5 Questions Insurers Should Ask to Assess Portfolio Risk
September 04, 2018
The importance of asset allocation in driving portfolio performance has been well-documented through extensive research over the years.
Done correctly, an insurer’s asset-allocation investment strategy should position the portfolio to deliver the investment outcomes that support, enhance and help achieve the firm’s business objectives. Done incorrectly, the investment portfolio may significantly detract from business results, potentially leaving the insurance company with asset-management gaps or at a competitive disadvantage.
Here are five questions insurers should ask when tackling asset allocation and assessing risk in a portfolio.
What tools should be used to evaluate risk?
Volatility, or standard deviation, is not a comprehensive measure of risk, and doesn’t correlate directly to the impact to an insurer’s capital. Insurers are in the business of risk management and know there are myriad risks for their business lines. The same goes for the portfolio. Value at risk, BCAR, stressed surplus growth and credit losses are all examples of risk measures that should be evaluated for every portfolio design.
What are the investment needs?
All insurers have four fundamental investment needs: yield generation, growth of surplus, inflation protection and risk mitigation. And, each asset class typically aligns with one or two of these needs. For example, investment grade fixed income generates yield and public equity helps support surplus growth. Understanding the purpose of each asset class — such as which need it best serves — is the foundation for an effective asset-allocation and risk-assessment strategy.
Will a traditional asset-allocation approach meet those needs?
Traditional approaches to portfolio design (portfolio optimization, factor investing) are based on the concept that for each level of risk or volatility, there is an optimal combination of asset classes that produces the highest rate of return.
But insurers have concerns that extend well beyond total return due to their business initiatives and constraints. Insurer portfolios almost never fall on the efficient frontier due to industry considerations. These include regulatory and rating agency guidelines, product and business development, surplus growth, alternative measures of risk and net investment income generation.
As a result, using traditional methods of asset allocation for insurance company investment portfolios may be incomplete and can lead to ineffective asset-allocation decisions.
What asset classes should be considered for inclusion?
It is a common approach to identify the investable asset-class universe before asset allocation modeling. It is very difficult to fully understand the trade-offs of different investments without evaluating all potential investment opportunities. While some assets will be eliminated due to state code constraints, size, or other considerations, starting with the full opportunity set for each unique portfolio is critical to identifying how “best” to help meet company objectives.
How can an insurer be confident their portfolio is designed to address these questions?
Over our more than three decades working with insurers, we have developed a different methodology: Objectives-Based Asset Allocation® (OBAA®). OBAA® is based instead on meeting the critical needs of all insurers and helping them to achieve their business objectives. And it moves asset-class optimization to the correct place in the process –— after these objectives are considered. We have designed and deliver a solution that helps directly align the portfolio with your business.
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