Investment management is a tough part of any business, but similarities within the insurance industry’s investment practices might make it seem less daunting.
It is well recognized that the scale of investments in an insurance company’s balance sheet and the impact of investment results on its profitability are more important than ever. The management of these investments is a key function in an insurance company that can create significant value for the company’s policyholders.
Dismal Investment Returns, No Relief in Sight
The most obvious and crippling fact when it comes to investing is that property/casualty insurance companies are dealing with declining investment returns that will continue to be dismal. Interest rates on fixed-income investments – the primary investment for most property/casualty insurance companies – have been kept low by the Federal Reserve. All indications going forward are that increases in those rates will be nominal and incremental, if there will be any at all.
Underwriting-led asset growth coupled with allocation-driven returns, declining yield structure, and lower returns on equity have resulted in a steady annual decline on investment returns for property/casualty companies’ investment portfolios. United States property/casualty insurers’ quarterly investment income dropped to the lowest since 2004 – totaling $10.9 billion in the first quarter compared to $11.7 billion a year earlier. The annualized yield on the industry’s portfolio fell from 3.1 percent to 2.9 percent, which compares to an average of 3.8 percent during the past decade. There were peaks of more than 8 percent in 1984 and 1985.
NAMIC’s Property/Casualty Investment Performance Evaluations Standards Report’s research and analysis found that the net yield on investment assets for all sizes of property/casualty insurance companies has declined each of the last five years.
Increased Importance of Expense Control
Investment costs and fees may appear small, or even be out of sight. But, over time, they can have major impacts on any investment portfolio.
Property/casualty companies that use investment advisers to manage their portfolios understand that advisers will charge annual fees based on the value of the portfolio. Nevertheless, too few appreciate the underlying investment expenses that may also be passed along to them.
Many insurance companies are able to negotiate down that fee to as low as a few basis points. But far fewer insurers are fully aware of the other expenses in portfolio management. These costs are often passed to portfolios in the form of fees deducted from the fund’s assets.
While most investors understand commissions charged on stock purchases, there are those that don’t know about the markups charged on fixed income securities, and they have little idea on how to find and gauge these expenses. These less-obvious costs and expenses can wipe out what little gains that can be found, particularly in this low-return environment.
Hard-Hit Smaller Companies
While investment prospects are fairly grim industrywide, research and analysis done for NAMIC’s PIPES Report have shown that smaller property/casualty companies, particularly
those with less than $150 million in investment assets, are getting significantly less return on investment assets. They are also being charged more in fees and expenses for fewer investment services and less advice.
Smaller and midsize insurers do not independently have the economies of scale to obtain the best investments with the best execution. PIPES data shows that these smaller companies are getting less than half the investment yield realized by property/casualty companies with more than $1 billion in investment assets. Yet, the big companies are paying far lower percentagew of their investment assets in fees and expenses.
Although NAMIC members vary widely in size and lines of business, research has shown that their investment portfolios are remarkably similar. In terms of asset allocation, quality, maturity, and turnover, NAMIC member companies – and the property/casualty industry as a whole – are not only similar but consistent throughout the last decade. While some have said that this consistency may illustrate an inability to adapt to a changing investment environment, it is important to remember that insurance regulators and rating agencies greatly value continuity and they question those that operate outside of the herd.
Could this investment continuity operate as an advantage for NAMIC members? It seems logical that efficiencies and economies of scale may be feasible. NAMIC’s Investment Services has been exploring the potential operational and financial advantages of such mutual asset management and will work with interested NAMIC members to explore these opportunities in more depth.
Management v. The Board
There are important yet distinct roles the management team and the board of directors play when it comes to a company’s investments.
Consider what Berkshire Hathaway CEO Warren Buffet has repeated in his last several annual letters:
This collect-now, pay-later model leaves [property/casualty] companies holding large sums – money we call ‘float’ – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume. Consequently, as our business grows, so does our float. And how we have grown. We enjoy the use of free money – and, better yet, get paid for holding it.
Clearly, investment management is a key aspect of the success of property/casualty insurance companies, and one that carries a heavy amount of responsibility. In general, the investment management functions at property/casualty companies are shared by the board of directors and company management, with each having its own important yet distinct set of duties.
Investment Responsibilities of the Board’s Investment Committee
In most cases, the relevant state insurance regulations will specify the investment responsibilities of the board of directors and its investment committee. These regulations and the judicial decisions interpreting these requirements vary from state to state. For those specific investment responsibilities, board members should obtain and maintain expert regulatory guidance on those specific state requirements as they evolve.
The bottom line, however, is that the board of directors is ultimately responsible for everything the property/casualty insurance company does, including its investments. Most boards choose to delegate investment responsibilities to an investment committee, but, even then, the board retains all fiduciary responsibility for investment oversight.
A primary responsibility of the directors serving on the investment committee is the fiduciary duty of due care. Under state law, a director owes a duty to exercise good business judgment and to use ordinary care and prudence in the operation of the business. Directors must discharge their actions in good faith and in the best interest of the company, exercising the care an ordinary person would use under similar circumstances. An investment committee should, therefore, include directors with experience and understanding of investments.
In the alternative, the committee should be comprised of directors who work with outside investment experts who enable them to provide a reasonable level of investment oversight to the company.
Directors must keep in mind that the role of the investment committee is to govern, not manage. The daily management of the property/casualty company investment portfolio cannot be done by board members. The investment committee is not a full-time job and committees are generally not equipped to make day-to-day investment operational decisions. The investment committee should concentrate its time and efforts on overall investment governance and not micro-manage the investment portfolio.
Therefore, it is the responsibility of the investment committee to ensure that the investment management function is carried out by a competent investment officer within the property/casualty company.
The investment committee will establish investment policy and hold the investment officer accountable to follow and implement the policy. To fulfill the oversight responsibilities, investment committees need to understand what the responsible investment officer is doing, ask hard questions, and, occasionally, make specific suggestions.
To perform its governance role effectively, the investment committee needs to understand with exact specificity who provides advice or any formal investment recommendation, who reviews and provides input on investment decisions, who implements the investment decisions, and who is provided with the details and results of those decisions.
In the event that the property/casualty company does not have these defined investment management responsibilities and/or the identified person(s) to implement them, the investment committee should take steps to ensure that the company makes this happen. An external investment management expert who operates under the direction of management could be an option. Combinations of internal and external investment responsibilities can further complicate this issue, though. It, therefore, requires specific investment responsibilities to be even more explicit and fully documented.
In short, if it is not abundantly clear as to which people have the responsibility for each component of the investment management process at the company, the investment committee needs to make sure it becomes clear. Otherwise, it is extremely difficult for an investment committee to govern, and that can lead to its governing ability being compromised if not precluded.
Investment Responsibilities of Management
Senior management of a property/casualty insurance company bears the responsibility for ensuring that company management has the authority, resources, knowledge, information, and experience to implement, manage, and report back to the board regarding the execution of the investment strategy and objectives set by the board.
But the ways in which property/casualty insurance companies staff and direct their investment portfolios vary widely. Larger companies tend to have internal investment managers and designated chief investment officers. Executive recruiters have reported that the compensation for CIOs at large insurance companies is often second only to the CEO.
At midsize and smaller property/casualty insurance companies, there is rarely a CIO. Oftentimes, there isn’t even a designated officer or employee who has the ultimate responsibility for investment management. In many cases, midsize and smaller property/casualty insurance companies diffuse various investment authorities and responsibilities among various internal and external personnel.
As a result, investment responsibilities at property/casualty companies can end up being part of the finance, audit, compliance, and legal departments. In a large number of these companies, the duties fall to various C-suite officers.
There is no regulatory requirement that a specific investment officer with the overall responsibility for investment management at the property/casualty company be named. This, unfortunately, can make investment management a secondary or tertiary priority of a department or person. And that can bring negative consequences.
The NAIC’s Increased Role in the Investment Landscape
With increased attention being paid to investments by insurance companies, it shouldn’t come as much of a surprise that the National Association of Insurance Commissioners is paying more attention to investments as well.
Two major themes stand out among the others, according to Jonathan Rodgers, NAMIC’s financial regulation manager: the number of investment-related disclosures that have been added since the financial crisis and the granularity of information that regulators are now asking of insurance companies when it comes to their investments.
Insurers are currently required to disclose their investment schedules to regulators on a yearly basis, but the NAIC discussed requiring the information to be shared with it biannually, if not quarterly.
“We raised the point at the NAIC Summer 2016 National Meeting that requiring disclosures more than once per year is disproportional for smaller companies,” Rodgers says. “[Small mutuals] might have to switch or upgrade software and that comes with a price.”
NAMIC is advocating that investment portfolios continue to be reported only on an annual basis.
The NAIC is showing more interest in granularity of investments mainly because regulators believe they can get a better picture of what companies hold, according to Rodgers.
Where regulators used to rate bonds on a one-to-six structure basis, they are now looking to expand it to 20 classes within that structure.
“Therefore the face of the annual statement is going to change. change,” Rodgers says. “The number of categories is obviously going to increase, as will the work for the companies. But for what benefit?
“We’re not going to argue that increased granularity isn’t going to make information more accurate,” he continues. “But are regulators going to capture more companies trending toward insolvency? We would say, ‘No.’”
The low-interest-rate, declining-investment-return environment that will seemingly remain dismal has left many NAMIC members disappointed with their portfolios’ returns and looking for other options. For many insurers, there are alternatives … literally.
“Alternative investments” can be described as ones that are not the traditional stock and bond investments and have the purpose to operate differently than the broader stock and bond markets. The goal of including alternative investments in a property/casualty insurance company investment portfolio is to reduce portfolio volatility, hedge against downsides, and boost portfolio returns in ways that do not correspond to stock market or bond market performances.
What Alternatives are Out There?
Bonds dominate insurers’ investment portfolios, and property/casualty insurance companies average more than 60 percent of investment assets allocated to bonds. The next largest investment allocation of property/casualty insurance companies is common stocks, followed by mortgage-related investments. In fourth place are “other long-term invested assets,” or National Association of Insurance Commissioners Schedule BA assets. Schedule BA assets include private equity and hedge funds, mineral rights, aircraft leases, surplus notes, secured and unsecured loans to corporations and individuals, and housing tax credits.
Although an increasing amount of property/casualty insurers consider investing in or already invest in Schedule BA assets, the overall industry investment in these assets is very concentrated. Large companies have shown a greater appetite for alternative investments and have taken significant positions in the markets. One-quarter of the almost 5,000 insurance companies reporting investment data to the NAIC hold Schedule BA investments, but the top 25 insurance groups account for 80 percent of the value of these assets. One large insurance group alone can account for more than 20 percent of the industry’s Schedule BA assets.
About 60 percent of the property/casualty sector’s Schedule BA holdings have been in affiliated hedge funds, private equity funds, and real estate, other than mortgage-backed, investments. Unaffiliated Schedule BA holdings by property/casualty companies have been about 50 percent in private equity funds, 30 percent in real estate, and 20 percent in hedge funds.
Private equity funds, hedge funds, and real estate pools are generally provided by private offerings exempt from federal and state registration and reporting requirements. Funds with $10 million or more in assets and more than 500 investors are subject to reporting under the Securities and Exchange Act. Sponsors will limit the number of investors to 100, which will also exempt the fund from the regulations under the Investment Company Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act enacted requirements that funds with between $25 million and $150 million in assets register with the state in which they operate. Funds with more than $150 million are required to register with the Securities and Exchange Commission. Registered funds must report to the SEC on Form PF. This form is kept confidential by the SEC, although the commission does use the forms to publicly report some summary data.
According to the NAIC, insurers’ valuations of other long-term invested assets are subject to the Statement of Statutory Accounting Principles No. 48 – Joint Ventures, Partnerships, and Limited Liability Companies. SSAP No. 48 generally requires an equity method of valuation in which the investments are valued at cost with periodic adjustments for gains and losses. Other long-term investments in Schedule BA that do not meet the SSAP No. 48 requirement must follow SSAP No. 21 – Other Admitted Assets (Collateral Loans).
Why Invest in Alternatives?
Most investors believe that private equity funds can provide improved risk-adjusted returns in return for a lock-up period. Alternative assets may be a potential component of more property/casualty insurance companies, but actually finding the appropriate investment can be daunting.
A 2016 survey from industry data provider Preqin reported a record-high 2,798 private equity funds in the market and 13,725 hedge funds open for investment. With that many options, the question becomes “Which to choose?” Interestingly, the market has given a clear indication recently of a preference for private equity over hedge funds.
The reason for that preference may be the delivery of the promised enhanced returns by each type of investment. On paper, at least, reallocating a portion of a typical insurer’s equity exposure to alternatives should enhance the return potential and diversification properties of the average portfolio. One 2016 analysis by PIMCO projects that even small allocations to hedge funds and private equity funds can lead to meaningful improvement in an insurance company’s investment portfolio’s Sharpe ratio. This happens by providing higher-than-expected returns and typically low correlations with traditional asset classes.
If returns on fixed-income investments are going to continue to be poor, insurance companies could benefit from adding alternative asset classes to improve return potential. There is analysis that attributes the shift of assets to private equity to the fact that these funds provide better returns.
According to David Rubenstein, co-founder and co-CEO of the Carlyle Group, the private equity industry provided more return to investors. In the lower-interest-rate environment, the cost to private equity also remained lower. Many hedge fund managers’ and mutual fund managers’ performance varied in accordance to the changes in the business cycle during the last five years.
Returns often come at a cost, though. The fees associated with many alternative investments are higher than other investments. The standard fees charged by managers of these alternative investments are often 2 percent of all assets under management, plus a percentage of the fund’s gains. Larger investors may have the leverage to challenge the 2-percent-plus-performance structure, and a number of large investors have publicly declared that they plan to rethink their fee structure for alternative assets. But midsize and smaller property/casualty insurance companies investing in alternative investments may not have the same leverage and ability to drive down fees.
It is important to be careful. “Better” returns should be analyzed in the larger context. From March 2009 until December 2015, United States broad market equity indices returned more than 200 percent, which exceed returns from many alternative strategies. Property/casualty insurance companies, particularly the midsize and smaller companies without market leverage, should get hard data from advisors as to whether the proposed alternative investments actually outperformed equities for relevant periods. Even then, they should fully understand the additional cost over traditional strategies.
Are Alternatives Worth the Effort?
The worth of alternative investments does vary by company. In order to make the best decisions for their organizations, property/casualty insurers should carefully evaluate their unique market exposures and the other key characteristics associated with a range of alternatives that serve their overall investment objectives.