Important Factors for Governmental Risk Pooling Investments

With several ongoing and moving pieces in the investment landscape, we spoke with AAM - Insurance Investment Management to get an update on the trends and topics that are most top-of-mind for both insurance companies and risk pools. Topics include asset allocation for risk pool portfolios; best practices for determining target duration; and, liquidity management.

Michael McLaughlin, CFA | Principal & Senior Portfolio Manager | AAM – Insurance Investment Management
michael.mclaughlin@aamcompany.com | Learn More >>

SAA: What does AAM feel are the most important factors for risk pools to consider when determining their investment portfolio allocations?

AAM: Risk pools must consider several factors when determining their portfolio allocations. One element outside their control is state investment statutes; some states only allow investments in U.S. government, agency, and municipal bonds, limiting risk and potential returns. Where broader investment options exist, the risk/reward trade-offs can widen meaningfully. Two critical factors that should be focused on are the duration of the fixed income portfolio and the allocation to risk assets.

The duration target of your portfolio impacts the amount of investment income generated by your fixed income portfolio and the portfolio’s sensitivity to changes in interest rates. The longer the duration of the fixed income portfolio, the more investment income is generated long term through economic cycles. However, the tradeoff is a longer duration portfolio is more sensitive to changes in interest rates which can impact a pool’s net position since GASB requires that pools report their investments at market value. It is important that a pool’s fixed income duration target reflects the pool’s investment goals, and they understand the risk/reward of different fixed income duration profiles.

Another key factor is how much of the portfolio is invested in risk assets, such as equities, high-yield bonds, bank loans, and convertible bonds. Risk assets can generate additional investment returns over investment-grade bonds but are more volatile. This additional return helps to grow net position over time. This potential for added return, combined with income optimization in the fixed income portfolio, can provide stabilization to member contributions. As with duration, the risk asset allocation should reflect the liabilities, liquidity, and financial position of the pool. If underwriting results shrink net position, reducing risk assets may be prudent. Risk pools often benefit from a structured asset allocation process that considers these factors. Industry practitioners have published various approaches to modeling these risks.

SAA: As part of that process, what are the best practices pools should utilize in determining the fixed income portfolio’s duration target?

AAM: The duration and liquidity of the fixed income portfolio should align with the pool’s liabilities and net position. In practice, this requires working with the pool's leadership to review historical cash flows and analyze actuarial reports and financial statements. Having an appropriate duration target and a fixed income portfolio structured to reflect the pool’s liabilities and liquidity needs can help maximize income within appropriate risk limits and reduce the need to sell securities in times of market stress at potential losses.

The importance of this practice was evident during the rising interest rate environment in 2022-23. Between rising interest rates and a large increase in reinsurance costs for property and liability pools, this period highlighted the risk of having to sell bonds at a significant loss. Portfolios with duration aligned with liabilities limited this risk significantly.

AAM has an insurance strategist who develops a model that can assist pools in determining an appropriate duration target for their fixed-income portfolio. Using the pool's financial history and actuarial reports, the model considers the estimated duration of the pool’s liabilities and level of net position to determine a duration range that is appropriate for the pool. This is a good starting point for discussion with management/staff to determine if that target seems appropriate.

SAA: As Property & Liability pools across the country deal with nuclear verdicts and increased claims from severe weather, how can P&L pools manage liquidity in their investment portfolio?

AAM: Liquidity management has become more important over the past few years as large property and liability claims have become more prevalent. Ensuring that you maximize the investment income earned on cash earmarked for future operating needs is crucial, as pools may need to hold cash for extended periods to meet future obligations, such as reinsurance payments or claims. One effective way to manage this is to maintain a separate short-term investment portfolio, distinct from your fixed income portfolio, where you can structure a portfolio to match future operating cash needs. For future operating cash needs that are only a few months or less away, or potential claims for which timing is uncertain, using a combination of U.S. Treasury Bills, money market funds, or state-sponsored liquidity funds is a good option to earn more income and keep funds very liquid. There are times when there are changes in short-term interest rates that cause one of these instruments to be more attractive, so it is a good practice to monitor these rates to make sure you are earning the most yield on your cash.

For cash needs a year or more out, you can construct a diversified portfolio of high-quality securities with predictable cash flows to enhance yield and limit credit risk. AAA-rated Asset-Backed Securities tied to credit card and auto receivables, A-rated Corporate Bonds, and Agency Commercial Mortgage-Backed Securities are all highly liquid with stable payment streams, making them effective vehicles for increasing returns on funds reserved for future operating requirements.

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. Any opinions and statements contained herein of financial market trends based on market conditions constitute our judgment. This material may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different than that discussed here. The information presented, including any statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Although the assumptions underlying the forward-looking statements that may be contained herein are believed to be reasonable they can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. AAM assumes no duty to provide updates to any analysis contained herein. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Source: Strategic Asset Alliance, AAM. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.