Portfolio Credit Review

As credit losses continue to mount in insurers’ bond portfolios, senior management appears to take one of two approaches.

Either they believe that rating agencies and regulators will see most insurer portfolios hurt and take no action, or they believe that there must be a better way to quantify and manage credit risk in the portfolio. We believe it will be the latter group of companies, focused on improving their investment process, who will prosper in today’s risky bond market.

Managing and monitoring credit risk starts with understanding that:

• The target spread you think you are achieving for interest sensitive products may not be achieved.  Arbitrarily choosing a credit default factor in pricing liability products is fraught with danger.
• Investing for the ‘best yield’ is probably a delusion. The stated yield to maturity on a bond portfolio is probably NOT what you will ultimately receive.
• Credit risk must be actively managed for success. The longer an investment grade corporate bond in held, the higher the probability of default since the historical transition in credit ratings for such securities is downward.
• Your company’s actual default rate will probably be worse than the investment grade corporate bond universe. Using rating agency default factors alone for estimating credit risk severely understates the true credit risk, depending upon the size and diversity of your protfolio. The following graphs are indicative of the difference in credit risk profile for the corporate bond universe and a well diversified insurer portfolio.

These and other related problems can be addressed with a careful analysis of your portfolio’s credit risk, which can assist in answering key questions, such as:

• What is the true average credit rating of our portfolio (as compared to the universally incorrect picture provided by investment reports)?
• What can we expect to actually receive in portfolio yield, after expected defaults and credit losses?
• What bonds deserve the most scrutiny because they contribute the most to our portfolio’s credit risk?