True Diversification for Insurance Companies

When interest rates are low, a large majority of insurers have found it necessary to make changes in order to improve the financial picture of the organization. For many this means a reduction in growth rates; however, for others it has meant more dramatic changes in product lines. It all depends upon the structure of the insurance products and the consistency with which the historic investments have been aligned with the specific products of the insurer. Some insurers held additional cash through the financial crisis or chose to be mismatched short of their liability needs, believing that interest rates would increase. Insurers that applied these strategies have experienced either the impact of “cash drag” on the portfolio or the income reducing effect of reinvestment risk. With low rates, some insurers find it necessary to “grasp” for additional book yield by adding too much of one security type to the portfolio. This impact of “grasping” for yield was devastating to those that over allocated to MBS and CMBS issues previous to the financial crisis.

The key for effective management of insurance assets is being diversified and to avoid making bets on the direction of interest rates. A diversified portfolio will have the ability to contain some assets that aid liquidity or performance in the future regardless of the direction of interest rates. Some portfolio managers recommend this strategy for improving total return; however, the focus should always be based upon having flexibility to improve the statutory financial picture of the insurance company. An asset portfolio that is aligned with the liabilities of the company can avoid both market risk and reinvestment risk. A well-diversified portfolio will also be armed with the ability to add products to the portfolio that can benefit the company in changing interest rates while maintaining a long-term strategy.

The actual product purchased should be specific to the unique needs of each company. One key in effective portfolio management is to work diligently at being sufficiently below the maximum limit restrictions on all of the investment plan allocation limits. This is the best method to aid diversification and to improve flexibility.

With regard to interest rates, we continue to believe that the winds of political pressure will remain focused on keeping interest rates low. There are many reasons for this opinion; however, at its core is the need for additional stimulus in the mortgage sector of the economy. A large portfolio of Commercial Mortgage Backed Securities (CMBS) were issued in 2005 – 2007 with five year resets on interest rates. Keeping rates low through 2013 would help avoid a potential “double-dip” in mortgages. Despite this belief, I am becoming more skeptical that this pressure will be able to actually keep rates low. Commodity prices continue to increase and are begging to be recognized within PPI. Institutions are begging to invest the cash they have been sitting on for so many months. Equity prices are increasing and volume is increasing significantly on days following any pull backs. This indicates a much stronger view of the financial picture in the US. When these aspects are considered in conjunction with the other aspects of government spending, inflation is becoming a more realistic concern in the shorter term.

There is a cycle to interest rates and with the short part of the curve still at historical lows, an increase will occur at some point. The question is not if, but when. The probability is increasing that this could occur sooner than might be desired by the political winds discussed above. Regardless of this view, it is important to remain diligent in the long-term strategy and avoid the common “bets” that could hurt net investment income or lower the portfolio book yield below the levels originally required to support a product when it was sold.

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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