Risk Assets: Key Factors to Consider

Given government risk pools take on risk as part of their core business, it is critical to balance the risk within the investment portfolio to that within the overall business.

In general, if an organization takes on more operating risk, it may be necessary to reduce the risk on the investment side; especially within the risk asset category.

If your company is looking to modify its risk asset allocation, it is important to model various asset allocation combinations; examining the volatility of surplus and worst-case drawdown profile of various assets and their impact on surplus.​

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Key Factors to Consider

Relation to Surplus:
Simply looking at overall risk allocation can be a bit misleading. What we’re really interested in is, “how much of your surplus is exposed to investment risk?” A more reliable metric is “Risk Assets as a Percentage of Surplus” (aka Net Position).

A strong surplus position may allow your company to take on additional risk. In turn, increasing the amount of risk assets relative to surplus should correspond with an increase in expected return. However, leveraging too much risk relative to your surplus that is not properly compensated can be detrimental to your investment portfolio.

Why Risk Assets to Surplus?
Your surplus has many demands: underwriting, reserving, risk management, state regulations, etc. Investments are just one component as it relates to how your surplus can be utilized in your organization’s best interest.

Understanding Regulations:
Regulations tend to act as constraints on potential allocations to certain asset classes or as limiting factors on those allocations. Government Risk Pools are often restricted to only investing in Treasuries & Agencies. For risk pools where regulations only permit them to invest in Treasuries & Agencies
or investment-grade bonds, exposure to risk assets can be achieved through the entity’s captive insurance portfolio.

Thus, a review of the applicable regulatory framework is an integral part of any asset allocation (and investment policy) development. The best asset allocation framework is useless if it cannot be implemented due to regulatory
restrictions.

Board/Committee Risk Tolerance:
The risk tolerance of the Board, staff and Investment Committee is important to the development of a suitable investment program. Risk tolerance cannot be determined via a canned survey completed by the committee.

Various scenarios based upon different investment structures can gauge the impact of these scenarios on key investment and company metrics. This can determine how much risk the Committee and Management are willing to take on the investment side given objectives and constraints on the business side (i.e. surplus levels, profitability, ratings, regulatory concerns, etc.).