Insurance companies have long faced obstacles in optimizing their asset portfolios as the balance sheets of highly regulated, complex operating companies providing various financial products. Traditional one-size-fits-all methods to solve agency problems and hesitancy toward adopting new technologies have held them back. Over- or underutilization of quant models as well as the absence of a clear process to manage multiple tradeoffs have also prevented insurers from achieving optimal returns and customization.
On the other hand, investment professionals and third-party managers have avoided insurance company asset management due to strict and multiple layers of industry regulation, and their complex capital/liability structure.
The pressure to get better returns, along with structural changes and emerging financial technologies, has caused insurers and asset managers to reassess their strategies and look for ways to transform their old ways of investing. That’s where the practice of Enterprise Driven Investing can help.
See also: A New Way of Thinking on Assets
Enterprise Driven Investing (EDI) for insurers is a business management process that attempts to address several pitfalls, improve decision-making and enhance results. The goal of EDI is to achieve a high level of portfolio customization in the most financially efficient manner. This is done through a four-step process.
Step 1: Establish the full set of financial variables and set priorities
EDI begins by establishing and prioritizing the complete set of financial considerations. The fact that there are multiple business factors that affect each other is the principle characteristic that distinguishes Enterprise Driven Investing from Liability Driven Investing and creates this first step. These considerations include form of ownership, liabilities from a global encyclopedia of risk, actuarially complex policy terms and product options, taxes, liquidity requirements, colliding capital objectives, affiliate structures, competing rating agencies and several regulatory regimes that are rarely coordinated and, in combination, are the most complex in business. EDI’s first step captures the complete set of these variables and then challenges the board and senior management team to establish those that are primary, secondary and less relevant to their organization.
Step 2: Design a portfolio objective, and related performance measures, from the financial priorities
Insurance asset management in any form is as much a design challenge as an investment one. Careful design of the primary objective is the gatekeeper to successful EDI. Portfolio objectives for these entities are no different than for other portfolios in that they are two-dimensional measurements of risk and return. The definition of each, however, has financial attributes linked to an operating company. Return can be total, net investment income (NII), cash flow, a combination or something else entirely. Risk can be portfolio volatility, CVaR, TVaR, economic shortfall, Solvency II capital charges, etc. Even the best selection will have shortcomings. A poorly conceived objective alone can offset, entirely, the talents of a high-performing investment team. Success in the design phase will occur if four guide rails are in place:
- Company-specific customization – Investment objectives should be dictated by market segment based on lines of business, ownership structure, scale and domicile.
- Clarity of timeframe – This should be longer term but explicit (e.g. three years).
- Proper selection and calibration of constraints. Sensitivity analysis is the radar that is used to navigate through changing circumstances and costs.
- Establishment of investment skill metrics – Legitimate performance evaluation of both internal and external managers remains one of the most challenging and increasingly important design requirements in insurance asset management.
Step 3: Establish a strategy to meet the portfolio objective with full consideration of the impact on factors not directly expressed in this objective
A portfolio objective expresses an insurer’s most important return and risk measurements. The challenge is balancing the portfolio objective with other dynamic financial parameters. One response to this challenge has been portfolio optimization with multiple constraints. While helpful, relying on a single output from these analyses has weaknesses. For example, it introduces black box risk and naïve precision. It also fails to consider important variables and masks the relative significance of various assumptions and financial relationships.
As a practical decision-making tool, EDI avoids these weaknesses by highlighting the collateral impact on key trip wires from changes motivated by the portfolio objective. While all companies estimate the changes in portfolio strategy against the portfolio objective, many do not grasp the shadow-pricing sensitivity of the objective to variation in constraints or, conversely, are blind to the impact of rebalancing on the full set of financial variables. For many companies, this sensitivity is both substantial and unknown. Managing sensitivity, to self-imposed limits, in particular, advances EDI from a passive to an active philosophy.
Step 4: Explore ways to improve tradeoffs through higher order changes
EDI begins by creating a comprehensive set of company-specific financial considerations, then establishes priorities (including the portfolio objective), and forms investment strategy after highlighting relationships between these variables regarding direction and leverage, through sensitivity analysis. In its most advanced form, creative reengineering resets trade-offs to a more favorable state and forms new ones. A few categories for these ideas are summarized below, but the opportunities are by no means confined to these topics:
- Improved capital and tax efficiency – Developing strategies to increase returns, reduce volatility, improve portfolio diversification and reduce capital charges.
- Bifurcation of assets based on line of business volatility rather than asset class volatility – Organizing the balance sheet by reserves and capital based on the volatility lines of the business.
- New approaches to asset/liability management (ALM) – Structured finance experts should create bespoke products that improve ALM, in the same way they have used their expertise for capital efficiency.
See also: How to Manage Strategic Relations
While EDI is the future of insurance company investing, it is also a framework for all investors to manage the tradeoffs of hyper-customization and pure investment efficiency. Also, because EDI explicitly recognizes, rather than avoids, the full set of enterprise variables, it represents a major advancement in balance sheet management from LDI and one-size-fits-all quantitative methods. As such, EDI reveals otherwise hidden paths to significantly better results. Finally, as a stable, but dynamic business management process, EDI principles accommodate the full spectrum of emerging financial theories and technologies.