Will interest rates continue their meek rise, aided and abetted by QE tapering at the Fed?  Or, will they fall reflecting the lack of inflation, a sluggish economy and continued QE at the Fed?

These and other questions may be answered when the Fed meets this week to discuss the Final Countdown.

By the Final Countdown, of course, I do not refer to the famous riff played by the 1980’s band Europe.  Nor, do I refer to the theme used by Gob Bluth during his illusion act in the revived comedy classic, Arrested Development.  And, of course, I do not refer to the 1980 movie where the USS Nimitz travels back in time to 1941 Pearl Harbor.

However, I do mean the Final Countdown to the end of QE that so pre-occupies financial markets worldwide.  The main fear in the markets is that the minute the Fed even hints at tapering (reducing purchases of US Treasuries and Agency RMBS), we will see a scare akin to 1994.

A trip back in time, without the help of the USS Nimitz, would reveal that from February, 1994 to February, 1995, the Fed increased its short term benchmark rate 300 basis points and the bond market reacted by increasing yields on the 30-year Treasury (that was the bond market benchmark, back in those days) by over 200 basis points.  Are we about to see a repeat?

Reread that last paragraph, and you can see that market participants are grappling for straws.  The Fed is not about to raise the fed funds rate by 300 basis points any time soon.

However, they will undoubtedly have to start reducing the size of their purchases of US Treasuries.

Why?  There will be less of that government borrowing going on, now that the year’s deficit is expected to fall from the $1 trillion+ level to something north of $600 billion.  Still, that is lots of government borrowing to stoke the political posturing nonsense in D.C., instead of, perish the thought, reasoned discourse.

With fewer newly minted US Treasuries to buy, unless the Fed truly wants to corner the market on government debt (many would call that monetizing the debt), they have to taper (reduce) those purchases in a similar manner.

As for the Final Countdown to the end of QE, Chairman Ben, much like Gob Bluth, has been playing the same song for some time.

Unless inflation rears its ugly head (not an issue at present), the employment part of the Fed’s mandate will call the tune.  Cutting through the cacophony coming from the financial press is sometimes as difficult as getting that band Europe’s riff out of one’s head.  But, let’s try and do that by going to the FRB Atlanta unemployment calculator.  Plug in your own assumptions, or use what the FRB has, and it looks like we are about 22 months from reaching the goal of a 6.5% unemployment rate, assuming the US economy keeps adding about 175,000 jobs per month (same as last month).  That is the springtime of 2015.

Of course, a net 175,000 jobs is a big number to consistently add every month, but this did occur in a few month during the last recovery (2001-2007).  So, the complete end of QE will have to wait for a while, giving the nervous nellies in the press lots to talk about.

But, what about the other Final Countdown, that may be first and foremost in the Chairman’s mind?   The number of months to the end of Chairman Ben’s term.   On January 31, 2014, his term will end and most sentient beings who obsess over these things are expecting the Chairman to step down and be replaced by someone with similar feelings about QE.

So, how momentous will the announcements from this week’s Fed meetings and subsequent press conference by Chairman Ben be?  Not very, but afterwards, we will all have time to recalibrate the various Final Countdowns.   Over to you, Europe…the band that is.

As for the continent, well they really do have their own Final Countdowns to worry about…

For More of the Latest Insurer Investment Insight, please visit InsurerCIO.com

Register now and receive InsurerCIO’s Weekly Newsletter, for the most riveting analysis and insightful resources to ensure you are always informed. View Sample

Also view:

Webinar: Investment Perspectives from the Insurer Investment Forum
Investment Perspectives Webinar: Q&A Sheet

OK, guys.  Enough is enough.  Every major developed country central bank is printing money like a 1920s gangster with a printing press in the basement and too much ink.

But, what does that money printing really do for the economies of the developed countries?  So far, very little except find its way into risk assets in a very big way.

The issue is not how much money is printed (really an increase in bank reserves offset by purchases of UST and Agency MBS) but if that money gets used in the real economy.  For a terrific description of the process, take a look at this Hoisington Review summarized at InsurerCIO.com.  Follow the link there for the entire paper.

Bottom line is that the dollars used to buy the UST and MBS are used to purchase many different kinds of investments, many of them risk assets (or certainly more risky than government debt).  The offset (net increase in bank reserves) sits on the balance sheets of the TBTF banks who are slowly, if at all, adding to their loans to businesses.

An unintended consequence of QE infinity is rates are so low in the corporate bond market that large companies find no use borrowing from banks.  While small and mid sized companies are very, very cautious in borrowing to expand in the current economic environment.  Ergo, those reserves do nothing but cause to reduce the velocity of money and act as a strong anchor against the winds of ‘money printing.’

Until economic activity picks up materially faster than productivity improvements, or the velocity of money stops falling and even starts rising a bit, there will be little cause for worry about inflation.  We might look to the housing recovery to help the situation, but post 08/09, housing is a rather small part of GDP.

Currently, the US is in a disinflationary (lower inflation) mode, with the latest PCE indicator coming in at 0.9% or over 60% less than the Fed’s target of 2.5%.  Couple this with nickel, tin and bellwether copper prices all in a bear market and you start to see where the central banks underlying concerns may be: further disinflation or deflation.

While the Bank of England and the ECB do their QE best to outdo the Fed (and they have as a percentage of GDP), the real QE big spender is Japan (planning to expand the BoJ’s balance sheet by at least 1% of GDP every month for the next two to three years).  Compare the BoJ’s QE to the Fed’s at only about 1/2% per month and you can see that Uncle Ben can only look up at (and out for) the BoJ.

So, while the Fed pushes against a string (opposed by fiscal incompetence in D.C.) to keep the US economy from stalling, other central banks have their own challenges…and they all seem to have the same ‘solution’.

Some may call this a ‘race to the bottom’ or a ‘currency war’, but I prefer to consider it a race to the bottom to avoid major disinflation and, perhaps, deflation.

The real challenges are ahead of us…not behind us.  “Low rates for longer” may only be just one investment challenge, should we approach nil inflation numbers.

For More of the Latest Insurer Investment Insight, please visit InsurerCIO.com

Register now and receive InsurerCIO’s Weekly Newsletter, for the most riveting analysis and insightful resources to ensure you are always informed. View Sample

Also view:

Webinar: Investment Perspectives from the Insurer Investment Forum
Investment Perspectives Webinar: Q&A Sheet

Today, the venerable and oft berated Goldman Sachs announced summary results of their annual Insurance Asset Management Survey. Although we await the full report, the summarized results provide some fascinating food for thought.

If past is prologue, the Survey of 252 CIOs and CFOs of insurers is heavily biased towards larger firms. I also have no doubt that a few mid and small sized firms snuck into the Survey.

The summary results released today are mostly obvious, but do have a few nuggets of interest.

First, one must remember that surveys are just that, surveys not facts. If I ask you if you are doing something you perceive as good, the natural tendency is for you to overstate your activity in the survey, and vice versa. Thus, there is a natural bias built in.

For example, the Survey says 40+% of CIOs plan on decreasing allocations to government and agency debt, as well as cash and short term instruments. Of course, if they were not already deemphasizing these low yielding alternatives, one wonders if they would be a CIO next year.

CIOs also intend to increase allocation to bank loans, US equity and real estate. Anyone involved in investing for insurers realizes that these asset classes are quite popular, to varying degrees. Although 37-43% of CIOs said they intended to increase these allocations, one must wonder to what extent the allocations will be increased. 1%? 5%? 10% or more? In any event, if a CIO wants to be seen in a good light, he or she will most certainly mention one or more of these asset classes. Perhaps the Survey will reveal this and other more pertinent details.

Contrast these sentiments with the Survey’s 30% who believe their peer group is taking on excessive risk, with 19% saying peer risk taking is insufficient. What are the true motivations behind these responses? Did those same 30% think the same about their peers last year? Or ten years ago? Are the 19% who say peer risk taking is insufficient really trying to goad their peers into taking on uncompensated risk, while they watch from the sidelines, waiting for the next inevitable ‘financial crisis’?

Perhaps the most useful data point in the Survey was the fact that more than half of the respondents think rates will increase significantly in the next two to three years. Or is it useful? Isn’t that about what the Fed’s timetable is (the Survey seems to have been executed in the latter part of 2012)? Wouldn’t it be instructive to know what these same companies thought about this question in 2011 or 2010? What is the trend, oh great and might Goldman Sachs?

I suppose when you add up the summary results of the Survey, as released thus far, one can attempt to conclude many things. But, one wonders how accurate those conclusions may be…except for the most important one.

The Goldman Insurance Asset Survey is a really good tool for raising awareness of Goldman Sachs Asset Management. Well played, Goldman Sachs. Well played.

For the Latest Insurer Investment Insight, please visit InsurerCIO.com

Also view:

Webinar: Investment Perspectives from the Insurer Investment Forum
Investment Perspectives Webinar: Q&A Sheet

In last night’s article from Bloomberg, “Apollo-to-Goldman Embracing Insurers Spurs State Concerns,” the relatively recent involvement of private equity (PE) firms in insurers was noted as a potential problem for policyholders and regulators going forward.

Let’s just say that this understates the problem.

First, let’s remember how PE operates: Find inefficiencies and take full advantage of them. How about state regulatory inefficiencies. With 50 plus jurisdictions involved in regulating insurers in the US, there will be some jurisdictions that are more efficient than others. The less efficient ones are thus the target of the PE firms.

Second, state investment regulations for insurers also can vary by jurisdiction. Although the National Association of Insurance Commissioners (NAIC) promulgated two versions of a Model Investment Law nearly two decades ago, neither has been adopted by enough states to be a requirement for state accreditation. Thus, there are plenty of loopholes, if you are willing to find them.

Third, the article points out potential abuses, but misses an important point. Insurers typically use investment grade fixed income securities to back their obligations to policyholders. Are these PE firms taking on ‘risky’ assets for that purpose, or are these ‘risky’ assets an investment of the insurer’s surplus (assets less liabilities)? And, if they are such an investment, is the amount of risk taken too much relative to that surplus?

Fourth, the article alludes to the importance of rating agencies. But, given an ‘out of the ordinary’ investment strategy, do you think the rating agencies are properly staffed for this challenge?

The folks running PE firms are quite savvy (how else to truly justify the lower tax rate on ‘carried interest’?). Questions should be asked about their strategies and the ability to fully understand the unique arena of investing for insurance companies. But, one wonders, with all due respect, if the regulators (state or now federal) or the rating agencies have the capabilities to perform this function.

Why does this start to sound like the sub-prime arena? Regulators and rating agencies without the capability to fully understand what the investors are up to.

The wolves have entered the insurance business in sheeps’ clothing. We now have to determine if their strategy of finding inefficiencies and taking advantage of them, in both the markets, regulators and rating agencies is a potential hazard for policyholders. And, those wolves are not about to tell us much more than is required by statute.

For the Latest Insurer Investment Insight, please visit InsurerCIO.com

Also view:

Webinar: Investment Perspectives from the Insurer Investment Forum
Investment Perspectives Webinar: Q&A Sheet

As 2012 comes to a close, we look back at some of the most insightful commentary provided by “From the Northwest Quadrant” in the past 12 months. While our commentary may not cover some of the most highlighted topics of 2012, (i.e., Libor, the fiscal cliff, Greece) we discuss issues intended to help insurers go beyond their usual approach to investments.

Financial Repression Marches On…And Over Insurer Financials, Part I & Part II
Back in February, the Federal Reserve had continued its financial repression march, which for insurers meant facing the largest investment challenge over the last thirty years. It is one thing when equity markets slump (most well managed firms realize that equities can easily sell of 20-30% in a given year, as we have occasionally seen in that period). However, it is another when fixed income market interest rates fall so low that they not only threaten product profitability but product viability.

There are four possible investment related responses (or some combination thereof) to financial repression:

- Change Risk Profile (credit, duration, liquidity, etc.)
- Use non-Core Fixed Income as a source of additional income
- Minimize Risk and waiting for more attractive yields
- Do Nothing substantially different

Investor Public Enemy #1, Market Manipulation Continues
In June, one major concern was the market manipulation created by global central banks. In manipulating the market, those luminaries caused a less than optimal allocation of capital. And that less than optimal allocation of capital has had major consequences – not just for the valuation of investment portfolios – but for the lives of the average person. Interest rates that are ‘lower for longer’ will continue to pressure investment income, underwriting activity, premium rates and yields on interest sensitive products at least through 2014 and probably longer. You can make the right decisions about the investment process, but market manipulation can make those decisions look foolish…even when that manipulation itself may prove to be even more foolish.

Uncertain Times? Not So Much, with a Solid Investment Process
Sometime in August, during a board meeting, we were asked, “How about we just get an investment manager that will get us the best return? Or, just always beat our benchmark?” We responded by saying, “At the very basic of levels, don’t we want to have the best investment process possible for our company?”

I had previously tackled this issue in my book, Uncertain Times: A Chief Investment Officer’s Journey: “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.”

At a 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.”

Key Questions to Ask Now, Part I & Part II
During mid-late November, with interest rates at historic lows and worldwide central banks are busy pumping up the money supply with no end in sight, we covered several key questions to ask about your insurer’s investment portfolio.

- What is our projected book yield (investment income) assuming interest rates do indeed stay low for longer?
- Can we consider changing our risk/reward profile?
- Should the change be strategic or tactical?
- Do we have the right investment manager to execute the strategy?
- Do we have the right benchmarks?
- Do the current investment strategies dovetail with the Board’s/senior management’s risk appetite?

Obviously, many of these questions apply to your company’s investment process, even if you do not make a change in strategy (and even ‘no change’ is a decision that must be analyzed as carefully as any proposed change). A careful, step-by-step approach to understanding how your company will meet its greatest investment challenges is a must in these uncertain times.

In Part I of this series, we asked several key questions you should be asking now about your insurer’s investment portfolio.  In Part II, we conclude with key questions that go beyond the greatest investment challenge faced by insurers in thirty years (low rates for longer):

Should the change be strategic or tactical?

Let’s assume you have decided on a course of action in order to improve your company’s portfolio despite ‘lower rates for longer’.  You know what you want to do, but should you make this change strategically or tactically?

Using a strategic viewpoint, your change will be based upon a long term view.  It will be discussed carefully amongst senior management and the Board, and will typically require Board/Investment Committee approval.  You will be able to execute this change carefully, over time, monitoring progress to putting the change into place.  This is the typical scenario for most, if not all, of the investment decisions made by insurers.

However, if this change is a tactical one, you will want to set specific parameters around which you will (and will not) execute the change.  Many of these parameters may have to do with more changeable variables, like financial market conditions, interest rates, spreads, etc.  You will want to execute this tactical change only when it looks to be advantageous and you will want to exit this change when things appear disadvantageous.  Alas, a tactical change requires a very active approach that requires active management – something that most insurers do not employ internally.  More importantly, without setting specific ‘triggers’ for exiting the position or delegating this to the external manager, many insurers will find it difficult to successfully exit (let alone enter) a tactical trade.  This is primarily because most insurers’ investment processes are geared to making strategic not tactical changes.

Do we have the right investment manager to execute the strategy?

Gertrude Stein said, “A rose is a rose is a rose.”  However “a fixed income manager is NOT a fixed income manager is NOT a fixed income manager.”  Different managers take different biases into their approach to the fixed income market.  Thus, even for a change in strategy that is limited to investment grade bonds, it will be important that your investment manager can successfully handle that change.

For example, let’s say your strategic change is to deemphasize corporate bonds and emphasize structured securities.  I can tell you from experience that I would feel very comfortable with several managers for this change, but would be more than uncomfortable for others.

Know what your manager can do really well and not so well, before asking them to be part of the change in strategy.

Do we have the right benchmarks?

First, if you are using the Barclay’s Aggregate Index, immediately make the change to a more customized benchmark that is more yield oriented than the heavily government/agency weighted, low yielding Aggregate Index.

Next, realize that whatever benchmark you choose it must be directly related to your company’s preferred asset allocation.  Thus, it must reflect this change in strategy.  If not, you are asking for the investment manager to beat a meaningless benchmark.

And, ask your manager to prepare a performance attribution analysis that compares actual to benchmark performance and answers the ‘whys’ behind performance.  For example, was it interest rate decisions, yield curve shifts, sector or security decisions that really drove performance?

Finally, always remember that an investment manager’s primary goal is to get your business and his/her subsequent goal is to keep your business.  Everything else feeds into those goals.  Thus, he/she will always want to stay close to the benchmark construction.  And that means understanding how your benchmark is impacting manager behavior, may be the most important part of managing your investment manager.

Do the current investment strategies dovetail with the Board’s/senior management’s risk appetite?

When all is said and done, no investment strategy is worthwhile if it does not dovetail with your company’s risk appetite.

Take a look at long term ‘drawdown’ studies to see how bad your ‘preferred’ asset allocation has performed in the past.  If the Board and senior management are in concordance with those expectations on the downside, you have the beginnings of an agreement on risk appetite.

Obviously, many of these questions apply to your company’s investment process, even if you do not make a change in strategy (and even ‘no change’ is a decision that must be analyzed as carefully as any proposed change).  A careful, step-by-step approach to understanding how your company will meet its greatest investment challenges is a must in these uncertain times.

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? 

Duration

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.

Credit

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.

Liquidity

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.

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.

Was LIBOR scandal encouraged by the regulators? More evidence that the regulators are in big banks’ pockets.

Is it LIBOR or lie-more at the big banks? Simon Johnson says the latter.

Why the LIBOR scandal is a bigger deal than JPMorgan’s credit derivatives trade.