can become significant dictates. Both statutory guidelines and Generally Accepted Accounting Principles (GAAP) apply to many insurers - the two are not always consistent. The need to hedge assets and liabilities efficiently may be further complicated by FAS 133 rules on how derivatives are to be accounted.
In addition, pressure for good current net investment income can bring conflict with the need for competitive longer term value as measured by total return. Statutory risk-based capital formulas assign different factors to different asset classes, not necessarily in line with genuine capital market risk/return relationships. Rating agency practices may overemphasize or underemphasize different investment types from time to time, causing other inefficiencies in insurance company portfolios. Some statutes determine outright the maximum amount of certain investments that may be held. Tax effects are also important, since taxes paid are monies out the door.
Although as a class insurance companies may be unique in their investment needs, each company is also an individual. The best investment policy, and the most effective execution, will depend on a specific company's mission and business philosophy, its risk-taking and risk-avoidance preferences, the diversity of its product offerings, the nature of its distribution system(s), its claim payment ability ratings, and its relative status within its peer group as to size and rate of growth, operating ratios, profitability, and existing investment profile. Techniques do exist to sort out and balance all these disparate issues, and SIAM as a matter of course has in place the methodologies to do so.
The importance of asset and liability management tools
The selection of ideal assets in the context of supporting the liabilities is the basic purpose of asset/liability management - applicable constraints become inputs to the ALM process. ALM is a fundamental business responsibility now mandated by scenario testing requirements and Dynamic Financial Analysis guidelines. Properly applied, ALM is a proactive tool for squeezing hidden profits out of the nooks and crannies in an insurer's balance sheet, and also for avoiding hidden or lurking losses, ones which result from the subtle interaction of assets with liabilities and surplus.
Clearly, asset allocation selection lies at the very heart of good investment planning. Asset/liability modeling is therefore an essential tool. In fact, good ALM skills, procedures, and systems, taken together, provide the “machine” from which meaningful investment policy and effective risk management flow. Periodic snapshots of the adequacy of asset/liability “matching” are now required for both life and property/casualty companies, by regulations and by the guidelines of professional bodies. But good ALM goes far beyond the reactive assessment of whether a given investment strategy might lead to bankruptcy. Good ALM provides objective quantitative data for selecting ideal investment mixes in the context of their alternative risk/return tradeoffs. Scenario Testing models, and routines for Dynamic Financial Analysis, when properly applied open a vivid window to how the moving parts of insurance and investment volatility impact income statements and balance sheets. A set of choices resulting in management's ability to intelligently chart its course for investment guidelines and performance hurdles. Surprises are thus avoided, and something concrete is documented in advance against which actual results can be measured and assessed.
More generally, lack of a clear framework for investments discussion and decision-making can lead to sub-optimal efforts, whose costs may sometimes be disguised initially but which nevertheless are real and do eventually emerge. Indeed, strong asset performance and a Best Practices investment infrastructure are integral to all three components of every insurer's economic value: existing net worth, the present value of future profits on in-force, and the value of sales goodwill. This helps management tell the best possible “company story” to outside audiences, to support the public's continuing appetite for the company's products and (when applicable) for its stock.
The insurance investment decision/direction loop
Since the ultimate purpose of investments is to support company goals, an effective investments process must begin with the top-down drivers. These include corporate mission, overall financial objectives, company culture, and ability to take different risks. From this flows the specific financial parameters, such as operating ratios or sales ranking or return- on-equity (or a combination thereof), which are most important to optimize. Sometimes these parameters are crisply stated at the outset. Other times some give-and-take brainstorming, with experienced discussion leaders, is helpful to pin them down. Most typically more than one financial parameter is important, so that tradeoff analysis is called for.
The next step is to derive from this firm foundation the specifics of an all-encompassing investment policy. To do so meaningfully, it is essential to understand all applicable constraints. But the word “constraints” is used here guardedly: while a constraint tells what you cannot do, the flip side is it also by implication says what you can do. Thus the full identification and quantification of constraints establishes the broadest possible envelope from which it is fair game to pick the components of asset strategy.
A number of technical components are needed to formalize a complete investment policy. To avoid counterproductive activity, the order counts. This is the heart of the insurance investment decision/direction loop.
• Corporate financial parameters to be optimized indicate what investment performance measures must be concentrated upon (investment income, total return, low reported defaults, etc.). To aid in stability of product pricing and corporate earnings, a bias toward investment income is often emphasized.• With the investment measures given, and a keen assessment of investment conditions, the best investment style or styles can be chosen. Neither static pure buy-and-hold nor excessive portfolio churning are wise for an insurer in today's high-pressure world. Thus a spectrum opens up, of how much active trading to perform, for what strategic and tactical reasons, under what actual market circumstances.
• Once the investment measures and styles are known, management and its investment advisors should select the benchmarks against which performance will be compared. The benchmarks should tie in closely with the overall corporate goals, and be relevant to the targeted investment measures, and be applicable to the chosen investment styles. This is so that outperformance relative to the benchmarks directly supports the Big Picture. Benchmarks can include peer group rankings of portfolio yield, proprietary surveys of total return, market indices adjusted for duration and quality differences, and/or one's own liability pricing/crediting interest rates.
• Now, and in truth only now, are the company and its investment managers ready to select the ideal guideline asset allocation(s). This is because all of the previous parameters are really needed to guide the asset allocation modeling inputs, and to meaningfully direct the critical interpretation of modeling outputs, both quantitatively and qualitatively.
• Once everything is in place, ongoing portfolio management occurs. The portfolio managers implement the guidelines, deviating within allowable bounds to achieve superior results.
• Finally, the entire framework must be assessed for effectiveness and relevance. Investment performance must be compared to targeted benchmarks, and the differences understood. Assumptions behind the ALM modeling should be revisited and updated. Changing corporate or insurance industry conditions, and altered investment market expectations, should guide a revisit to the basic components of policy. Only in this way can an effective feedback loop be closed, achieving accountability for results, and overall positive control. Too often, disappointing outcomes can be traced back to a failure to periodically assess effectiveness and relevance of the whole system, a failure to close and clinch the feedback/accountability cycle.
Investing for success
Since portfolio management is such a crucial part of any insurer's investment operations, whether in-house or outsourced (or some of both), this topic merits special attention. Portfolio management is one of the key services SIAM offers its clients, as part of the global investments management firm Scudder Kemper Investments, Inc.
The worldwide investment markets may seem at times like a chaotic bundle of disparate asset types. But with a sound foundation of research, ALM analysis, and trading acumen, the markets can be accessed as a coherent menu of possible risk and reward combinations. The job of SIAM's insurance strategists is to help each client find the best blend - its own customized ideal investment policy - within this almost infinitely variable and ever-changing menu.
It is worthwhile now to revisit asset/liability management, because portfolio management is where ALM most comes into play. The task of good ALM is to help seize appropriate upside opportunities and avoid untoward downside risks. Risks to analyze and manage exposure to include inflation risk, currency risk, reinvestment risk, disintermediation risk (interest rate spike-up risk), quality risk, and equity value risk. The durations of assets and liabilities should not drift too far apart, because losses can occur through mismatching. But the durations of assets and liabilities are themselves interest sensitive, when options are imbedded or claims are paid in CPI-adjusted dollars.
Since assets typically include call/prepayment features, while liabilities typically include put/withdrawal provisions or some tie-in to inflation, the insurer's market value surplus is in fact a kind of stealthy but real “short straddle” position: net worth can be impaired by any interest rate change, whether that change be a rise or fall in rates. This is known as the negative convexity problem, familiar to ALM practitioners. It can down-lever business outcomes through subtle multiplier effects. Coping with convexity, like all risk management and risk positioning, requires advanced analytic systems, and demands constant attention to updating portfolio structures, fine-tuning balance sheet behavior, and hedging economic value.
Thus, considerable experience and a constant presence in the markets is needed to squeeze out the greatest profit potential. One point of stress on company earnings is a low interest rate environment. Tightening of sector spreads can be a mixed blessing as well, possibly improving in-force total return while impairing new investment yield. Some alternative assets with attractive return potential can be quite complex to model and to trade successfully. Greater cash liquidity may appear to offer safety, but too much liquidity can impair returns as well - in fact private placements often deliver an attractive and consistent yield premium for their lower liquidity. Below-investment-grade bonds, and international investments, offer higher promised results, but with greater risk of underperformance. Common and preferred stock, and hybrid assets such as convertibles and equity-linked notes, also have a proper place to help grow company surplus, in a wider context of the whole portfolio make-up. That context should include awareness of the benefits of covariance, i.e. improving value at risk (VAR), by combining dissimilar asset types - many insurers have an increasing desire to own non-traditional investments, such as emerging markets or risk control derivatives. Finally, as mentioned earlier, the posture of rating agencies and insurance regulations, applicable taxation, and evolving accounting rules, may complicate the choice of specific securities to hold, or to dispose of, at a given time. SIAM's portfolio managers work with our insurance strategists constantly to find the arbitrages sometimes created by these external dictates.
SIAM strongly advocates the development of risk-appropriate portfolio solutions for every client, as a basis for ongoing investment management. When a company works through the insurance investment decision/direction loop, insights will be gained on risk preferences and tolerances, and on the best yield-enhancing strategies. Return objectives can then be set to be ambitious but realistic, within a constrained environment that nevertheless offers great opportunities for sales and earnings competitiveness and financial solidity. This is a dynamic process. The moving parts to be coordinated include strategic asset allocations by type, sector allocations, quality rating mixes, and specific security selection. This must be done with good information on what maturity and duration structures ought to be maintained, and on the amount of convexity and yield curve risk (and other mismatch risk) that is desirable, all while obeying diversification limits which prevent over-concentration in one class or name, and industry or country. The net effect of all this coordinated effort is to deliver consistently superior portfolio results.
In the challenging environment the insurance industry now faces, investing for success is crucial. Dedicated research, insurance strategists, and portfolio managers must work as a team. Insurance companies need to pursue customized investment management which only experienced insurance investment institutions can provide. Importantly, size of the institution suggests market presence and momentum for: access to the latest research and analytic skills, the most profitable buy and sell decisions, and the best possible trading execution. Additionally, emphasis on full-spectrum operational support, regulatory updates and accounting rules, rating agency familiarity, periodic reports to internal company management, Schedule D and other accounting data, and compliance with Regulation 126 scenario testing and Dynamic Financial Analysis standards will serve as important elements to optimizing the investment function. Ideally, the investment partnership should be mutually beneficial, consultative, and intellectually stimulating for achieving desired objectives, expectations, and leading edge ideas.
This article was produced by Scudder Insurance Asset Management (SIAM), specializing in providing a wide array of investment management services exclusively for insurance companies. For more information, please contact Barton R. Holl, senior vice president and responsible for directing the marketing and sales effort for SIAM.