By Alton Cogert
Investing for insurers is getting more difficult and more complex all of the time. We even have to vault over important hurdles to key decisions made by the Investment Committee and the Board.
Management guru Peter Drucker probably put it best when he said, “If you can’t measure it, you can’t manage it.”
How true, but what if you are measuring what the party doing the managing wants you to measure? Perhaps we start to see a conflict of interest brewing.
Economists call this an example of agency theory. Put simply agency theory is about resolving problems that can exist between principals (your company) and their agents (your investment manager, in this example). Two basic problems that can arise:
(1) goals of the principal and agent are in conflict and the principal is unable to verify what the agent is doing, and
(2) the principal and agent have different risk tolerances.
The “Pitch Book”
At this point, you might ask, “Isn’t that why we have an investment policy and customized benchmarks?”
Yes, that is true, provided the policy and benchmark are the result of a disciplined investment process as we have discussed here.
However, each quarter (or perhaps more frequently), your investment manager dutifully brings out his book of graphs and Power point slides to tell you how the portfolio is performing and how he or she feels so very comfortable with their strategy going forward.
Now, consider that book for a moment. Think back to when you first interviewed that manager. My guess is that the outward appearance of that book is quite similar to the ‘pitch book’ the manager used to convince you to hire them. Could this be a coincidence? Or does this book of quarterly information have an additional purpose: to keep you convinced of the fine performance and viability of the manager’s investment strategy?
Thus, we have the beginnings of potential problems that fall under agency theory.
Once again, Dr. Drucker’s “If you can’t measure it, you can’t manage it” comes to mind. But within the problems found in agency theory, it becomes even more important to take another look at how you are measuring your portfolio.
As investment consultants, we are always trying to do just that. Our partner clients rely upon us to provide customized reporting.
But, we thought it would be interesting if we provided a standardized reporting package that added value well beyond what investment managers typically provide. In other words, an investment reporting package that provides actionable intelligence. Here are some examples of questions you might want to get answers to:
– How about taking a look at how your fixed income portfolio combines interest rate and credit risk? We call that credit duration and it really serves as an early warning against one of the (many) problems with ratings from our friends at the NRSRO’s (S&P, Moody’s, Fitch, etc.). These credit raters will typically stamp the same rating on an issuer’s bonds whether it has one year to maturity, or thirty years. Are we to really believe that credit risk can be accurately projected over the next thirty years?
Of course, you may say that the manager would sell a bond if the issuer was having credit problems. And, indeed, this is what the manager will try to do. But, in an increasingly changeable economy, where public information is supposed to be shared instantaneously to all interested investors, there is an increased probability that virtually no manager will be able to avoid all credit problems. Add in the Damocles’ sword called Other Than Temporary Impairment and we know a bond need not be downgraded before it becomes a credit event for accounting purposes.
– Managers tell us about our unrealized gains or losses, but what credit ratings harbor those gains or losses? And what does that say about our ability to realize those gains or losses, depending upon the financial goals and objectives of our company?
– Did you know that practically every investment reporting system does not report your fixed income portfolio’s true average credit rating? Our firm has existed for twenty years now and we have yet to see an investment manager show the true average credit rating. This practice is perpetuated by the fact that most investment policies take the manager’s calculation into account when comparing to what the required ‘minimum’ average credit rating should be. However, wouldn’t it be better to know what those credit ratings mean for the expected long term default rate of the portfolio? You see, the manager’s reporting systems typically assume that credit quality gets worse in a linear fashion as you go down the credit rating scale. However, long term default statistics from the rating agencies tell us that defaults actually accelerate in size as you go down the credit rating scale. Recalculating the average and getting a better idea of the average long term default rate is a much more realistic way of looking at credit risk.
– How bad have price drops impacted your portfolio in the past? Depending upon how your current asset allocation compares to your existing allocation, this can give you a good idea of how risky your portfolio might be in the future. And, that can serve as a starting point for risk appetite discussions with the Investment Committee and/or Board of Directors. This can be determined by looking at a “Drawdown” chart.
Of course, there are many more questions for which your current investment reporting may not be providing answers. And our standardized package can provide actionable intelligence that may be of interest.
Basic to Interesting
Interestingly, in our informal research, we have found that the usefulness of reporting provided by managers does vary greatly from very basic to very interesting. And, this is really due to two major factors: (1) the standard reporting capabilities of the manager, and (2) the questions asked and reporting requested by the insurer.
Interestingly, these two factors probably are less tied to the size of both the manager and the insurer than you might expect. In other words, just because you are using a ‘big name’ manager or, perhaps, are a large client for a given manager, please do not assume you are getting top shelf, useful and actionable reporting.
We realize that an insurance company is a complex entity, focused on risk management, from both sides of the balance sheet. But, one wonders if all insurers are being properly served by reporting that assists in understanding relevant investment risks and returns.
Perhaps useful, actionable reporting can be one step in helping manage the problems of agency theory since “If you can’t measure it, you can’t manage it.”