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How to Define Risk in Investment Portfolio

A conservative investment.

An aggressive investment.

If you’re like me, you can readily define those terms—or at least give examples. A Treasury note indexed to inflation? Conservative. Stock in a small company in an emerging market? Aggressive.

But what makes an insurance company’s overall portfolio conservative or aggressive? And however you describe your or your organization’s risk tolerance, how do you know your portfolio is in line with your perception of risk?

If those questions are harder to answer, they also merit more thought than the relative riskiness of any single security. Exploring portfolio-level risk and risk tolerance in ways that go well beyond labels should help your investment team come to a shared view about how much risk you are—and should be—taking in your portfolio.

Define investment risk

While it is imperative for you to understand and adhere to regulatory risk definitions and constraints, it is equally important for you to clearly define investment risks and your own risk tolerance. To explore conservatism and aggressiveness through the lens of an insurance CIO, let’s consider a hypothetical insurance company—call it Insure-a-Co.

Insure-a-Co is a small/mid-sized property and casualty insurer that invests core portfolio and surplus assets in search of income and a stated return target. Like most of Vanguard’s insurance clients, the company’s chief investment officer describes her approach as conservative.

Naturally, Insure-a-Co faces liquidity needs dictated by claims and operational expenses. Risk-based capital regulations also come into play. Liquidity and regulatory concerns help to explain why Insure-a-Co historically has favored individual U.S. government bonds for safety, as well as individual municipal and investment-grade industrial and financial corporate bonds. That said, because of historically low yields and its fairly high return target, the insurer is considering owning more equities.

Risk is situational, not absolute

A central fact about risk is that it isn’t absolute. Rather it’s relative, or situational. A suitable level of risk for Insure-a-Co, given its operational needs, underwriting and investment objectives, and state regulatory influences, may be irresponsibly excessive, or inadequate, for another insurer.

See also: Cognitive Biases and Risk Management  

Important business-line differences might include the extent to which a P&C insurer’s book of business concentrates on lower-risk policies, such as homeowners’ coverage in regions where natural disasters are rare, or higher-risk policies, such as auto coverage for operators with poor driving records. The extent of any reinsurance may also affect judgments about investment risk.

Volatility is an incomplete risk measure

Certainly, Insure-a-Co executives go beyond labeling themselves and their portfolios as “conservative” or “aggressive.” They often distill investment risk as volatility—specifically, as the standard deviations of the total returns of their individual holdings and overall portfolio.

But even as the standard deviation of returns tries to neatly summarize volatility, it may obscure crucial factors that contribute to performance swings. These include market risk, concentration risk, manager risk and interest-rate risk—which is especially important for Insure-a-Co, given its large fixed-income exposure. Other significant risks may be only loosely related to volatility. Inflation risk and shortfall risk are examples.

Complicating life for Insure-a-Co is the fact that seeking to minimize one type of risk may raise other risks. For example, market risk and shortfall risk are more or less inversely related, so taking less of one necessarily means taking more of the other. For Insure-a-Co, holding more equities raises market risk and boosts risk-based capital requirements, but holding fewer equities raises the risk of not meeting its return target.

All other factors being equal, we believe a better-diversified portfolio is a more conservative portfolio. As such, we’d likely suggest that a real-world Insure-a-Co consider venturing beyond a collection of individual U.S. government, municipal and corporate bonds. While such a portfolio may be perceived as conservative, it may leave an insurer exposed to substantial inflation or shortfall risk—hazards that may be limited by more diversified exposure to bonds of various maturities, sectors and credit qualities, as well as professionally managed, diversified equity exposures. International holdings may also be appropriate.

What to do?

At this point, you may be wondering how Insure-a-Co can possibly calibrate its portfolio for risk. The multi-dimensional and changing nature of risk obviously renders inadequate a decision to seek “conservative” or “aggressive” investments and means it is a mistake to rely on volatility as a standalone risk proxy.

However, there are steps an insurer can and should take:

  • Create clear, measurable, appropriate goals. To zero in on goals, start with a keen focus on your investment policy statement.
  • Develop a suitable asset allocation. We believe in balance across asset classes, within the parameters of insurance regulation, and diversification within asset classes.
  • Minimize the cost of investing. In our experience, cost is one of the biggest drivers of portfolio performance.
  • Maintain a disciplined investment approach. Even sophisticated institutional investors can change course at the wrong times, allowing market or economic changes to spur misguided investment changes.

See also: Global Trend Map No. 13: Investments

Labeling an investment or your risk tolerance as conservative, aggressive or something in between means little to nothing if your risk tolerance and the risks of your portfolio are misaligned.


  • All investing is subject to risk, including the possible loss of the money you invest.
  • Investments in bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
  • International investing is subject to additional risks, including the possibility that returns will be hurt by a decline in the value of foreign currencies or by unfavorable developments in a particular country or region. Diversification does not ensure a profit or protect against a loss. 

Are Portfolios Taking Too Much Risk?

Institutional investors are set to make bigger bets on riskier assets during 2017 in pursuit of higher returns, according to a new report.

“Faced with greater volatility and continued rate pressures, [institutional investors] appear to be doubling down on their bets by increasing allocations to equities, private equities and other high-risk assets seeking to generate returns,” says the report from Natixis, the global asset management firm.

The report surveyed 500 decision-makers at global tax-exempt institutional funds holding the purse strings for assets earmarked for pension payouts, insurance settlements and funding for endowments, representing $15.5 trillion.

Despite a market environment buffeted by political, geopolitical and regulatory uncertainty, 70% of those surveyed believe their return expectations for 2017 are achievable. However, 75% of respondents believe investors “might be taking on too much risk in pursuit of yield,” according to Natixis.

See also: 4 Steps to Integrate Risk Management  

“Faced with prospects of increased volatility, six in 10 institutional decision makers believe they are prepared to handle the risks in 2017,” the report says, “but given the economic complexities, coupled with ongoing political upheaval, only 2% offer up strong convictions in their ability to succeed in this critical endeavor.”

Market volatility poses the biggest risk to portfolio performance, institutional managers said, with 62% saying they were confident in their ability to manage such risk. The top organizational concern, however, is low yield. Given the uncertain investing climate surrounding today’s global markets, “few institutions are relying on traditional portfolio strategies to meet their performance goals,” Natixis said. “Instead they are increasing their exposure to equities and alternatives and turning to illiquid assets and the private markets for risk-managed return generation and yield replacement.”

The top challenge for these organizations in 2017 looks to be balancing growth objectives with short-term liquidity needs, according to 60% of respondents. The second-ranked challenge is gaining a consolidated view of portfolio risk (46%), followed by complying with new regulations (39%).

“While risk factors change over time, the challenge for institutional investors remains to deliver long-term results while navigating short-term market pressures,” said David Giunta, Natixis’ president and CEO for the U.S. and Canada, in a statement. “Given their mandates, avoiding risk is not an option for institutional investors,” Giunta said. “They have to beat the odds or change the game, and they are doing so by balancing risks and embracing alternatives to traditional 60/40 portfolio construction, but always with an eye on their long-term objectives.”

Half of the respondents cited market volatility as the biggest risk to performance in 2017, which was followed by geopolitical risk (43%) and interest rates (38%).

Most respondents said they were confident of their ability to meet their long-term liabilities; however, they weren’t all that confident in their peers. Some 62% think most institutional investors will fail to meet those commitments. Sixty-nine percent agree that “traditional diversification and portfolio construction techniques need to be replaced with new approaches,” Natixis said.

Managing risk is a pressure that “cannot be underestimated,” the report says. And in doing so, managers are “hedging their bets,” the report says. Nearly 70% of institutional managers surveyed said they “are willing to underperform their peers to ensure downside protection,” the report says, noting that just 54% of respondents believe that portfolio diversification “can provide adequate downside protection.”

See also: How to Outfox Our Brains About Risk  

Other findings in the survey include:

  • Sixty-seven percent of institutional investors think private equity provides higher risk-adjusted returns than traditional asset classes, and more than half (55%) believe private equity provides better diversification than traditional stocks. The three areas they consider most promising are infrastructure, healthcare and the technology, media and telecom sector.
  • About one-third (34%) of institutions report that they are planning to increase allocations to real assets, including real estate, infrastructure and aircraft financing, in the next 12 months. As seen with their broader views on private markets, 63% of institutional decision makers’ primary goal for investing in real assets is earning higher returns.
  • Half of institutions (50%) report they are increasing exposures to alternative investment strategies this year. The adoption of alternative investments isn’t limited to growth portfolios, as 77% of respondents say alternatives have a role in liability-driven investing, as well.

By seeking to meet risk/return objectives, decision-makers are going outside their own team to tap into specialized capabilities. Four out of ten institutions (42%) are outsourcing CIO or fiduciary manager tasks. “On average, those organizations that outsource have turned over management for 37% of their total portfolio,” Natixis said.

This article was first published on BRINK.

Breakthroughs in Managing (and Insuring) Tangible Assets

In recent years, high-net-worth families have increasingly turned to tangible assets for more than their aesthetic values. A 2012 Barclays report found that high-net-worth individuals in the U.S. hold an average of 9% of their wealth in tangible assets. A 2011 ACE Private Risk Services study of high-net-worth households found that 74% of respondents, all with more than $5 million in investable assets, cited investment value as a reason to purchase rare art or wine, valuable jewelry, sports memorabilia or classic cars. Two-thirds said the potential for appreciation in value was important in their purchase decision.

As values of many categories of tangible assets have escalated, these assets increasingly serve to diversify investment portfolios during periods of volatile market gyrations. In the ACE study, more than half of the respondents reported that the investment diversification value of their tangible assets has become more important to them since 2008.

“Investors are increasingly looking to hard assets, such as valuable art, antiques or fine watches and wine collections, because of the perceived ability of these assets to hold value during market fluctuations,” says Tom Livergood, chief executive officer and founder of The Family Wealth Alliance, a Chicago-based family wealth research and consulting firm. “Across the industry, we’ve seen investors rush to safety and stay there.”

Blind spot

Even as tangible assets gain recognition as a new asset class, high-net-worth individuals rarely bring to their passions for art, wine or jewels the same rigor they have when making financial investments or business decisions. In ACE’s 2011 study, despite the growing number of households reporting greater importance of tangible assets to their investment portfolios, nearly 40% of those surveyed did not have all of their precious items insured against property loss with a valuables policy. Additionally, one in three reported that they were not updating the market value of these assets at least once every three years, and a full 15% of respondents had no formal documentation of their non-financial assets.

“It’s amazing how often some advisers, especially those with sophisticated knowledge of financial markets, suddenly turn unsophisticated when it comes to non-financial assets, notably art,” says Ronald Varney, owner and president of New York-based Ronald Varney Fine Art Advisors.

To Evan Jehle, a New York-based principal at Rothstein Kass, a professional services firm with a significant family practice, wealthy families typically pay 
far less attention to their personal property than to their business affairs. “Our clients would never let something fall through the cracks in their professional lives, but many families have never thought of their tangible assets in this way before.”

Thomas Handler, partner and chairman of the Family Office Practice Group at Handler Thayer, a Chicago-based law firm recognized as a leader in serving family offices, private businesses and high-net-worth individuals, says his office often advises clients who don't have a business plan for their tangible assets. “It is incredibly important for wealthy households to understand how to hold, report, title and insure their non-financial assets in estate planning.”

Challenges of managing tangible assets

Today’s investors have the opportunity 
to reap significant benefits – financially
 and aesthetically – by investing in
tangible assets, but these investments 
pose risks and challenges different from investment
 in traditional assets. Wealthy households and their advisers may cheer the rebounding market for art and other valuables, take comfort that they have diversified their investments and look forward to potential price appreciation in the future. However, those cheers could be premature if owners of non-financial assets fail to understand and properly address the critical issues facing these assets. Those issues include: value and authenticity, documentation, estate and tax planning 
as well as insurance; additionally, owners of tangible assets should embrace the new technology tools that dramatically improve the management of tangible wealth.

Value and Authenticity

The market value of tangible assets can change, sometimes rapidly. In July 2013, a 1954 Mercedes-Benz sold for $30 million, the highest price ever paid for a car at an auction, shattering the previous record of $16.4 million set in 2011. Global sales of wine, diamonds and precious gems have also been increasing, often to record levels. In December 2012, Sotheby’s recorded its highest one-day jewelry sales in the Americas, selling $64.8 million of high-carat diamonds and precious gems. The Live-ex Fine Wine 50 Index reached 106 in April 2013, up 5.3% in the first half of 2013. Over a 10-year period, prices for gold more than quadrupled, only to retreat more recently.

The market for fine art is especially robust. In 2012, Christie’s auction sales totaled more than $6 billion, a 10% increase from 2011. In May 2013, Christie’s reported $640 million of sales in its Post War and Contemporary department in one week, setting an auction record for any individual category.

Dramatic shifts in the market present challenges as well 
as opportunities for investors in tangible assets. “Today’s market is both global and complex,” Varney says. “Modern and contemporary art have made all the headlines, for that is where the greatest demand is today; but by next year the market could be turned upside-down, as happened in the fall of 2008 amid the global financial crisis.

Alan Fausel, vice president and director of the Fine Art Department in the New York office of Bonhams, a London-based auction house, cites the rapidly changing market as a serious issue for investors. “There is a huge risk and reward in today’s market because so many investors are entering uncharted territory. Today’s contemporary market has seen so much volatility and so much uncertainty with newly famous artists, that investors are especially challenged to understand the true value of the works they own.”

Protecting investments in art, jewelry, antiques or wine begins with an appraisal. Smart investors should perform their due diligence to select appraisers with specific expertise in the genre of their assets. “An accurate appraisal is the foundation for every decision 
an investor will make regarding his or her tangible assets,” says Anita Heriot, Philadelphia-based president of Pall Mall Advisors, a U.S. and U.K. art appraisal firm. Before donating, selling, insuring or placing valuable items in a succession plan, investors must know how much everything is worth. “Wealthy individuals must understand that the values of their tangible assets have changed, and these values will continue to change over time,” Heriot says. “Without understanding the value of their property, people cannot even begin to make correct decisions.”

Heriot observes that wealthy individuals sometimes drastically undervalue their tangible assets. She recalls one family that was tracking assets based on appraisals from 1983, with nearly 30 years between consultations. The collection was originally valued at about $2 million, but, after an updated appraisal, the
 fair market value was nearly $100 million. “There were paintings of incredible value hanging on only one nail, including a Rothko with an insurance value of at least $70 million. Had this family known what their property was worth, they certainly would have taken better care
 of it.” An appraisal from a qualified professional can
 also minimize other risks, as well as provide guidance regarding potential fakes and forgeries. In addition, an appraisal can identify other issues that could affect the value of the item or the right to ownership. These include the sale of items made from protected species, protected antiquities or stolen works.


All too often, high-net-worth individuals and families find the process of documenting, tracking and managing
the contents of their home, including fine furniture and other valuable items, to be onerous. Proper documentation of personal property typically involves photo or video records, storage of purchase receipts and, in the case of highly valuable items, expert appraisals, proofs of title and provenance and records of any restoration work. Moreover, values need to be regularly updated, sometimes on both a depreciated-value and replacement-cost basis.

“Families rarely keep accurate records of their tangible assets because, quite frankly, it can be a lot of work,” says Jarrett Bostwick, wealth transfer and estate planning specialist at Handler Thayer, the Chicago law firm.

“If someone buys two pieces of art, a piece of jewelry, two watches and a diamond pendant for his wife, then they have to sit down and put a schedule together, contact the insurance company and have them come in and have them ask you a whole bunch of questions, which is kind of a pain. Rarely do our clients partake in this kind of rigor.”

If documentation is done at all, it tends to be completed inadequately and infrequently. ACE Private Risk Services and Trōv have been collaborating on a program in which specialists have examined the contents of more than 3,000 homes of high-net-worth families. In this Home Contents Valuation program, ACE risk consultants used Trōv technology to provide the industry’s first customized estimates of the value of a home’s contents at policy inception. Nearly 50% of the homes evaluated did not have enough insurance to cover their contents, and the average amount of underinsurance exceeded $415,000 per home. Condominium homes were particularly at risk. Nearly 80% had inadequate contents coverage. Among homes warranting an increase in contents coverage, those with a structural value of $2 million to $3 million had an average shortfall of $417,000 in contents coverage; those with a structural value of $5 million to $7.5 million had an average shortfall of $852,000. Furthermore, many valuable items were only protected by general contents coverage in the homeowner policy, when they should have been listed as scheduled items in a valuables policy.

The lack of proper documentation of a family’s tangible assets can lead to wide-ranging problems. “You have to know what you have in order to be worried about it, and to take steps to avoid losing it,” says Joy Berus, attorney at Berus Law Group in Newport Beach, Calif., a specialist in tangible asset protection. “If a family doesn’t have an updated inventory of their valuable possessions, they leave themselves vulnerable to taxes that could have been planned for and reduced, discrepancies, risk of serious financial loss and the inability to pass down their assets to the next generation with a step up in basis. Proper documentation of a household’s tangible assets is the first step in identifying a family’s tangible wealth, and can make the difference between security and paralysis.”

The magnitude of the potential issue is evident in one statistic: Over the next
 30 years, as much as $27 trillion of 
family wealth will be transferred from 
Baby Boomers to their children and grandchildren. That inheritance will include a great deal of tangible assets that will need to be documented, appraised, accounted for and protected.

Wealth managers often encounter situations in which a client dies and the family or trustee does not know where all of the valuables are. “These issues don’t usually come up until a client passes and you have to collect all of the assets and figure out what’s there,” says one wealth manager who works with high-net-worth clients. “Tangible assets aren’t addressed enough in the typical conversations between wealth managers and their clients.”

Handler, the attorney, points to a noted photographer who was living in a retirement home. 
He kept with him a large collection of negatives of images of leaders, celebrities and historical events.
The photographer suffered from dementia, and over
 the years most of the collection slowly disappeared. “Unfortunately, the family did not have a record of everything and didn’t know who took the photographs,” Handler recalls. “We found some of the items on the black market on websites. But the vast majority is never going to see the light of day.”

Berus recalls working with professional athletes and asking if their wealth advisers asked them if they possessed sports memorabilia. “Every one of them said the same thing, ‘Nobody has ever asked before.’ One retired football player talked about how he lost the majority of his lifetime collection because it had been in a fire, and it wasn’t insured. He couldn’t prove what he had and had a major loss because of it.”

Berus adds, “When people don’t know what they have, they can lose money and be taken advantage of by people who do know what they have. You don’t want to lose the value of what you own or be taken advantage of. You also don’t want to cause tax problems for yourself or pay unnecessary taxes. When you know what you have and know what it is really worth, you can make better decisions.”

Loss Prevention

By definition, tangible assets are subject to risks of physical damage, theft and the ravages of time. Yet experts say that high-net-worth families often neglect
 to take steps to protect their art, jewelry, wine and other valuables from these threats. One ACE study, for example, found that 40% of wealthy individuals surveyed failed to take advantage of the services of a risk consultant who could help them reduce the risk of damage and theft.

Collectors do not always realize the risk-prevention measures available to them to help guard against, 
and minimize, exposures, says Heather Becker,
 chief executive officer of the Conservation Center, a Chicago-based provider of conservation services for fine art, textiles, photography and sculptures. “No one wants to think a significant loss will happen to them.”

Many families display or store their precious possessions in ways that increase the risk of loss. For instance, they hang artwork above an active fireplace, where the hot, dry air and soot accelerates deterioration. They neglect to place a historical artifact, such as a letter written by a famous figure, in an archival box protected by anti-ultraviolet protective glass, exposing the artifact to dangerous rays and fumes.
 Or they store a valuable stamp collection in a closet beneath a bathroom. If the tub overflows or the toilet develops a leak, the stamps could be ruined. “So many people forget that these assets – art, wine, gems – are very fragile,” Varney says. “Valuable assets can go from $1 million in value to $0 in the blink of an eye.” Investors who fail to properly address these threats remain vulnerable to severe financial loss.

Even items made of strong, durable materials can be
ar risk. Becker recalls the story of an ancient metal sculpture, which its owner stored in a warehouse for several years while not on display. While the owner made sure the sculpture was stored in a protective crate, the crate was stored on its side, instead of standing up. “The sculpture was severely warped and sustained considerable damage,” Becker says. “There is a cumulative effect to these risks that individuals must account for.”


Given the increasing value of rare art, precious gems and fine wine, and the array of physical threats and other financial exposures confronting these pieces, proper insurance represents a critical part of a complete wealth-protection plan. Often the best place for families and their wealth advisers to start addressing this need is with an insurance broker or independent agent who specializes in serving families with emerging or established wealth. These insurance advisers, who can be recognized by their access to specialty insurance carriers, can usually suggest and coordinate services from a variety of experts.

While investors of tangible assets may go to great lengths to acquire the items they desire, they frequently fail to adequately protect them. In a 2012 ACE survey, fully 86% of insurance agents said the families who insure their homes and possessions with mass-market insurance companies likely carry too little insurance for their treasured items. One in three wealthy families was updating the market value of their collections every three years.

“Waiting three years or more mean their valuations will be wildly out of date,” says Fausel of Bonhams.

ACE Private Risk Services and Trōv analyzed 94 valuables schedules to compare stated replacement values with current market values. For the 48 schedules of fine art assets, comprising 1,722 objects, 665 objects were potentially underinsured. For the 46 jewelry schedules, one in four objects was potentially underinsured. Moreover, 32% of all the analyzed items had descriptions that were too vague or incomplete to allow for an accurate valuation. If a loss were to occur, this could lead to a dispute.

Emerging technology

For individuals and families with substantial tangible assets, new technology tools exist to make tracking, analyzing and sharing information about their assets significantly easier and more efficient. Pall Mall’s Heriot sees high demand for these tools: “As tangible assets become more valuable and wealthy families become more invested in their personal property, we see clients begging for a better understanding of what they own and greater knowledge of what it’s all worth.” The goal for wealth advisers and their clients should be to make tracking and analyzing information about personal property regular, everyday actions rather than infrequent behaviors.

Progress is promising. ACE Private Risk Services offers clients access to its Home Contents Valuation service, providing guidance regarding general contents coverage at policy inception–at the moment, coverage for personal property, a home’s contents, is typically assigned based on a percentage of the home’s structural value or it is a guess. Trōv has developed technology, partnerships and applications to tame the unruly mass of data about every tangible asset in its members’ lives. The core of the
 Trōv platform is a private, online digital locker where the information about property and possessions is collected and securely managed (called a Trōv, like treasure trove). Because most of Trōv users’ important personal property is located in their private spaces, Trōv is training appraisers and insurance risk managers to use its Trōv Collect application when they are in their clients’ homes. With the acquired information, a Trōv is activated – and with it a complete knowledge of what each family owns, where it’s located and what it’s worth. Acquisitions can be automatically added to a personal Trōv at retail point-of-sale, via electronic receipts and through a mobile application. The Trōv Mobile app enables members to snap a picture of any acquired item, add any support information, such as a receipt, package art, bar-code or QR-code, and send it to their Trōv in real time. As purchases are added, and as values change within the Trōv, the member can choose to have his or her advisers automatically notified to ensure the items are always accounted for and adequately protected.

Vision of the future

The future of wealth management encompasses an understanding of a client’s tangible assets as well as financial assets, completing the picture of total 
net worth. By using a continually updated inventory
 of personal property, families can manage risk on a real-time basis, applying effective loss-prevention techniques, securing the proper amounts of high-quality insurance coverage and anticipating tax and estate-planning issues. Insurance companies such as ACE will be able to recommend safety measures and introduce coverage rates that are increasingly fair, accurate and economical. Private bankers, estate planning attorneys and family offices will develop deeper relationships with their clients and referral networks. Wealth advisers will be able to expand the perspective they offer to clients and engage other appropriate professionals, such as insurance brokers, on a more timely and routine basis. Advisers who provide clients with a full-circle view of their assets will be well-positioned to gain a competitive advantage.

Cloud services, such as those provided by Trōv, will even enhance enjoyment of prized possessions. With a few simple strokes on a mobile device, an owner will be able to find like-minded collectors. Buying, selling and sharing will become a dynamic experience, and, because it will be easy to track the history of an object, every possession with have a story built into it. 


Demand for tangible assets of art, wine, jewelry and other collectibles is on the upswing, and auction sales across the globe continue to skyrocket. As these tangible assets are increasingly recognized as means of investment diversification, wealth advisers are challenged to provide a full-circle, comprehensive view of a client’s entire portfolio. Fortunately, new technology tools are meeting these ever-expanding demands. Mobile and cloud technology services improve the tracking, management and valuation of tangible assets, providing families and their advisers with greater awareness. Furthermore, these tools enable families to secure comprehensive insurance coverage and loss-prevention services, assess investment risk across both financial and tangible assets and more effectively anticipate tax and estate-planning issues. In today’s digital age, an analysis of any high-net-worth individual’s assets must include these tangible assets to complete the picture of total wealth management.

For the white paper on which this article was based, click here

ERM: Everything Risk Management

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.

Minding the Gap: Investment Risk Management in a Low-Yield Environment

A significant component of managing a property/casualty insurance company’s investment portfolio is gap management — ensuring that asset cash flows and returns always exceed claims and expenses by a healthy amount. Because risk-based capital levels, as well as loss and combined ratios, inform various aspects of an insurer’s existence on everything from basic solvency to growth capacity to credit rating, protecting and growing this margin is an imperative. Yet as nearly every insurer is aware today, maintaining portfolio income levels and minding that gap is an adventure fraught with peril.

This article sets forth some reminders about concentration risk management, appropriate duration strategies and suggests possible modes of investment, such as ETFs, to boost yields while maintaining liquidity.

For P/C insurers, while catastrophe-related losses in 2012 were lower than in 2011 (notwithstanding some estimates that Hurricane Sandy could cost upward of $20 billion in the final tally), the liability side of the ledger also remains challenged, with a middling ability to raise premiums in many market segments due in part to slow economic growth.

For life insurers, product guarantees combined with low interest rates on long-dated investment options make for an uncomfortable forecast, though life insurers typically have more time to work through the low rate dilemma than do P/C insurers.

Insurer balance sheets continue to be squeezed from both sides, and, based on the Fed’s last bit of commentary, insurers could still face another two years of policy-suppressed interest rates. In the midst of this yield drought, it is easy to get out over one’s skis by moving into areas of the market with which one is not familiar.

The trends are similar across time and market cycles, although the downturn from 2008 to present has been deeper and lasted longer than many other cycles. According to SNL Financial, the aggregate net investment yield for P/C insurers has declined from 4.20% in 2008 to 3.68% in 2012. When yield is scarce, fixed income investors of all types — not just insurers — tend to begin seeking yield by stretching credit parameters or duration targets, and sometimes both.

For insurers, this has the potential to create exposure to capital volatility, as credit “drift” in a portfolio might lead to heavier weightings in certain lower quality parts of the fixed income market. This might equate to a greater allocation to BBB category securities, or to a particular segment such as financials, which have maintained generally higher credit ratings on their debt, but whose performance may correlate more closely with an insurer’s own performance during another downturn.

There has also been a general trend among insurers toward diversifying into asset classes that many have not historically utilized: REITs, MLPs (master limited partnerships), bank loans, emerging market debt and even gold, which offers no current income but simply the opportunity for capital appreciation.

The foregoing can create a new operating framework for insurers who manage their portfolios in-house, because it requires a more active portfolio management effort than has historically been employed. The effort needs to focus on questions, such as:

What are the proper thresholds for allocation to the lower levels of the investment grade bond universe? How does extending duration play into this decision? Given such changes to an insurer’s portfolio, what is the impact on risk-based capital of market corrections of varying magnitudes? How quickly can the portfolio be repositioned in down-trending markets? What is the liquidity profile of so-called alternative asset classes? What is their exposure to event risk?

Fueling these portfolio management questions is the substantial increase in issuance by those credits that make up the Barclays U.S. Aggregate Bond Index—a proxy that many total-return insurance portfolios benchmark themselves against. There were over 5,000 issues brought to market in 2012, while over the preceding 24 years the average has been approximately 3,300 issues per year.

Further complicating an insurer’s decision-making framework is the fact that since 2005 the trend line in credit quality of the issues in the Agg index has been toward lesser-rated credits. This is especially evident with new issuance: Approximately 47% of issuance in 2012 was BBB, while the average over 25 years was 37%. The glut of issuance in 2012 saw greater nominal numbers of fixed income issues in the AAA, AA and A credit categories, but as a percent of total issuance both the AA and A credit categories were below 25-year averages.

In the context of this data, it may be easier for an insurer to — somewhat unwittingly — let portfolio credit quality drift when the universe of available issues has itself drifted! Compound this with entry into unfamiliar and potentially less liquid asset classes, and it is easy to see that minding the gap never took so much work.

Despite these numerous market challenges, we must be constructive about finding responsive solutions for insurance portfolios. Standing still is not really an option, as inaction and inattentiveness carry their own risk. In some regards, solutions are simple, though that is not to say they are easy. To wit:

Risk management in the portfolio. Keep a close eye on concentration issues, whether by credit rating, industry or issuer.

Understand the specific dynamics that portfolio targets create, such as that a focus on more highly rated credits can lead to an overweight in financials. Conversely, there are many solid BBB names, including many industrials and utilities whose steady performance over time fits well in a portfolio that aims for low volatility.

There are also a host of “new” BBB names resulting from credit downgrades in recent years.

Credit research and selection and an understanding of the liquidity of a given bond are still paramount issues.

Maintain a defensive posture. Inflation does not appear to be looming large at the moment, but fixed income market volatility over the past few years—and even the past few months—has been significant. Extending duration on the core capital portfolio could create undesired downside capital volatility when interest rates rise.

Keeping a defensive posture can mean keeping portfolio duration slightly short of benchmark duration, as it can allow active portfolio managers to seek alpha, i.e., excess return above a market index, through sector and name selection, while subjecting the insurer’s portfolio to less price volatility.

Take risk smartly. This is a principal issue when insurers begin to extend their portfolio into asset classes where they have not historically invested. The modality of the investment can be as important as the asset class.

There are now more than 85 NAIC-rated exchange-traded funds available for insurers, a number of which cover NAIC-3 and NAIC-4 rated investments, such as convertible bonds, preferred stocks and high-yield debt. If an insurer determines that it wishes to seek out additional yield in the high-yield space, is it better to do so via individual bonds or via a single ETF composed of several hundred securities?

Embrace discomfort. This is more of a psychological tactic than a portfolio management tool. But understand that market dislocations, disruptions, downturns and disorder are likely to have a quicker and more widespread impact across economies and industries given global economic connectedness.

The capacity to assimilate market cues and quickly make adjustments to a portfolio can safeguard an insurer’s capital.

For an insurance portfolio, having a risk budget can function akin to a stop-loss policy—if the portfolio or a sub-component erodes by “X” percent over a period of time, the position is reduced or eliminated according to the risk budget parameters. And pursuant to the prior bullet point, the modality of the investment is a component of swiftly executing on a plan. It’s unlikely an insurance portfolio can avoid entirely the pain that down markets can inflict; the key is having a plan to minimize the pain.

For a P/C carrier’s investment portfolio, having a risk budget can function akin to a stop-loss policy on the underwriting portfolio.

These preceding points are not overly complex. Yet they require an active focus and a dexterity that market conditions have not always demanded of insurance portfolio managers. The current environment demands a daily discipline to make sure: that the good risk management practices overlay portfolio construction, that the insurer’s portfolio is positioned with an appropriate duration given market and inflation outlooks, and that any “plus” or return-seeking asset classes complement the rest of the portfolio and remain as liquid as possible.

There are plenty of spots where one can get tripped up and see some erosion in the all-important gap between assets and liabilities, but there are also numerous opportunities for an insurance portfolio to thrive while maintaining low volatility.

Step lively, have a plan and execute on it. The gap shouldn’t be enough to trip us up!

This article first appeared in Carrier Management Magazine.