Importance of Sufficient Cash Flows

As an insurance company, the basic obligation is to have sufficient cash flows to provide for the policyholders or members of the company. This obligation is the basis behind the statutory guidelines of the NAIC. Assets are carried on the books at amortized cost in order to allow a company to focus on cash flow and not total return. In addition, reserves such as IMR/AVR, for life companies, were designed in order to discourage security trading and protect the company from credit risk.

Overtime, some shifted away from this focus in an attempt to optimize total return. A positive aspect of economic crisis is a return to the conservative foundation of insurance investing. Total insurance risk is reduced when investments are structured to provide for the known cash needs of the company. With a sound cash structure in place, an insurer can focus on enhancements to net investment income and proper yield spreads to meet product needs. Several issues caught insurance companies off guard during this crisis, but one of the most important was the aspect of diversification. Insurance companies that considered typical portfolio theory were often hurt by investment decisions. Diversification for an insurance company should consider the size of any investment as it relates to the capital and surplus of the firm and the amount of any AVR reserve (for life insurance companies). Targets should be set that would allow for several defaults before capital is actually reduced. Unfortunately, this crisis informed many insurers that their exposure to certain issues was too high. It has also been challenging for insurance companies to resist the temptation of the higher book yields offered by structured products. These securities were severely impacted by the crisis. Understanding the extent of this ahead of time might have been impossible; however, a focus on diversification and aligning cash flows with product liabilities would have limited this exposure for the majority of insurance companies. Unfortunately, many asset classes, including non- agency mortgages, CDOs and CLOs have continued to experience defaults. A significant portion of U.S. insurers experienced decreases in capital and surplus resulting from impairments in these issues. As the number of insurers experiencing significant impairments grew; the NAIC started to worry about the Risk Based Capital (RBC) levels of these companies. For many insurers, the impairments were significant enough to reduce values near to or below the authorized control levels. It was quickly realized that the old accounting rules were inappropriate for valuing these issues as impairments were often far below the expected future cash flows on these securities. The NAIC has incorporated new valuation methods for mortgage and structured securities that will reduce the negative impact for some insurers. Most notable is SSAP 43R that allows insurance companies to mark lower credit mortgages to the present value of discounted future cash flows in situations where an insurer can hold these assets to maturity. In addition, the NAIC hired PIMCO to develop a rating grid matrix on all RMBS issues held by U.S. insurers. This was a move away from reliance on the rating agencies with a shift in the risk focus from the risk of the security to exposure risk that the holding presents to the insurer. SSAP 43R and other rule changes demonstrate the need for an insurer to focus on cash flow and book yield. In general, some of these changes are exciting as the focus is a return to conservative investing that considers the true nature of an insurance company.

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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