Proper Diversification

When compared to other investment portfolios, performance objectives and risk considerations are very different for an insurance company. Performance for insurance companies is centered on enhancements to net investment income and positive impacts to capital and surplus. The ability to impact these performance objectives is determined by the risk constraints of the company, which can differ dramatically from one insurer to another. The two most important factors for controlling risk are diversification and the relationship of the investments with the products that the insurer sells. The products offered by insurance companies are unique and therefore the investment portfolios should also be different. The type of products offered by the insurer is the main factor that determines the appropriate portfolio maturity and cash flows. The purchase of a ten year bond could be a high risk for one insurer while significantly reducing the risk of another. This feature is centered on the basic obligation that there are sufficient cash flows to provide for the policyholders or members. This is the nature of many state and NAIC regulations including book value accounting and reserves such as IMR/AVR. This concept was discussed in more detail in the last review on interest rates.

Diversification is just as important; however, it is often applied inappropriately to insurance portfolios. This is one reason that we recommend that it is specifically addressed within the investment plan. Most people understand the importance of not having all of your eggs in one basket and diversification is discussed by most investment managers and investment programs. What is sometimes overlooked is that diversification parameters are very different for insurance companies when compared to other types of investors. Insurance companies that consider only typical portfolio theory can be unintentionally 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 reduced. Unfortunately, the recent economic crisis informed many insurers that their exposure to certain issues were too high. For example, two companies with $100,000,000 in assets may require two very different maximum exposure limits to any single security. An investment of $1,000,000 in a single A rated bond may be appropriate for one company with a capital and surplus of $60,000,000, but could represent great risk to a company with a capital and surplus of only $5,000,000. We typically recommend that investment grade holdings be limited to a range of 5 – 20% of capital and surplus or unassigned funds. This range allows for government securities at the 20% level and other investment grade issues at the lower levels. This allows for multiple issues to occur before significant deterioration is experienced in unassigned funds. It is limited in size to the point that the company’s standard AVR reserve can absorb several issues or surprises before any impact to capital occurs.

It is still important to consider diversification across all categories in assessing the risk of any investment portfolio. This includes diversification by asset type, geographic location, industry, collateral type, coupon, maturity and placement into the market. Additional research is often necessary so that overlap is limited among imbedded aspects of similar securities. For example, underlying geographical exposure of any MBS securities must be considered in order to avoid having too high a percentage of overall book value and capital exposed to a single location. The key is that every insurance portfolio needs to be unique and structured around the products offered and the specific reserves and capital of each 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.

For More Information

We welcome your inquiry and can be reached by mail at Parkway Advisors, L.P., P.O. Box 5225, Abilene, Texas 79608 or by phone at (800) 692-5123 or by fax at (325) 795-8521. A copy of our Form ADV, Part II is available upon request.

For more information, please emailĀ info@parkwayadvisors.com.