The other day, we were meeting with an insurance company Board of Directors discussing the company’s portfolio.

“Why don’t we just get the best yield?” said one Director.  “How about we just get an investment manager that will get us the best return?  Or, just always beat our benchmark?” said another Director.

Those were all worthy goals, we told them.  But, let’s take a step back and ask what we want from our investment process.  In fact, what do we want from any process at the company – whether it is the underwriting process, the sales process, or the Board communication process?

That last one got their attention.  As a Board member, you bring your vast experience and knowledge to an enterprise you spend a few hours per quarter reviewing – not a lot of time to make you feel 100% comfortable in your decisions.

“At the very basic of levels, don’t we want to have the best investment process possible for our company?” I noted.

In my book, Uncertain Times: A Chief Investment Officer’s Journey, here is how I handled this issue:

“One thing is certain about investing: a solid process gives you the best opportunity to produce solid results.  Good results may occur in spite of an inadequate process, but that may be attributable to a degree of luck.  Though there are no guarantees, solid investment results will most likely follow from a solid investment process.”

But, woe is me, for not expanding upon this topic.  Of course, the entire book is about the Investment Process Value Chain (each Chapter is devoted to one of the links in the Chain).  But, I really should have expanded a bit on the importance of the investment process and its related decision making process.  As promised in my last blog, here is my chance to do so.

We begin with one way to look at the decision making process.  It is a simple two by two matrix that compares the Process to possible Outcomes:

At a recent CFA meeting in the UK, Michael Maubossin, CIO at Legg Mason put it best:

“Mauboussin believes the main difference between good and great investors comes down to temperament and focus. Good processes and good outcomes deliver deserved success, just as bad processes and bad outcomes are a form of poetic justice. Conversely, bad processes that yield good outcomes are just dumb luck. Investors often confuse the two. Successful poker players and renowned economists agree that better decision making comes from evaluating decisions on how well they were made rather than on outcomes.”

This is all about having a disciplined process that is the best one for your insurance company….and following that discipline, something that can be quite difficult to do.

I like to tell the story about some of our clients toward the end of the last millenium (late 1999, that is).  The Dot-com boom had contributed to sky high metrics for common stock and with that an accelerating upward equity market…smiles all around in the Boardroom.  As those common stock valuations pierced the investment policy maximums, as ratified by the Board and part of a solid investment process, I had the duty to relate the ‘bad news’:  With equities higher than the policy limits, we should reduce our equity position to get it back to within the policy range (most likely within the mid-point), an act of rebalancing the overall portfolio.  Each client viewed my communication in different ways, but they all came down to one basic point: “Hey, we’re playing with house money now.  Let’s not make any changes.”  This approach was confirmed for a couple of quarters, as stocks continued to levitate.  Later, as the Dot-com boom became the Dot-com crash, I had to underline the bad news, while noting the Board had indeed managed to get the equity allocation back within policy limits.

The point of this story is twofold: (1) the importance of a solid investment process and (2) the importance of a disciplined approach, even when it seems like it is not the ‘right’ thing to do at the time.

Hopping back over the ‘pond’, here is a relevant article from the London Business School’s “Business Strategy Review” that makes six important points about decision making:

1. Results are irrelevant as a measure of decision quality.  Remember our two by two matrix and you can see what the authors mean.

2. Results don’t necessarily reflect a high-quality process.  The ultimate criteria for good decision making is tied to: (a)  What are we trying to achieve with this decision, (b) What can we feasibly do? and (c) What do we have to watch out for?  These all relate to specific areas of the Investment Process Value Chain as described in Uncertain Times and on this web site.

3. Using results as a measure of decision quality leads to organizational crises.  In other words, you don’t want to have a ‘blame culture’ that is triggered by bad results.  The Board and senior management must tolerate failure and error to some degree…but with a focus on improving the process…

4. Being accountable only for results is not the right standard for performance.  People should be held accountable for what they control, not what they do not control…back to the important of process and of understanding how the process is supposed to work, etc.

5. It’s not enough to measure organizational leaders on results; how they achieved them is equally important.  Back to our two by two matrix.  What can be done to achieve solid results?…a solid process.

6. Being compensated only for results doesn’t measure one’s true contributions to the organization.  An investment manager who experiences good results, but whose process is not understood might describe someone named Madoff, etc.

These are just a few ways to look at the importance of the investment process ahead of investment results.  Perhaps with this in mind, your company will not have as many Uncertain Times in the future.

As always, I look forward to your comments and questions.

How many times in life have you asked yourself, “I wish I could do that over again. Then, I would do it better (or not make that mistake).”

As we all know, that is a wistful wish.  However, due to the sometimes wonderful world of blogging, I now have that opportunity.

Through the financial crisis that set off the Great Recession, I was in the process of writing a book about the investment process for insurance companies.  “Uncertain Times: A Chief Investment Officer’s Journey,” was designed to be a bit entertaining by centering the rather dry topic of investment process around the fictional account of the life of Bob Short, a Chief Investment Officer (or should I say former CIO) at a mythical property/casualty insurer.

Published in late 2009, it was well received, but I still had this sinking feeling in the pit of my stomach.

Practically every day, as consultants, we see a lot of different, interesting situations at insurers and their investment processes.  And, we continue to improve what we do in assisting those insurers.  Yet, the process in “Uncertain Times” was far from certain.  It was cemented at a point in time 2008-2009, as the financial markets, regulators, rating agencies and indeed the entire approach to investing for insurers has continued to change.

With that in mind, I will utilize From the Northwest Quadrant to update you on a few of the improvements we have instituted since Uncertain Times was published.  This will be the first in an occasional series of blogs on this subject.  Consider it a mea culpa with a lot of mea and just a little culpa.

As you might expect, our introductory chapters about the investment process and the importance of communication still rings true…perhaps even more so today.

Thus, let’s begin with Chapter 3, Strategic Asset Allocation.  We spend some time discussing the Markowitz efficient frontier, as well as Dynamic Financial Analysis (aka Asset/Liability Management).  Although both analyses have their place in determining risk and reward and the preferred strategic asset allocation for an insurer, there are other ways to look at things.

DFA and ALM are terrific tools when it comes to understanding the company’s overall expected cash flows and interest rate risk.  However, we have found a more direct, less ‘black box’ approach also being embraced by insurer senior management teams and Boards.

Of course, understanding the duration of liability (reserves) is important, as it helps point us in the right direction for the core fixed income portfolio.  However, when it comes to looking at the impact of the company’s ‘risky bucket’ (investments that are not investment grade core fixed income), we prefer a drawdown analysis.  The drawdown analysis is designed to look historically at the performance of the ‘risky bucket’ as well as the overall portfolio, by tracking how long the portfolio heads down in value, how far down it went and for how long.

We think this gets Boards thinking more in terms of what its risk appetite really is.  For example, are the Board and senior management comfortable with a portfolio that, historically, has gotten as bad as x% ‘underwater’ for ‘y’ quarters?  If so, and if this still will meet with ‘worst case’ assumptions for the rating agency risk capital models (especially AM Best), we have one reasonable possibility for an asset allocation.

Compare this view of ‘downside risk’ to that imbedded within the Markowitz efficient frontier.  The latter assumes risk to be the same as standard deviation.  And standard deviation assumes that assets have a return distribution that mirrors the normal distribution (‘bell curve’).  If only this was true.  Whenever you hear a money manager say that was a 5 or 10 standard deviation move, you can only know that he is using the wrong distribution in order to characterize the risk of the portfolio.

Well, that’s just one way I would improve “Uncertain Times”…by taking a better look at uncertainty when making an asset allocation decision.

In future blog posts, I will come back to the only book on the subject of the investment process for an insurer, and try to update it with more current thinking.

And, as always, I look forward to your thoughts and comments.