 By Harry Breda, product marketing, SunGard’s iWorks Financials solutions (with contribution from James Webb, product marketing director, SunGard’s iWorks Risk solutions)
To the uninitiated, managing an insurance company could be considered a relatively simple game: match claims with premiums, and earn a profit when premiums or income from invested premiums exceeds claims outflow. This analogy, of course, greatly simplifies the complex insurance business. But in today’s soft markets, insurers are struggling to gather premium income (assets) that exceed expected claims (liabilities). Armies of actuaries and platoons of product managers have developed detailed formulas for both premiums and claims. Insurers have then relied on their investment departments to bolster their profits.
Historically, insurance companies have focused their intellectual efforts on determining an accurate estimate for claims, as actuaries assess detailed risk parameters related to the expected client base to develop assumptions about claims over time. Insurers have developed sophisticated models and complex tables to assess liabilities, aided by modern technologies. . The focus has been on the future and what must be paid out.
Meanwhile, the income side of the equation, investment income from premiums, has seen reduced returns due to the current economic conditions, which is increasing demand for better analysis tools. Product developers use detailed pricing models to determine premium income, based on product sales assumptions, product life cycles, competitive pressures and the propensity of purchasers to buy. But insurers have not yet benefited from the same level of granular analysis on the investment portion of the income question.
There has historically been an overreliance on return on assets, which at times was taken as a given. However, with today’s low interest rate environment, insurers are finding that the typical assumptions about total return no longer hold. Moreover, insurance investment managers have found that increasing investment returns—without dramatically increasing risk—isn’t quite so easy. And with regulators increasingly focusing attention on risk management, limiting available investments in the name of solvency, avenues for greater income and capital appreciation are slowly drying up.
In this environment, insurers are doing all they can to understand and manage investment risk. Generally insurers look at investment risk two different ways. First, there is the risk to principal—the risk that some event or investment strategy causes a decline to the asset base, putting in jeopardy the company’s ability to meet future liabilities. The second view is risk to income: the risk that the investment income of the portfolio will not grow at a rate needed to cover the expected liabilities over the long term.
Today’s focus on enterprise risk and solvency emphasize principal risk. Given the mortgage crisis and the events of 2007-2009, regulators have emphasized solvency above all else—the risk that a company’s asset base may deteriorate so much that it would be unable to remain an ongoing concern, and that policyholders would not be protected. Up until now, regulators have focused on high severity, low probability events.
The interconnectedness of modern industries engenders more extreme and complex risk, such as the contagion effects attributed to the mortgage crisis. Regulators have attempted to counter the effects of shocks by developing stress tests for insurers. These tests involve variables such as extreme interest rate or currency movements, drastic changes in global equity markets, swings in credit spreads, dramatic asset outflows, and many others. A significant part of an insurer’s risk management process will now be tied to the results of these stress tests.
Investment Risk
On the other hand, risks to income are becoming paramount in today’s investment environment. With yields falling across the board (traditional safe haven issues like U.S. government bonds yield less than 2%), insurers are using different tactics to improve yields and expected returns. Some investment managers are looking at lower credit quality issuers, moving down the credit spectrum to pick up additional yield, while others have moved further out the yield curve, purchasing longer bonds for higher yield. In each case, added yield comes with added risk—price volatility with the lower credit quality issues, and duration risk with longer-dated bonds.
Alternatives to traditional government and corporate bonds offer promise, but different asset classes hold their own risks. For example, floating rate notes are often touted as an attractive alternative to high yield bonds. These notes offer a floating interest rate that can reset every three to six months, helping to reducing price sensitivity to interest rate movements. But they also have higher credit risk, and the notes are less liquid than traditional bonds.
Mortgage-backed securities are another option, though these issues have their own concerns, such as the quality of the underlying borrowers and repayment risk given low mortgage rates. Some investment managers consider real estate investment trusts (REITs) to be an income-oriented opportunity; however, REITs are equity securities and thus have significantly higher price volatility than bonds. In addition, insurers investing in more exotic instruments are seeking better hedging strategies.
Evaluate and Manage Enterprise Risk
A fully holistic view of insurance enterprise risk would involve assessing both sides of the balance sheet: assets and liabilities. Given that actuarial departments and investment departments are traditionally separate areas with different expertise, and that risk measurement in both areas is often complex and opaque, regulators and directors are seeking new methods to measure risk across the enterprise.
New developments in asset-liability modeling promise to provide a more complete understanding of overall risk. Specifically, asset-liability software solutions now incorporate modelling factors such as management actions and policy holder behavior in response to economic factors, such as the reduction in bonus payments in a falling investment market. Many software providers offer solutions that include multiple asset classes for the investment side (bonds, equities, cash, and so on), as well as a broad range of stress tests including interest rate changes, management decisions and policyholder actions. For insurers using collective investment schemes, new tools can provide a detailed view across multiple portfolios for a more accurate picture of principal and income risk.
Emerging solvency discussions in both the U.S. and the Eurozone are raising the bar for regulatory compliance, forcing insurers to proactively evaluate the relationship between assets and liabilities on their balance sheets. Furthermore, additional investment regulations are causing insurers to more carefully analyze both the risk to principal and the risk to income. Today’s leading insurance companies are eagerly identifying partners who can help them quantify, manage and report both actuarial risk and investment risk across the enterprise, which may end up being a competitive advantage in the industry.
.
|
