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.

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 email info@parkwayadvisors.com.

Timing the Increase in Interest Rates

As insurance companies focus on strategies to maintain the net investment income levels of the past, the low interest rate environment remains one of the primary concerns. Across the nation, companies are reducing product growth rates and altering product design in order to adjust to the book yields offered by the market. Low interest rates affect all insurance companies. However, a deeper look reveals that the impact can differ from one company to the next depending upon product mix and the current portfolio. Risk reduction for an insurance company is dependent upon diversification as it pertains to adjusted capital levels and investments that are properly aligned with the products sold by the insurer. Companies with shorter products or higher annuity mixes are clearly experiencing accelerated declines in book yield if they are maintaining their risk profile.

With interest rates low, the common perception is that rates should not fall much lower. This reasoning often causes some companies to attempt to “time the market” and shift their assets short versus the liabilities in order to increase book yield when rates improve. In fact, some companies have been doing this for several years. Interest rates are near historically low levels and at some point they will cycle back up; however, the timing of this event is clearly difficult. In fact, history indicates that 95% of professionals lose when attempting to time the market. Additionally, insurance companies are not in the business of timing, and focus must remain on providing for the policy holders (or members) while limiting both market risk and reinvestment risk. Over the last few years, insurers that were mismatched to their products on the short side have experienced declining book yields. These declines have been to a much greater degree than that of their competitors employing a strategy of insurance risk reduction through alignment with product liabilities. Of course, companies must also guard against shifting long versus the liabilities in order to gain book yield. This would increase market risk should rates rise. This is only one brief example of why companies need to have appropriate assets compared to the products of the company.

There will certainly be an increase in interest rates; however, the timing is unknown and complicated by the vast amount of government involvement. Currently the pressure is aimed at keeping rates low or even reducing them. Residential mortgages were the leading catalyst in the recession and many fear that commercial mortgages could be the next market issue to occur. The current desire is to keep rates low as many CMBS securities have interest resets that occur five years after issue. A large amount of CMBS product was issued in 2005, 2006 and 2007.

As stated, we do not know what interest rates will do, and because of that we are not making bets. Rather, it is prudent to properly immunize asset and liability cash flows in various interest rate scenarios. By properly aligning a portfolio over time, slow and methodically, portfolio yield should be more constant and likely increase over time.

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.

Recent Changes to Insurance Investing

In the past few years there have been difficult times in the economy as well as many changes unique to the insurance investment arena. In the last half of 2009, SSAP 43R was released by the NAIC. This new regulation allows insurance companies that can hold assets to maturity to mark lower credit mortgages to the present value of discounted future cash flows. Also, the NAIC hired PIMCO to develop a rating grid matrix on all RMBS issues held by U.S. insurers. This move shifted the historical dependence from the rating agencies to security exposure risk that the holding presents to the insurer. SSAP 43R and other rule changes demonstrate the need for an insurer to return to conservative approaches and focus on cash flow and book yield.

Since the peak of the recession, a general improvement in the markets has occurred. Some lingering effects still remain for many insurance companies. Specifically, there are certain collateral types such as residential loans and Alt-A paper originated in 2006 and 2007 that are still experiencing increasing defaults in the underlying loans. However, the general marketplace has yielded moderate improvements. While some economists and technical analysts are concerned with a possible double dip, the majority predict a stable environment with continued improvements in the mortgage arena.

One of the biggest struggles for insurance companies is maintaining investment book yield. Although rates have stepped up from their lowest levels, reinvestment is likely below the average portfolio yield. It is important for insurance companies to remain faithful to their investment plan in times such as these. Although the pressure to grasp for book yield is high, stay the course with the long-¬term plan. Moreover, diversification plays a large part in maintaining book yield. Not only should diversification be considered for asset classes, but also time of purchase as well as placement along the curve. Investing in this manner will allow for various types of investments being purchased across the curve at a variety of differing times. This will lead to greater diversification and has historically proved important to assisting in the preservation of book yield.

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.

Importance of Sufficient Cash Flows

As an insurance company, the basic obligation is to have sufficient cash flows to provide for the policyholders or members of the company. This obligation is the basis behind the statutory guidelines of the NAIC. Assets are carried on the books at amortized cost in order to allow a company to focus on cash flow and not total return. In addition, reserves such as IMR/AVR, for life companies, were designed in order to discourage security trading and protect the company from credit risk.

Overtime, some shifted away from this focus in an attempt to optimize total return. A positive aspect of economic crisis is a return to the conservative foundation of insurance investing. Total insurance risk is reduced when investments are structured to provide for the known cash needs of the company. With a sound cash structure in place, an insurer can focus on enhancements to net investment income and proper yield spreads to meet product needs. Several issues caught insurance companies off guard during this crisis, but one of the most important was the aspect of diversification. Insurance companies that considered typical portfolio theory were often 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 actually reduced. Unfortunately, this crisis informed many insurers that their exposure to certain issues was too high. It has also been challenging for insurance companies to resist the temptation of the higher book yields offered by structured products. These securities were severely impacted by the crisis. Understanding the extent of this ahead of time might have been impossible; however, a focus on diversification and aligning cash flows with product liabilities would have limited this exposure for the majority of insurance companies. Unfortunately, many asset classes, including non- agency mortgages, CDOs and CLOs have continued to experience defaults. A significant portion of U.S. insurers experienced decreases in capital and surplus resulting from impairments in these issues. As the number of insurers experiencing significant impairments grew; the NAIC started to worry about the Risk Based Capital (RBC) levels of these companies. For many insurers, the impairments were significant enough to reduce values near to or below the authorized control levels. It was quickly realized that the old accounting rules were inappropriate for valuing these issues as impairments were often far below the expected future cash flows on these securities. The NAIC has incorporated new valuation methods for mortgage and structured securities that will reduce the negative impact for some insurers. Most notable is SSAP 43R that allows insurance companies to mark lower credit mortgages to the present value of discounted future cash flows in situations where an insurer can hold these assets to maturity. In addition, the NAIC hired PIMCO to develop a rating grid matrix on all RMBS issues held by U.S. insurers. This was a move away from reliance on the rating agencies with a shift in the risk focus from the risk of the security to exposure risk that the holding presents to the insurer. SSAP 43R and other rule changes demonstrate the need for an insurer to focus on cash flow and book yield. In general, some of these changes are exciting as the focus is a return to conservative investing that considers the true nature of an insurance 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 email info@parkwayadvisors.com.