References to enterprise risk management (ERM) pervade insurance discussions of late. Driven by impending regulatory reform in the U.S. and UK, the investment-related aspects of ERM were amplified in the aftermath of the financial crisis, as insurers dealt with impairment and other-than-temporary-impairment (OTTI) issues in their portfolio, while at the same time operating in a market with soft pricing for many underwriting lines. Efforts to take a holistic approach in managing enterprise-wide risk can present various challenges in integrating the potentially vast flows of information.
The classic Peter Drucker axiom “what gets measured, gets managed” still rings true, but determining which are the key metrics as one embarks on the ERM journey can prove daunting. ERM feels like “everything risk management” and frequently, it seems, the investment portfolio is not fully counted in the calculus. Five years on from the peak of the financial crisis, memories are fading of how financial market turmoil can ravage an insurer’s investment portfolio and thus impact its entire business model.
From an investment perspective, preparing an investment portfolio for a rising interest rate climate is a critical component of the ERM complex. Rising interest rates pose a challenge to an insurer’s capital by diminishing principal value on a market-to-market basis. Insurers are often less concerned about positioning their portfolio for rising rates than they should be, particularly if their organisation has historically employed a book yield, buy-and-hold mentality that involves infrequent selling of bonds prior to maturity.
With an ERM framework in mind, let’s briefly examine three risks that all have a bearing on an insurer’s capital growth and preservation, and what they portend in a rising interest rate environment.
Investment Risk No. 1: Complacency, or a static approach to managing assets
A static approach to managing a bond portfolio is most problematic if rates rise very quickly. A portfolio which is not repositioned proactively as market dynamics change simply reinvests at the mercy of prevailing rates when bonds mature. Reinvestment of coupon income and maturing bonds may pose little trouble if rates are rising, however if the bonds must be sold prior to maturity, an insurer may not realize the price reflected in the carrying value.
A quick review of bond issuance over the past few years shows a universe in which credit quality has decidedly migrated downward. In fact over 50% of the corporate bond market is BBB or below (the BBB-category is the lower bound for investment grade, below is considered high yield or ‘junk’), according to Barclays and Securities Industry and Financial Markets Association (SIFMA) data. Additionally, the maturities of debt issues have extended. The average maturity of a corporate bond was nearly 14 years in 2012. Ten years earlier, average maturity stood at eight years. It makes sense, after all – what corporation’s CFO would not want to borrow for as long a timeframe as possible given the historic lows of today’s interest rates? An insurer that seeks to replace the yield of maturing bonds in today’s environment may, somewhat unwittingly, extend itself both in terms of lesser credit quality and longer maturity. Neither are good for protecting capital when rates begin to rise.
At Sage, even when we manage a core bond portfolio with book yield constraints we monitor issues of portfolio duration and credit quality rigorously. There is no semi-aware “drift” into lesser or longer credits in the pursuit of absolute yield. As an extension of our captive clients’ risk management function, we seek to imbue the investment process with the same risk-awareness as the rest of the insurer’s operations.
A static approach with the surplus portfolio can also challenge capital. Frequently, when insurers seek additional capital growth and return in non-core asset classes such as preferred stocks, high yield bonds, or segments of the equity market, the same buy-and-hold approach prevails. We are firmly of the belief that a more active and tactical approach to managing surplus investments is just as important to investment risk management as it is in the core bond portfolio. Rarely will a constant allocation to yield-seeking segments bear out an optimised risk/return profile for the insurer, as the next point demonstrates.
Investment Risk No. 2 Asset allocation
It must be firmly acknowledged that the business goals and operating cashflow needs of a captive or risk retention group (RRG) are the primary driver of asset allocation. After all, an insurer cannot set asset allocation in a vacuum. There is no “standard” portfolio irrespective of the insurer’s underwriting book or corporate structure. A quickly growing RRG may seek to protect surplus to the utmost and carry no equity exposure. A single-parent captive with a parental liquidity backstop may invest 60% or more of the portfolio in equities and alternatives with a goal of growing capital more quickly. An 831(b) captive may invest in more tax exempt instruments in an effort to minimise the lone taxable element (investment income) of the captive.
A bunker mentality does not benefit a captive’s portfolio. Our perspective is simply that the portfolio must be constructed in a fashion that supports the captive’s liabilities and parental objectives, with securities that enable a transparent and efficient means of providing both return and liquidity, while always seeking to protect downside volatility. Just like a static approach to investing the captive’s portfolio can be detrimental, so too can an overly narrow universe of investment options, such as limiting a portfolio to only a few types of instruments. In 2012, the range of returns on fixed income segments was actually greater at 16.18% (from emerging market debt with 17.95% return vs. international government bonds at 1.77%) than was the differential between the top-performing segment in the equities/alternatives space when compared to the bottom segment.
In the past, we have discussed the merits that exchange traded funds (ETFs) offer to insurers of all types in crafting exposure to equities or alternatives such as bank loans, emerging market corporate debt or sovereign debt. For de novo captives (generally single parent, depending on domicile guidelines) there are NAIC-rated fixed income ETFs covering every major bond market segment that allow for a diversified, high grade portfolio from inception. We have managed tactical ETF portfolios alongside core bond portfolios for over 15 years, and ETFs are one area where insurers experience continued improvement in cost and efficiencies in their portfolio.
An insurer is the ultimate arbiter of what is appropriate for their portfolio. At the business-as-usual end of the continuum, protecting capital erosion preserves competitive flexibility and operating margin; under the most severe of market conditions, protecting capital precludes the need for a liquidity injection from the corporate parent or capital calls to group or RRG members.
Investment Risk No. 3 Confusing capital quality with liquidity
Capital quality (i.e. the credit rating of a bond) and liquidity should not be confused. A captive insurer seeking to sell 25 bonds of a well-known ‘AA’ rated corporate issue may find a much better bid side than does an insurer seeking to sell an identical amount of bonds for an ‘AA’ rated, but thinly traded municipal issue.
Likewise, even a high grade bond portfolio which has extended its duration in an effort to maintain or seek out additional yield will have a different liquidity profile when interest rates begin to rise. The integration of various risks (business, operational, investment) is at the core of ERM framework. If a variety of challenges bear down on an insurer all at once, for instance if a natural disaster which triggers claims payments coincides with falling bond prices, a captive should have a sound understanding of the liquidity profile of its investments. Beyond the core bond portfolio, a captive who holds a portfolio of individual equities may find their ability to quickly raise cash limited under certain market conditions. Given the smaller average size of a captive portfolio, the lots tend to be smaller and therefore have a more limited bid side. And apart from pure liquidity concerns, the frictional costs of moving into or out of individual equity positions can chip away at the captive’s capital.
The challenge with distinguishing between capital quality and liquidity is that it doesn’t matter until it matters.
Captives in the US and Europe may avoid the requirements of solvency self-assessment due to minimum premium thresholds under the NAIC and EIOPA frameworks for ORSA. Nonetheless, for ERM purposes, the foregoing considerations will help captives and RRGs manage investment risk, particularly in the face of rising interest rates. Proper planning with the portfolio will enable improvisation on the business side if needed.
This article first appeared in Captive Review Magazine.