Insurers Beware: The Hidden Cost Behind Your Decisions

By Alton Cogert |

Ever wonder “What if?”

Of course you have.

What if I had decided to go to that other college instead of the one I went to?

What if I had chosen a different spouse? Or my spouse would have chosen differently?

What if I had decided to move to a different location for a different job opportunity?

The “What if’s go on and on…”

But, since this is a blog about investments for insurers, let’s focus on some of the big what if’s there.

What if our company had a different asset allocation? Would our financial results be better or worse?

What if we had chosen a different investment management firm? Would the other manager have added more value than the one we have?

What if we had chosen a different investment consultant? Would our results be different?

Yes, even for the investments of insurers, the ‘what if’s’ go on and on. Thankfully, though, there are more quantifiable answers to those questions than to some of the more all-encompassing questions of our lives.

Put another way, there is a way to quantify the cost of your decision. Let’s look at one scenario:

Concerned about the direction of the financial markets, the XYZ Insurance Board of Directors approves an asset allocation that materially increases investments in US Treasuries. “Sure they yield less than other investment grade bonds,” says the Chairman, “but nobody ever lost money investing in Uncle Sam!”

Actually, some investors have. Witness the government’s actions in running away from any implicit guarantee on FNMA/FHLMC preferred stock. But, let’s not quibble with the Chairman’s logic.

What is the cost of XYZ’s decision? You will never see it on their financial statements, but it is imbedded in those financials, hiding in plain sight. It’s better known as opportunity cost.

Opportunity Cost is an economics term, but it is best defined as “the loss of potential gain from other alternatives when one alternative is chosen.” So, for XYZ, having an investment in US Treasuries instead of higher yielding investment grade bonds is indeed a cost.

Assuming those higher yielding investment grade bonds do not default, the opportunity cost may be estimated by looking at the difference in yields of the two investment choices. (In this example, we assume XYZ is focused on investment income more than the pattern of total returns that may occur prior to maturity of the bonds.)

Of course, for the XYZ CFO, there is neither an entry or footnote in the financials that say, “Opportunity Cost.” Because it does not appear there, doesn’t mean it doesn’t exist. Lots of things don’t appear in financial statements…even more important things like the lifetime value of a customer or the economic value added from operations or …

You get the picture. Opportunity cost is very important, but it is nowhere to be found in financials. Alas, it is little discussed in Board rooms.

Usually, the closest we come to that when looking at insurer investments is when we trot out peer group analyses. Now, these analyses seem to have their own lives, as one manager after another offers them for free to insurers (ironically, when you get something for ‘free’, there is usually an opportunity cost).

Over the years, we’ve seen managers churn out these analyses in virtually novella size. Thankfully, their explanations are not Faulknerian, but their graphs and charts may as well be the equivalent.

For Strategic Asset Alliance, our peer group approach has always been one that is focused on more than just a comparison. What is the hidden opportunity cost of a given company’s investment strategy? And, as they say during final exams in college, “Please be brief.”

This can be graphically shown by comparing estimated risk and return, and even a measure of embedded risk appetite in the portfolio. Here are two examples:

In the first chart, we can see how Insurance Company XYZ’s portfolio is expected to perform on a risk/reward basis, as compared to its peers (similar size portfolios, same major line of business).

The key takeaways for XYZ’s Board and senior management:

  1. You can improve expected return to what Company A’s asset allocation may be, but do you feel comfortable with taking on the greater risk?
  2. You can improve expected return a little bit to what Company B’s asset allocation may be with less risk, but, are you OK with their actual asset allocation?

However, this begs the question of XYZ’s risk appetite.

Most insurers, as well as most investors, have a terrible time expressing their risk appetite in dollars. In fact, we have yet to meet an insurer that doesn’t say its approach is ‘conservative’. However, one company’s ‘conservative’ is another’s ‘too risky for us’ and even another’s ‘too plain vanilla for us’

In the second chart, we compare the implied risk appetite of Insurance Company XYZ and its peer brethren. We try to quantify risk appetite by representing it as the expected drop in surplus due to a three standard deviation negative event.

Interestingly, this chart is counter-intuitive, as one would expect the expected return to be tied to greater risk appetite. In other words, the dots on the chart should generally move from the upper left (higher return, greater risk appetite) to the lower right (lower return, lesser appetite for risk). However, for this peer group, there appears to be a slight increase in return as risk appetite is lessened.

Specifically, Company C has a portfolio with greater expected return than XYZ, but they are doing that while having a lesser risk appetite. And this is even more the case with Company D. How can this be? Have we found another ‘free lunch’ in investing besides the well-known benefits of long term diversification?

If only that was the case.

Actually, we are showing that insurers who can better define their risk appetite can use it to balance two of the major investment decisions they make (1) how much surplus risk to take, and (2) what should be the allocation within risk assets. And, by balancing those two decisions, they may indeed discover an asset allocation that improves expected yield while limiting risk of surplus degradation.

Interested in learning where your company stands using these metrics? Then please contact us to request a complimentary peer analysis.

Of course, these charts can begin to be used to determine reasonable estimates of what that opportunity cost may be over the next seven or so years. This is quite important as, we can calculate opportunity cost in the past, but, unless your name is Marty McFly, you can only change your opportunity cost going into the future.

One other point about peer group analyses that we all should keep in mind.

Like you and me, insurers are, to some degree, hostages of their past.

Unlike you and me, what insurers chose to do is shown for all to see in the financials. Likely, there are some very good reasons for the different strategies you see behind those peer group graphs. But, every one of them has hidden costs – opportunity costs – that must be considered in understanding what the best investment strategy is for your insurance company.