Category Archives: Research

Goodbye LIBOR

July 28, 2017

The London Interbank Offered Rate, more commonly referred to as LIBOR, is on its way out the door.  Many associate LIBOR with scandals including manipulation and false reporting.  To others, it represents the index to which over $350 trillion of financial products reference.  Technically, LIBOR is the average lending rate of banks in the London interbank market.  However, fraud and collusion have led to the loss of reliability and ultimately the demise of the popular index.

The UK Financial Conduct Authority (FCA) announced yesterday it plans to phase out this 50-year old benchmark by the end of 2021.  The FCA’s head, Andrew Bailey, believes there is no longer a market to support LIBOR.  Moreover, he believes establishing a firm schedule will aid financial institutions to manage transition.  This is part of a global reform of benchmark rates by the FCA.

So what is the impact of the FCA’s decision?  And more importantly, how will it affect your investment portfolio?  Currently, the main impact is the uncertainty this has inserted into the market.  Since no rate has been defined as a specific replacement, financial institutions and investors are left in the dark as to what will occur.  Clearly, new investments introduced to the market will no longer reference LIBOR.  However, it is widely uncertain as to what will happen with the existing products and securities that currently associate with LIBOR.  In the short term, expect increased volatility and even illiquidity in these types of products until the market has clearer direction as to what might be replacing the benchmark index.  With regard to these products, Bailey said it depends on “preparations that users of LIBOR make in either switching contracts from the current basis for LIBOR, or in ensuring that their contracts have robust fallbacks in place that allow for a smooth transition.”

Depending upon your appetite for risk, this uncertainty could create motive to take advantage of uncertainty and capitalize on mispriced products.  Alternatively, it might necessitate avoiding any new purchase of LIBOR-linked investment products until the seas have calmed.

Build America Bonds and ERP

Well, the government has done it again. Yes, federal subsidy payments to issuers of Build America Bonds (BABs) and other direct-pay bonds will be cut by 6.8% in fiscal 2016. Again due to sequestration, this cut follows two others on the BABs in recent years: 7.3% in fiscal 2015 and 7.2% in fiscal 2014. According to officials, fiscal 2016 cuts are lower due to Medicare and its growing costs. Specifically, sequestration necessitates about $109 billion of cuts divided evenly between defense and nondefense programs. As such, a little over $54 billion for nondefense programs is divided between discretionary programs and entitlements such as Medicare. Since Medicare sequestration cuts are capped at 2% of its costs and due to the rising costs of Medicare, more of the $54 billion comes from entitlements than from the discretionary programs.

So, how does this affect bonds? The reduction of the subsidy allows issuers of BABs to redeem bonds early. This has caused some issuers to follow through and actually redeem; however, most have simply reminded bondholders that they have the right to redeem their bonds, flexing their muscles to an extent.

Now, let’s take this opportunity to explain exactly what this Extraordinary Redemption Provision (ERP) is and how it differs from a structured call provision. BABs, like other municipal bonds, typically have standard call features. This means they have the right but not the obligation to redeem a bond prior to its stated maturity according to the call schedule stated in the prospectus. As far as the BABs are concerned, the first call dates are typically 2019 or 2020 (10-years after their issuance in 2009 and 2010). An Extraordinary Redemption Provision (ERP) goes above and beyond the regular call. For BABs, if the government reduces the issuer’s subsidy (which has already happened) the bonds can be redeemed at ANY TIME. Moreover, any holder of BAB municipal securities currently has some element of risk under this extraordinary provision.

While risk is present, this has been a possibility since initial issuance. As previously stated, this is the third reduction in the subsidy and only a handful of issuers have executed their right under this provision. More specifically, there have been $188 billion total of BABs issued. Of this amount, only 10-20 issues have actually been redeemed under this provision, with the largest issue being $100MM. Ultimately, far less than 1% of all BABs have been redeemed under the ERP due to the reduction of government subsidy. This is the place where I give you the advisor disclaimer: “past performance is no guarantee of future performance.” In this case, translate that to mean simply because many issuers have not exercised their right to prematurely redeem under this ERP does not mean they will not. With that said if interest rates rise the ability to refinance these issues at low interest rates diminishes. There is still risk and even though it may be limited this decision lies in the hands of the issuing municipality. In theory, as rates rise the flexibility to refinance this debt reduces as the interest burden is greater on the municipality.

The specific details of each issue’s provision vary. Some can be redeemed at a specific spread to a U.S. Treasury while others dictate a stated price, usually par or a slight premium. With that said, the lower the redemption price, the greater the risk in theory as it makes the redemption less expensive for the issuer. For instance, redeeming a bond at par would be cheaper for the municipality than paying a 100-basis point spread over a 30-year Treasury (considering the coupons of the BABs). Since interest rates are low prices are higher. Additionally, depending upon when the BAB was purchased (whether in the new issue or secondary market and at what point over the last six years), the book price of the issue may be at a premium. Moreover, if the bonds are redeemed at a lower level (closer to par) the more likely it is for a loss to be realized. Another aspect of risk to consider is whether the issuer has the ability to exercise their ERP right (at whatever respective price) and re-issue as a tax-free municipal. This throws another variable into the mix that is also difficult to ascertain and determine a mathematical answer as to whether it makes sense for the issuer or not.

All of this information is to say: know the risk in your portfolio. If you are loaded up on BABs, know the specific ERP details of each. It is not our stance that BABs are or have been a poor investment; after all no return can come in excess of the risk free rate without some form of risk. However, the purpose of this article is to inform the reader of the situation as well as help you become familiar with the risk.

If you need assistance ascertaining the specific Extraordinary Redemption Provision risk of the Build America Bonds within your portfolio, please do not hesitate to give us a call.

Disclosures

Parkway Advisors, L.P. is an investment advisor registered with the Securities and Exchange Commission offering investment management, consulting, and statutory 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 email info@parkwayadvisors.com.

Investment Plan Design

One of the most important documents for any insurance company is the investment plan. An effective plan will establish the ground work for achieving and monitoring long-term performance objectives, while controlling risk. Therefore, the investment plan should be part of, or consistent with, the enterprise risk management policy and overall business plan of the organization. It is also important to remember that the investment plan is a document of the insurance company and not that of any third party such as an outside investment advisor. The plan should address the specific needs and objectives as they pertain to the overall assets of the organization. Any relationship that works to serve the insurer should be bound by contract to comply with the investment plan of the company. While it is possible for a plan to be complex and with too many limits on flexibility, the most common error is not efficiently addressing the risk constraints of the organization. An appropriate plan should be dynamic enough to address company specific risk and inclusive of policies that are a current concern to regulators. Following are several of the main concepts that should to be part of an investment plan.

Approval: The investment plan is a document that should be reviewed and approved on an annual basis. Additionally, it is important to report periodically (quarterly or monthly) as to compliance with the plan. This includes investment transactions and policy adherence.

Applicable Laws/Regulations: An insurance company is highly regulated and must comply with appropriate laws and regulations. Since this is so obvious, a common mistake is to avoid mention within a plan. Most auditors require inclusion of applicable law in order to demonstrate understanding and acceptance. At a minimum, it should be stated that the insurer must comply with the regulation of the State Insurance Department and all applicable guidelines of the NAIC.

Risk: While there are many risks inherent in investing, there are two specific policies that are most effective in controlling risk for an insurance company. These are diversification and a policy that aligns the assets appropriately with the products that are sold to members or policy holders.

Diversification Objectives – For an insurance company, appropriate diversification must consider the size of any investment as it relates to surplus or the AVR level for a life insurer. An effective plan should address the maximum amount that can be allocated to any single entity. The diversification objectives can be addressed in a single policy or broken out in detail under each asset class section of the plan. When possible, a plan can significantly reduce risk by limiting the exposure to any single fixed income entity to less than 10% of surplus and an amount less than the default component of the AVR for a life company. Higher rated securities should be allowed a larger exposure than lower rated securities and investment below a certain rating should be restricted. Where these restrictions occur depends upon the unique characteristics and risk tolerances of the organization. The total exposure allowed in any asset class that is marked-to-market, such as common stock, should be highly scrutinized as to the potential risk to surplus and RBC in a downward market. When surplus is low as a percentage of total assets, this type of asset class should be avoided entirely in order to protect the company. In other situations it could be appropriate to limit total exposure to a level that would still keep net income positive even in a 50% market decline. It is important to remember that as an insurance company you are entrusted with funds and should not make “bets” on the market.

ALM Policy – The most effective tool for reducing surplus risk is an effective policy designed to structure the assets appropriately for the products that are sold by the organization. As every insurance company is unique, this strategy must also be tailored to the needs of each company. For some insurance companies with stable liabilities, this strategy may entail more of a direct matching of the cash flow of the assets to the liabilities. However, for other insurers, additional parameters and qualifications are necessary due to the volatility of the future cash outflows. The key is to understand what could happen to the company in various interest rate scenarios. A situation must be avoided that endangers the policyholders regardless of how unlikely that scenario may seem given the current economic environment. Remember, we are stewards of other people’s money and we must be diligent in our process for caring for others.

Policies Desired by Regulators: Insurance departments vary across the nation in what they prefer to have included in an investment plan. However, the following categories are becoming more uniform as states are becoming more uniform in many respects.

OTTI Policy – Previous to 2009, no specific single Statement of Statutory Accounting Principles (SSAP) addressed the potential write-down of investments for other than temporary impairments (OTTI). Following the financial crisis, several new regulations were developed to provide guidance including SSAP 43R and several updates to the Purposes and Procedures Manual of the Securities Valuation Office of the NAIC. Although something you hope to never use, a comprehensive OTTI policy will demonstrate to regulators that you are prepared and understand current regulations.

Watch List Procedure – To identify potential securities whose value may be impaired, a company watch list should be maintained. The investment plan should detail how this list is determined. Parkway recommends a three tier approach to a watch list:

  1. A downgrade list that details any security viewed to have a high potential of becoming non-investment grade or falling below the minimum level allowed for purchase by the insurer.
  2. A concern list that details securities already below the initial level or viewed as having greater concern that the issue could become an MTM or impairment issue.
  3. MTM/Impairment watch list that details all securities viewed as having a high potential that some future principal payments will not be collected. By rule this category should include any security with a rating below CCC/CCC.

Stress Testing and Scenario Analysis Policy: Initially led by the state of New York, many states now require a comprehensive stress testing and scenario analysis policy within the investment plan. A policy should be implemented to provide guidance with regard to reporting to the Board of Directors while providing analytical tools to the investment team in regards to liquidity, call, credit, and impairment analysis. Of particular importance is a comprehensive impairment policy that focuses compliance to the Purposes and Procedures Guide of the NAIC. This policy often defines reports needed by the board for quarterly review including value at risk report, maturity changes due to interest rate shifts, cash flow graphs, category book yield analysis and other reports specific to each 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 email info@parkwayadvisors.com.

Reducing Volatility to Surplus

Reducing volatility to surplus is fundamental in building a successful long-term investment program for an insurance company. A key objective of any successful investment program should be based upon generating an appropriate return while assuming the least amount of risk. Most investors are accustomed to comparing the total return of a portfolio to a benchmark. Many astute investors also consider the standard deviation (volatility) and use other measures that provide insight into performance on a risk adjusted basis such as alpha. While these concepts can be a very effective measure of performance and risk, care must be taken to ensure that the return measure, volatility measure and the benchmark are appropriate and focused on the actual needs. This article is designed to provide insight into aspects of these measures that differ significantly for an insurance company.

Return Measure: Investing insurance assets is unique in comparison to all other types of portfolios as the majority of the assets “entrusted” to the insurer are backing reserves. These funds must be invested in a way that provides for the future claims of the policy holders that have trusted the insurer. The capital and surplus represents the excess assets above that which is necessary to provide for the liabilities. Regulation, regulators and AM Best are concerned about both the stability of capital and the risk to capital for insurers. This is because they never wish to see asset levels fall to the extent that the ability to provide for future claims is in danger. The stability of capital is the basis of many of the statutory regulations of the NAIC including Risk Based Capital (RBC), cost accounting and reserves such as IMR/AVR. Amortized cost accounting is the foundation of statutory accounting and aimed at encouraging insurers to “buy and hold.” The desire is to encourage insurers to focus on how cash flow, book yield and surplus relate to the products that are sold by the company. This unique aspect places a high emphasis on the net investment income of the insurer. While total return includes the market value of an account at any given time, book yield is directly correlated to net investment income and provides for the ability to maintain surplus, pay growth rates on products, maintain RBC levels and provide for operations. This does not mean total return is of no importance. What is critical to understand, however, is that decisions made only to enhance total return often result in reduced surplus, lower net investment income and higher IMR/AVR levels due to the nature and purpose of an insurer and the application of accounting regulations. Net investment income, cash flow and book yield must be a part of any return measure emphasized by an insurer.

Volatility Measure: Standard deviation is a measure of volatility and very important; however, it is normally based upon total return when discussing investment performance. The problem with being focused on the standard deviation of total return is that it provides little insight into the real risk of an insurance company. What is most important to focus on is reducing risk. The two most important methods to reduce portfolio risk for an insurance company are: diversification by holding a small percentage of surplus or unassigned funds in any one investment and a focused strategy of having assets that are appropriate for the products that are sold to the public. If the assets of an insurance company produce cash flows that provide for the future claims, the policy holders are protected and risk is minimized. This is why an insurer does not report the market value of investment grade bonds. The market value of a bond will fluctuate with changes in interest rates. When the maturity of the bond is structured to provide for future cash needs, the company is secure as long as there is no credit event, regardless of what happens to interest rates between now and the date of the cash need or claim. Therefore, the volatility of total return is less of a concern than the volatility of book values or capital and surplus. This does not imply that one should never look at the standard deviation of total returns, but if focus is placed on reducing this volatility, it could inadvertently result in increases to the volatility of surplus and RBC levels. A low standard deviation of book yield is what separates an insurer over time. There are many ways to reduce the standard deviation of total returns on a bond portfolio. Unfortunately these methods are not correlated to providing cash flow around the liabilities of the company. Insurance companies sometimes make well intended decisions to reduce volatility only to experience later unintended declines in surplus. For these reasons, volatility measures must consider surplus and the book value of assets.

Benchmarks and Alpha: Alpha is one of five technical risk ratios used in modern portfolio theory (MPT) and is intended to help determine the risk-reward profile of a portfolio. Simply stated, alpha represents the value that a portfolio manager adds to or subtracts from a portfolio’s performance. Alpha can be very important as an investment tool; however, before applying it to an insurance portfolio a deeper understanding is critical. The alpha calculation plots the abnormal rate of return of a portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM). CAPM is a graph that draws a line between a “risk-free” investment and that of the “market.” The points of each are simply plotted by considering the standard deviation and the total return of each security. Typically the 90 day T-Bill is used as the risk free rate and the S&P 500 Index is used to represent the market. The return of the portfolio is then plotted and if it is above the line it has a positive alpha. Unfortunately, these measures have no basis for the assets of an insurance company. Of prime consideration is the fact that the risk-free rate must be appropriate. For most types of investors this may be the 90 day T-Bill as it reduces volatility and is backed by the Government. However, the risk free investment for an insurer is unique and very specific. The risk free portfolio for an insurer would be a series of US Treasury Strips “laddered” in a way where the maturities directly align with the future liability cash flows. This is also unique for each insurer as products and history differs for each company. The benchmark index used to replicate the market should be one with a duration that approximates that of the liabilities of the company and comprised of investments that are allowed by the insurance department of the state of domicile and appropriate for the insurance products sold by the insurer. If both of these are calculated, then the alpha of the portfolio will be a true reflection of the value added by the portfolio’s design. However, if the standard risk free rate is used, the results will not align to the unique characteristics of the company.

The purpose of this article is simply to point out some unique characteristics of an insurer that impact the return, volatility and benchmark measures used to gauge performance. As with any portfolio, it is important that all valuation tools are in line with the actual needs and objectives of the account. An insurance company is unique in comparison to all other types of portfolios. In summary, a focus on net investment income, surplus volatility, statutory accounting, IMR/AVR (if applicable), RBC and the liabilities can be accomplished while producing a good total return. However, the reverse is not necessarily true. A focus only on total return can have very negative consequences for an insurer, especially if the benchmark and volatility measures are not tied to the value of the insurer. It is for this reason that volatility of surplus is such a key factor for regulators and AM Best.

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 email info@parkwayadvisors.com.

Value-Based Investing

Is it important that the investments within your portfolio are reflective of your values? How does this concept impact performance? These are two of the questions that frequently come up in discussions with insurance company presidents and should be properly addressed. Moreover, the following discussion addresses these questions and the impacts of value-based investing on performance.

Parkway Advisors strongly believes that Christian principles are appropriate in developing and growing an ethical organization. These principles are incorporated in our strategic initiatives and our internal principles of performance. We are also very confident that the consistent application of these principles has dramatically assisted in our success as an advisor.

We also believe that consistency in life is paramount to success. It is important to be the same person whether dealing with family, friends, work or charities. It is also important to understand that every insurance company is unique. The culture, history, products, members/policyholders, employees, historical performance and values of your company are wonderfully unique and the reason your firm has value to its clients.

Moreover, after personal discussions with many insurers, we have determined values are very important to your organizations as well. Some of you actively embrace the helpers of people concept and participate in community development. Others take pride in their background and culture. When these values are shared by your employees, management, members or policyholders, the relationships are in most cases more developed and lasting. The key is being genuine and consistent. In many instances these values are reflected in the groups to whom you choose to market your products.

The specific strategy is unique for each insurer and is based entirely upon your values and direction. For some, it means an active strategy to incorporate the investment in companies that also promote the same values. For others, it might be meaningful to “screen” potential investments for companies that participate in products or values that are not consistent with the values embraced by your organization. This style of investing adds consistency to your organization and allows those that embrace these same values to connect and identify with your company. It also allows employees to feel good about their work and to tie work to more important concepts of life.

Many companies have considered value-based investing; however, some do not know where to start or are afraid of a potential impact to return. An effective strategy that is tied to the company values may actually enhance the performance of the insurance company as a whole due to the characteristics discussed above. Most important is the loyalty of policyholders and employees. Again, we are all human and looking to have meaning in our work and relationships. When shared values are honestly communicated, we are more likely to have a better relationship.

How does a value-based investment strategy impact the performance of the company’s investment portfolio? If applied correctly, the answer should be that there is not an impact either way. Risk for an insurance company must always be controlled through diversification in light of surplus and any applicable IMR/AVR reserves and by investing in securities that are consistent with the products that are sold by the company. Performance should always be viewed in terms of surplus and net investment income. If value-based investing is applied while these other aspects are emphasized, investment performance can remain higher than that of the competition while achieving the other traits discussed above. The only potential negative is that a solid strategy can mean more diligent work through active research of investments. However, sometimes the most meaningful and rewarding things in life require work.

The key to an effective value-based investment strategy is being genuine and consistent with the application of your values. It must also be clearly defined in your investment plan and be able to be communicated to all parties related to the insurance company. A value-based policy can add to the overall performance of the company when the values are shared by employees and customers. When this is the case, an effective strategy can help develop relationships and increase the respect of an organization.

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 email info@parkwayadvisors.com.

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 email 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 email info@parkwayadvisors.com.

Negative Effects of Total Return

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. Investment success is often measured 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 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 email info@parkwayadvisors.com.

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.

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

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.

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 email info@parkwayadvisors.com.