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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.