Skillful insurance asset management today involves taking a holistic view. Steven C. Doire, Barton R. Holl and Kevin D. Holt report.
Interest rates have hit historic lows and stocks have demonstrated significant levels of volatility. Tomorrow's financial markets will certainly bring more challenges. How can property/casualty insurers manage the risks associated with this uncertainty? The answer lies in rethinking the concept of the company. The traditional view separated the company into two parts, an underwriting entity and an investment entity. The evolving view considers the company to be a combination of financial instruments, both assets and liabilities, that result from operating in selected business environments. A look back over the last two decades will provide perspective on the evolution of this holistic view.
A look back
In the late 1970s, at about the time of Scudder Insurance Asset Management's creation, the financial world was much different than today. The domestic capital markets were less sophisticated and international investing, one of the original alternative investments, was considered by only the most avant-garde investors. There were few choices within the primary fixed asset classes and even fewer non-fixed income substitutes. Structured securities as we know them today did not exist. Mortgage-backed security specialists, lacking today's computer technology, struggled to model the effects of embedded options on the price behavior of even the simplest securitized mortgage instruments.
Within the insurance marketplace, companies practiced conservative buy-and-hold investment strategies, viewing the investment function as less important than product development, distribution, and underwriting. Most companies managed their investment portfolios with in-house staff, often struggling with some of the same tax and regulatory issues which exist today. The rating agencies began refining their reviews of insurance company financial results and balance sheet risks, setting the stage for even greater involvement in the years to come.
Financial market events such as the stock market downturns of the 1980s and bond market shocks of the early 1990s have resulted in periods of considerable capital and surplus volatility. Adroit insurance organizations acknowledged the need to better understand the financial intricacies embedded in their assets and liabilities. No longer could insurance asset management exist separately from the rest of the company. Larger companies allocated internal resources to develop models and strategies, while many small to mid-sized companies realized the investment function was best outsourced to a professional insurance asset manager.
Where are we today?
Today, skillful insurance asset management acknowledges the reality of this holistic company construct. Asset managers must be sensitive to liability characteristics, tax considerations, rating agency issues, and surplus growth objectives. The goal is to understand the impact each will have on the future economic value of the company; only then can an appropriate portfolio be constructed. In response, the modeling techniques used by insurance asset managers have grown in sophistication. For example, insurance asset managers are starting to utilize a relatively new modeling technique known as dynamic financial analysis (DFA). DFA is a rigorous modeling technique that integrates the insurer's financial structure and business plans with extensive business and investment scenario analysis. Models like DFA facilitate analysis of the interplay between the balance sheet and income statement, cash flows, financial ratios, and regulatory criteria.
These comprehensive models are proving their worth during this year's difficult investment environment. No insurance company has been insulated from the recent capital market volatility. However, insurance organizations that have implemented company appropriate portfolio solutions are managing better than those who have not. For instance, property/casualty insurance companies often purchase oversized allocations of non-US Treasury securities (that is, spread product) to enhance yield. The enhanced yield is earned for assuming greater risk; a risk that has been readily apparent in the recent emerging economy meltdowns. A flight to quality (US Treasuries) has ensued which has hurt all categories of spread product. Those companies that understand their risks and their potential impact are prepared to adjust quickly and appropriately.
Property/casualty insurers must realize that the underwriting and investment components should be thought of together. After overall corporate risk has been evaluated, insurance asset managers can then construct an appropriate investment portfolio from the multitude of fixed income sectors and asset classes. For those companies with low risk tolerance, a well diversified portfolio may contain US Government Notes, US Agency Debentures and Mortgage Related Securities, Municipals, US Investment Grade Corporate Bonds, US Dollar Denominated Foreign Bonds and Preferred Stock. Constructing this portfolio, the insurance asset manager must understand the portfolio risks. These risks do not stand in isolation. They need to be defined relative to the company's liabilities and operating objectives. The insurance asset manager must monitor a variety of risks including duration, convexity, reinvestment and sector risk relative to corporate needs and benchmark objectives. In the present investment environment, it is critical to understand, hedge and optimize portfolio risk. To cover the risk of further rally-induced spread widening, convexity and duration can be enhanced. Structuring the yield curve exposure can also offset other risks. Having the ability to use appropriate portfolio management tools in every type of investment environment is a mandatory requirement of each insurance asset manager.
As the property/casualty company's risk tolerance increases, more asset classes become available. High Yield Corporate Bonds allow for incremental yield while still maintaining debt characteristics. Common stocks become one of the first non-debt asset classes of choice once appropriate surplus is accumulated. Companies will typically define their appropriate common stock exposure as a percentage of surplus. Convertible bonds trade-off lower income for partial equity participation. A variety of new pooled asset vehicles are available through the growth of the Collateralized Bond Obligation and Collateralized Loan Obligation markets. These collateralized markets have increased rapidly this past year, offering a structure that is appropriately diversified. Finally, Emerging Market bonds, while currently in distress, can offer long term diversification enhancements.
A holistic view of the company is a necessity in the ever growing competitiveness of the property/casualty industry. Insurance asset management that operates from this point of view capitalizes on the opportunities created by product development and distribution groups while managing risk. Successful property/casualty companies will be those that capitalize on the opportunities this framework provides.
Steven C. Doire is assistant vice president, Scudder Kemper Investments, Inc. Mr Doire specialises in client financial analysis, industry accounting and regulatory issues, and the development of computer models for the insurance group. Prior to Scudder, Mr Doire was an assistant vice president for treasury operations, corporate planning and analysis and financial systems at Providence Washington Insurance Group. He also served as a senior accountant specializing in audits of financial institutions for KPMG Peat Marwick. Mr Doire received his BS from Brayant College.
Barton R. Holl is senior vice president, Scudder Kemper Investments, Inc./director of marketing and sales for Scudder Asset Management Group, focusing exclusively on insurance companies. Previously Mr Holl was the director of marketing for Charter Oak Capital Management. He was a vice president for institutional sales specializing in global asset strategies at Wells Fargo Bank. Additionally he maintained responsibility for institutional sales at The Travelers, Kidder Peabody, Inc. and Honeywell Inc. Mr Holl attended Babson College (BS).
Kevin D. Holt is senior vice president, Scudder Kemper Investments, Inc./chairperson of Scudder Insurance Asset Management's investment strategy committee which is responsible for formulating the interest rate outlook and its impact on portfolio duration, yield curve and sector allocations. He also maintains senior investment responsibility for a wide range of insurance company accounts, with a specialty focus on taxable and structured products. Prior to Scudder, Mr Holt was an investment officer with Northern Trust. He attended Northwestern University (BA) and University of Chicago (MBA) where he majored in economics and finance respectively.