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Risk Pools & Asset Allocation Modeling:
Higher Reinsurance Costs / Lower Investment Income
We spoke with AAM - Insurance Investment Management to discuss how risk pools may benefit from reviewing the current asset allocation of their portfolio amid higher reinsurance costs and lower fixed income yields for the foreseeable future.
SAA: Why is now a good time for government risk pools to rethink or review their asset allocation?
AAM: This is a challenging time for risk pools. Top of mind for most pools is the hardening reinsurance market in which even pools with property exposures that were not directly impacted by storms in recent years are seeing dramatic reinsurance rate increases. Some pools are unable to find reinsurance coverage for cyber or infectious diseases, and if they can, rates are significantly higher than they have been in years past. Claim severity is increasing as well. Drivers of the increase in severity can be seen in the daily news with just two of many examples being high lumber prices impacting the cost of many property claims and the cost of ransomware attacks increasing.
At the same time, low interest rates are negatively impacting investment income. While all investors are impacted by low interest rates, those pools with shorter duration profiles are most acutely impacted. A shorter duration portfolio leads to more securities maturing in the near term, with proceeds needing to be reinvested at prevailing low interest rates.
Finally, member budgets continue to be stretched thin, yet the services that pools provide for members are as important as ever. One of the defining values of pools is to be able to provide coverage for members through cycles and provide stability in insurance pricing. The key value proposition of many pools is to provide member benefits including grants, audit support, dividends, and other services. Despite these challenges, I expect risk pools will stay true to their core values and do all they can to continue to support their membership.
One way to help combat the pressures on net position is to review the investment portfolio and ensure that the asset allocation in place today is maximizing the expected portfolio return without adding undo risk to net position. Changing the portfolio allocation will likely not be enough to completely overcome high reinsurance renewals or the impact of lower interest rates, but an appropriate asset allocation can help preserve the net position that ultimately supports members.
SAA: What are some of the key factors risk pools should consider in determining an appropriate asset allocation and what is the typical mix of assets that result?
AAM: As I mentioned before, the goal of asset allocation modeling is to help determine an asset mix that can maximize expected return without adding undue pressure on net position in periods of market volatility. The most important factor in determining an appropriate asset allocation is first determining how much investment risk a pool can withstand. In my experience, determining an appropriate amount of risk can be challenging, as there is no “right” number. However, we recommend that a pool begins with first considering their underwriting risk. If adverse underwriting results in a stress case scenario may lead to meaningful stress on net position, a pool may want to consider dialing back on investment risk. However, if even in a stressed underwriting scenario, results will not materially damage the net position of a pool, more investment risk may be warranted.
It is critical that a pool ensures no matter what allocation they chose, they can hold that allocation through periods of market stress. This analysis includes incorporating stress case underwriting and investment results. A worst-case scenario for any investor is having an allocation that has to be liquidated in the midst of market stress, so care should be taken to consider those scenarios.
We recommend risk pools add a layer of conservatism in the analysis. The reason is that not only do pools need to ensure capital can support liabilities through market cycles, but the pools also need to maintain a high level of member support. Often when there are stresses in the markets, it is at the same time as an economic contraction and that is exactly the time when members most need stability from their pools.
With a comfort level established regarding the appropriate amount of risk, next a pool should consider the goals of the portfolio in support of liabilities and member services. This is often a trade-off between the need for current income versus long term price appreciation. Generally, it is appropriate to include assets that address both current income needs and long term net position growth. The exact allocations will depend on the regulatory environment and needs of the pool.
Typically, allocations contain a large proportion of investment grade fixed income to provide stability and consistent income. To help increase current income outside of investment grade fixed income, we often see pools consider high yield bonds and bank loans. Asset classes to help grow net position over time usually include equities, both domestic and international, as well as convertible bonds. For some pools, adding illiquid assets to the mix, such as private placements and commercial mortgage loans, can help support current income. However, those asset classes often require a portfolio to be fairly large before considering including them in the mix. Of course, any allocation must comply with statute, and in many cases, pools are limited to very conservative bond portfolios.
SAA: What are the limitations of modeling?
AAM: Asset allocation modeling is an incredibly important tool, but like most tools, modeling has limitations that users should be cognizant of when reviewing the output. While there may be other limitations, two important considerations are understanding the data being used and appreciating the time frame being assumed.
Asset allocation model outputs often convey a sense of precision. Expected portfolio returns and volatilities may be shown to the hundredth of a percent. It is important to keep in mind that the actual results will not precisely match the model outputs. Ideally, a model will provide general guidance regarding the ultimate results and help illustrate the risk and returns available from a diversified portfolio. Modeling outputs are largely driven by the assumptions entered into the model for the risk and return of each asset class. We recommend that pools review the assumptions that are input into the model and ask questions to ensure they are comfortable. The more comfortable users are with the inputs, the more comfortable they can feel with the output.
Not only are the actual inputs critical, so is the timeframe the model attempts to capture. At AAM we take a long-term view to asset allocation modeling, recommending strategic allocations meant to support the pool’s liabilities and membership through cycles. We do not expect an asset allocation model to be able to choose which asset classes will outperform in any given year.
Asset allocation models are very important tools, and we do recommend pools consider reviewing their asset allocation at this time. However, it is important to always keep in mind that an asset allocation model is not a crystal ball.
Source: Strategic Asset Alliance, AAM - Insurance Investment Management The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.