Reducing Insurance Risk

When compared to all other types of investment portfolios the performance objectives and risk considerations are significantly different for insurance companies. Performance for insurance companies is centered on enhancements to net investment income and positive impacts to capital and surplus or unassigned funds. In comparison, most other entities are focused on total return. The ability to impact insurance performance objectives is determined by the risk constraints of the company, which can differ dramatically from one insurer to another. Of primary importance is an understanding of how any investment transaction will impact the statutory financial statements of the insurer. “What-if” analysis should always be performed by the manager of the portfolio. Any transactions involving security liquidations should include pro-forma income statements and IMR/AVR schedules for life companies. Decisions based entirely upon total return considerations can often have negative income, reserve and other financial consequences for statutory based insurance companies.

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 each insurance company are unique and therefore the investment portfolio of every insurer should also be unique. 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 the nature of book value accounting and reserves such as IMR/AVR.

Diversification is just as important; however, it is often applied inappropriately to insurance portfolios. Diversification objectives should be at the core of any well-developed insurance 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 the typical areas of diversification can be unintentionally hurt by investment decisions. In some cases, well-intended managers that applied the traditional concepts of diversification caused adjusted surplus to fall below the authorized control levels of Risk Based Capital (RBC) during the financial crisis.

Diversification for an insurance company should consider the size of any investment as it relates to the capital and surplus (or unassigned funds) of the firm and the amount of any Asset Valuation Reserve (AVR). Targets should be set that would allow for several defaults before capital is reduced. Unfortunately, the economic crisis of 2008 informed many insurers that their exposure to certain issues was too high. Additionally, exposure for many insurers increased as surplus was reduced as a percentage of total assets. Investment grade holdings should be limited to a range of 1 – 20% of capital and surplus or unassigned funds. This range allows for government securities at the upper 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. Many insurers are also required to hold an Asset Valuation Reserve (AVR) or credit quality reserve. When an AVR is applicable, the investment in any single security should be limited to the point that the company’s standard AVR could 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. Regardless, the main factor that protects insurers is diversification in relation to capital and surplus or unassigned funds.

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.

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