The old saying goes that it is better to know what the question is than the answer. Perhaps this is the best way to go about investing when interest rates are at historic lows and worldwide central banks are busy pumping up the money supply with no end in sight.
With that in mind, here are two of several key questions to ask now about your insurer’s investment portfolio (future blogs will raise other key questions):
What is our projected book yield (investment income) assuming interest rates do indeed stay low for longer?
If you have not seen such a projection over a period of quarters, please stop reading this blog and email or call your investment manager now. This projection, which is available from most investment analytic systems, allows you to see what your book yield will be, assuming that the manager continues to invest in the same manner (i.e. same market yield of purchases) as he or she is doing now. It should take into account the yield on dollars ‘running off’ the portfolio and the maturities, prepayments, interest, etc. that will be reinvested at today’s low market yields. Graphed, this line will show a gradual descent.
Please remember that, per the Fed, there will be low rates through 2015. Thus, the analysis should be run at least through that time period. In fact, if you see consumer deleveraging continuing beyond that period, you should probably run the analysis further. And, remember that the analysis should assume no new net cash flows. To the extent your company generates such cash flows, you can always run the analysis another time, showing the approximate amount of ‘new money’ added to the portfolio. The result should be an even quicker descending line.
Although this analysis will not solve any problems inherent in ‘low rates for longer’, it is the first step in successfully dealing with that by understanding the magnitude of the problem.
Can we consider changing our risk/reward profile?
With an upward sloping yield curve, it is important to get a good handle on the duration of your insurer’s reserves. This will allow you to see if there is a possibility of picking up marginal yield increases by simply better matching assets and liabilities (overall or key rate duration). We do not recommend increasing duration where it is not justified by reserve duration.
With rates kept unusually low, the Fed wants investors to take on more risk, with the idea that will goose the economy. Good luck, guys. However, it has caused a general rally in assets with many different risk characteristics. Thus, it is important to review your company’s credit risk parameters (average portfolio credit rating, minimum rating, etc.). We highly recommend, though, that you think through the ramifications of any change on a quantitative basis. Our firm uses a Portfolio Credit Review approach that allows insurers to see the probability distribution of losses imbedded in any portfolio of corporate credits….because, just because losses are low today, that does not mean they will be low tomorrow, or that OTTI (other than temporary impairment) may rear its ugly head once more.
Most insurers hold investments for long periods of time, making a certain amount of the portfolio potentially a good source of liquidity for certain bond issuers (private placements, etc.). We cannot stress enough the importance of having an investment manager with strong expertise in any asset class, especially in the private placement arena.
‘Risky Bucket’ Size and Diversification
We call the ‘risky bucket’ the portion of the portfolio that is not investment grade fixed income. The size of the ‘risky bucket’ should largely be a function of the insurer’s capital and surplus, as well as the risk appetite of the Board and senior management. The types of assets that are included in the ‘risky bucket’ are also related to the risk appetite.
We cannot tell you the amount of times we have seen analyses of the risky bucket using the well-known Markowitz efficient frontier. We think that is a good starting point, but the efficient frontier analyses typically make one big mistake and that is equating risk to standard deviation. And, using standard deviation assumes that asset returns follow a normal (bell curve) distribution. Nothing can be further from the truth. Thus, we recommend the use of a Drawdown analysis, so the Board and senior management can see which ‘risky bucket’ sizes have produced ‘worst case’ results in the past. And, the company can then ask itself if it is willing to live (or can live) with such results, given risk capital and other parameters.
These are just two good questions to ask (with several follow-up questions, as you can see) in order to deal with the biggest investment challenge facing insurers in thirty years: Low rates for longer. Future blog entries will outline other key questions.
Meanwhile, I look forward to your comments and questions.