Strong investment performance can set a property and casualty (P&C) insurer apart from the competition.
P&C investment portfolios have a dual mandate: satisfy liability requirements while adding incremental income (return on surplus). The chart below demonstrates that investment portfolios have been the main driver of return on surplus since the Global Financial Crisis. In today’s “lower for longer” environment, P&C insurers now have an opportunity to review their asset mix to ensure their portfolio continues to drive value for their business.
Contribution to return on surplus
Source: Regulatory OSFI filings
P&C insurers face unique challenges when making investment decisions:
- Capital charges and tax rules for certain asset classes add an additional layer of complexity to traditional asset allocation optimization
- Accounting rules – including the impact of portfolio yield on the calculation of liabilities and the treatment of realized gains and losses – can cause certain assets to be more or less favourable to management
- The possibility of large, unexpected claims from catastrophic events requires that insurers have a good understanding of their liquidity capacity and needs
It’s time for a tune-up: Four ideas to enhance your investment portfolio
The unique nature of each insurer’s operations and line of business means that there is no single asset allocation that best manages each of these challenges. To help provide long-term stability and improve their chances of success, P&C insurers can consider four portfolio enhancements:
1. Set a holistic risk and capital budget at the total portfolio level that considers both investment and operational risk
P&C insurers tend to have a short duration liability profile, often with significant catastrophe exposure. In order to decide how much investment risk and capital spend to allocate to the investment portfolio, it is important to understand all potential risks, and create an overall risk and capital budget.
To help with this, P&C insurers can conduct an analysis of their position relative to peers (see example below). This exercise can flag areas where they are outliers in metrics like leverage or capital spend. This allows management to decide where they are comfortable with their position relative to the industry (perhaps related to a strategic/competitive advantage) and where adjustments are necessary.
Companies should also project and stress test their income statement, balance sheet and statement of cash flows to help to determine key areas of potential risk. The results of this stress testing can inform the allocation of capital and risk budgets. For companies with a high operational leverage ratio or a tight capital ratio relative to target, there may be less desire to invest in volatile or capital intensive assets. For insurers that have higher operational and/or investment leverage and volatile net income, there may be more of a desire for yield focused assets. For well-established companies with stable underwriting and healthy margins, riskier assets may be desirable if they provide a high enough risk adjusted return. These companies have the flexibility to focus on adding yield while incorporating a total return lens.
Source: Regulatory OSFI filings
The risk assessment and capital budgeting exercise should also involve a qualitative component. Investment managers can work with management to understand their philosophy and goals for the portfolio relative to growth and spending plans. This can help both parties to better assess the appropriateness of the portfolio relative to the objectives of the broader organization.
2. Clearly delineate your portfolio into a component intended to hedge liabilities, and a component intended to preserve and grow surplus
Having assets clearly delineated into a liability hedging component and surplus component separates assets in a way that aligns with the objectives of a P&C insurer:
Core portfolio: investing a portion of assets with the liability profile as the primary consideration allows the insurer to set clear objectives that reflect their tolerance for volatility between their assets and their liabilities.
Within the core component, P&C insurers often look to optimize yield within a capital efficient and risk management framework. This includes spending capital on compensated risks, such as credit risk through well-diversified allocations across issuer types and geographies, while avoiding spending capital on uncompensated risks such as interest rate and foreign exchange risk.
Surplus portfolio: this separate component can then be efficiently allocated to achieve the insurer’s capital preservation and growth objectives subject to overall capital and risk budgets.
3. Ensure that fixed income assets strike an appropriate balance between liquidity needs and yield requirements
Due to the unpredictable short-term nature of P&C liabilities, ensuring there is sufficient liquidity in portfolios is key to the insurer’s ability to withstand adverse events. However, there is such a thing as too much liquidity. P&C insurers that hold excessive liquidity sacrifice opportunities to acquire illiquid asset classes that could provide additional yield and diversification.
Insurers should model current and future liquidity needs arising from both assets and liabilities. Investment portfolios can then be designed with an understanding of the following:
- The likelihood of future cash flow patterns
- A range of potential adverse and/or catastrophic events, either deterministic or stochastic
- Resulting liquidity needs and transaction costs
Optimal portfolios provide sufficient liquidity to support operations without diluting return on surplus. For the portion of investments not required for liquidity, managers can target higher yields available on less liquid assets.
4. Manage assets with an awareness of capital needs and accounting impacts
While some assets may be attractive on a standalone basis, it is important to assess their relative value net of the capital required. Considerations include capital charges, tax benefits and risk. Ultimately, investments should provide a sufficient amount of yield per unit of additional capital.
Deep credit expertise is important when assessing the attractiveness of different assets. For example, BBB bonds are attractive from a yield, risk and minimum capital test (MCT) perspective, but if these bonds are downgraded to below investment grade, there will be a significant additional capital charge. Given lack of depth of the below investment grade market in Canada, it could be difficult to exit the position.
The table below shows that risk really impacts the ranking of economically efficient asset classes. We can see that preferred shares become much less attractive while high quality U.S. structured product rises to the top of the list.
|Asset Class||Net Risk Premium||Asset class VaR||Net Risk Premium / VaR||Net risk premium rank||Net risk premium / VaR rank|
|U.S. structured fixed income||1.54%||2.50%||0.62||3||1|
|Canadian corporate BBB>1yr<5yr||1.32%||2.40%||0.56||4||2|
|Canadian corporate A>1yr<5yr||1.04%||2.40%||0.44||5||3|
|Canadian corporate AA>1yr<5yr||0.69%||2.50%||0.28||6||5|
|Federal and Federal agency||0.10%||-||-||8||8|
Source: FTSE + Barclays Market data, SLC Management internal capital market assumptions and OSFI Minimum Capital Test (MCT) rules
Accounting and management treatment of realized gains and losses is also important. Investment managers should partner closely with insurers to help avoid trades that lead to accounting surprises and reporting headaches. For example, if managers sell a bond at a loss, is there an offsetting gain that can be realized? Close collaboration with management can ensure that the portfolio is a beneficial accounting tool, rather than a source of unwanted accounting volatility. A customized portfolio, as opposed to a pooled fund, is best positioned to incorporate these considerations into the management of a P&C’s investment portfolio.
Are you ready to tune up your portfolio?
Given the current market environment and the importance of investment returns for P&C insurers, we believe now is the right time to review your portfolio.
Here are three actions P&C insurers can take now to help set themselves apart from their competition:
- Consider the COVID-19 environment. Was your organization able to keep up during this catastrophic event? Model the impact of adverse or unforeseen events on your portfolio to help avoid these situations in the future.
- Conduct a peer analysis to understand how your organization compares to others in the industry. How does your leverage and capital spend stack up?
- Evaluate your core portfolio. Are you missing an opportunity to diversify geographically into capital efficient assets or harvest excess yield by investing in private assets?
This document is intended for Canadian institutional investors only. It is not for retail use or distribution to individual investors. The information in this document is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained in this document.
SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association.
Unless otherwise stated, all figures and estimates provided have been sourced internally and are as of September 30, 2020. Unless otherwise noted, all references to “$” are in CAD dollars.
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