Low Interest Rate Strategy

This article focuses on an insurance investment strategy that is unique in a low interest rate environment. The focus of this strategy is based on insurance specific methods to enhance surplus, improve Risk-based Capital (RBC) levels or reduce risk and build upon the concepts of other diversification topics. For related articles regarding risk for an insurer, please search our Insurance Investment Research section. These simple concepts are the premise behind statutory accounting and insurance reserves such as IMR and AVR. Unfortunately, misapplication of these principles is often the reason behind surplus issues. Proper application protected surplus even during the most recent financial crisis. These principles must be addressed in order to demonstrate why performance objectives must go beyond total return and be based upon net investment income, surplus and RBC targets. Investment decisions for an insurance company must consider the impact to the statutory financial statements prior to any transaction.

Understanding these unique insurance characteristics allows the prudent investor the tools necessary to find opportunities in different economic environments. Current interest rates are near their all-time lows. Insurance companies work on a spread basis and live off of net investment income. Over the last several years, the downward drift of interest rates has reduced the book yield of new investments. In turn this has decreased the growth rates offered on products and placed added pressure on company surplus levels. As a result of these features, most insurance companies are complaining about current interest rates and typical rate discussions are inherently negative. The prudent insurance investor understands that unique opportunities are often available in trying times and a low interest rate environment is no exception to this rule. Identifying these “opportunities” requires a comprehensive knowledge of insurance accounting. As a result of the recent financial crisis many insurance companies experienced downgrades within their bond portfolios. With the Treasury curve near all-time low levels this may be an opportune time to reduce the lower rated securities within the portfolio. Not only are yields at low levels, but the spread on credit issues has contracted as many investors are searching for yield. While this opportunity is an obvious one, there are more profound justifications for initiating current liquidations based upon credit quality. Many of the securities downgraded during the financial crisis remain viable “going-concern” institutions. Therefore, an insurance company often has the tendency to hold on to these securities. Other insurers choose to hold lower rated securities in an attempt not to realize a loss as the security accounting treatment is based upon amortized cost. However, for insurance companies reporting an asset valuation reserve (AVR) and looking to enhance Risk Based Capital (RBC), liquidation of these securities could improve the overall financial picture for the insurer. AVR is a reserve that simply removes funds from surplus ahead of time in order to buffer the portfolio in case of a credit event. Higher risk securities require a higher AVR and thus a lower reported surplus. The calculation for AVR is comprised of a basic contribution, a reserve objective and a max reserve. The reserve objective is the targeted annual reserve and the max reserve represents the highest level the AVR can reach. The lower the rating of a security, the closer the reserve objective factor is to the maximum reserve factor. One of our many services to the industry is performing comprehensive portfolio consulting reviews for use by insurance officers in making decisions. In many of our more recent reviews we have pointed out to several internal portfolio managers examples similar to the following: A company has 90% of its investments rated in the NAIC 1 (highest category), 5% in NAIC 2 (still investment grade) and 5% below an NAIC 2 rating. In this hypothetical example the 5% that is non-investment grade is responsible for 45% of the AVR reserve. A swap aimed at reducing this 5% can have a dramatic impact on enhancing surplus even when the liquidation results in a loss. Not only is the loss buffered by the AVR reserve, but the future AVR is lowered due to the quality improvement of the portfolio. This reduces the “January effect” and improves stability of surplus. In addition to AVR, RBC can sometimes improve dramatically as the securities identified as the highest concentration risk always begins with the lowest rated issues for RBC.

The current environment also offers the liquidity to diversify the portfolio. As discussed in other articles, the amount invested in any one security should be a small percentage of surplus and any applicable AVR. Should an unfortunate credit event occur, like Lehman Brothers, the surplus of the company would not be impacted in the base year under this strategy. However, in addition to surplus protection, RBC has the potential for additional improvements as the number of holdings increases.

In applying either of these strategies, it is important to consider the impact to book yield and to reinvest in issues that enhance the relationship of the assets to the liabilities. Slow and methodical is typically the most effective course of action and statutory “what-if” analysis should be performed.

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.

Performance Objectives – Beyond Total Return

As discussed in other research, risk for an insurer must focus on diversification as it pertains to capital and surplus (unassigned funds) and how the assets relate to the products that are sold to policy holders (members). The following discussion will utilize a few of these concepts to explain why performance objectives must go beyond total return and be based upon net investment income and the surplus of the insurer.

A key factor in the success of an insurer is the performance of the investment portfolio; unfortunately, the valuation tools used to measure insurance performance are often inappropriate. As an insurer, it is easy to be conditioned to view investment success by comparing the total return of our portfolio to that of a benchmark index of similar securities. This approach is extremely appropriate for most investment portfolios. Consider for example the equity portion of your personal IRA or 401-k account. If the total return on the portfolio over time exceeds that of the S&P 500 Index you are probably excited about your portfolio. The appropriate asset allocation of your retirement account is based upon the risk that is appropriate considering your personal needs and objectives. The expected time until retirement is normally the greatest factor in assessing the appropriate portfolio risk that can be assumed. The objective is essentially to generate the largest pile of money possible considering the risk profile appropriate for your needs.

When insurance assets are managed to optimize total return there are several unintended consequences that often adversely impact the insurer. Furthermore, decisions that a prudent investor would make in order to optimize total return may actually reduce surplus or the net investment income of an insurer. A key to understanding these potential issues is centered on the ultimate objective of the insurer. An insurance company is entrusted with funds that represent future payments to members or policy holders. This simple concept is the basis for statutory accounting principles and the majority of regulations developed by the NAIC or various state departments.

A large component of total return is the unrealized position of a portfolio at any given time. However, insurance companies carry the majority of assets at amortized cost. The basis for cost accounting is that fixed income investments are to be held to maturity in a manner where the cash flows are sufficient to provide for the future expected claims of the insurer. This reduces the concern related to decreasing market prices and places the focus on net investment income. This focus is appropriate and actually reduces risk. Securities purchased should support the future cash flows of the representative product and provide sufficient book yield (spread) to support product growth rates and operations. This is true regardless of the direction of interest rates. Insurance investing should not focus on speculation or “bets” on interest rates, but work to ensure that surplus and net investment income are appropriate in any economic environment.

Additionally, there are circumstances where a focus on total return would dictate the sale of a security in order to realize a gain and reinvest in another security with a better appreciation profile. If an insurer files an Interest Maintenance Reserve (IMR), then the gain on a disposal would not be realized initially, but amortized into income over the remaining life of the security that was sold. When a gain is considered, reinvestment would typically occur at a lower current yield; therefore reducing the overall book yield of the portfolio and negatively impacting net investment income. If taxes come in to play, the impact to income is amplified by the tax rate.

Another tool that is often used in an attempt to generate positive return versus an index is shifting between asset classes or qualities. This reduces diversification and has significant impacts to Risk Based Capital (RBC) in addition to creating volatility in the AVR. This in turn can place downward pressure on surplus in addition to the trading impacts to IMR. More importantly, if the amount invested in any single security is large in relation to surplus, the risk to the insurer is enhanced. This would not be the case for other types of investors as diversification is considered based upon total assets.

One final total return concept that is impracticable to apply to insurance investing is the typical strategy of a total return benchmark. As an insurance company your products, members, marketplace, liabilities, statutory reports, surplus and history are unique. Appropriate investing must consider the liabilities and surplus; therefore, every insurance portfolio should be unique. This makes the common benchmarks that are applied to all portfolios meaningless even when total return is the objective. Each benchmark would need to be custom designed, which reduces the ease of market understanding. Regardless, a total return benchmark could never quantify the specifics of investing to match liabilities, enhance surplus or better position IMR/AVR. Better benchmarks for insurers are: ALM objectives, book yield comparison to competition, surplus enhancements or anything that more efficiently ties performance to the true needs of the insurer.

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.