The fundamental purpose of insurance is to transfer the risk (uncertainty) of large financial losses. Investing insurance assets requires strategies that account for these uncertainties and their impacts on the investment horizon, liquidity, and cash-flows. In addition, insurance assets have multiple stakeholders with varying priorities which influence when, how, and where these assets may be invested.
Insurance Assets
Varying stakeholder priorities:
- Policyholders
- Regulators
- Rating agencies
Taxes on income and realized gains.
Corporate cultures, risk tolerance, and organizational structure.
Impact on Investment Strategy
The “universe” of investible assets can be limited by domicile.
Capital allocation across capital markets and underwriting operations.
Taxes should be explicitly addressed by asset class.
Cardinal’s Approach
Economic Capital Model:
- Constrained frontiers
- Risk-based capital
- RAROC
- ORSA support
Explicit consideration of taxes:
- After-tax efficient frontiers
- Active gain/loss management
- After-tax performance reporting
Insurance Assets
Liability durations ranging from 3 months to 5+ years.
Varied cash-flows depending on timing of premium payments, reinsurance recoverables, and operational needs.
Impact on Investment Strategy
Incremental yield (carry) is earned for investing farther out the time horizon but downside risk from interim price volatility increases. The cost and benefits of both must be balanced.
Cardinal’s Approach
Cash-flow modeling
Pro-forma financial projections
Stochastic and deterministic stress testing
Insurance Assets
Underwriting (and profit) cyclicality
Catastrophe exposures create unpredictable and sometimes significant liquidity needs
Impact on Investment Strategy
Imperative to know the cash needs of the enterprise for:
- Ongoing underwriting operations
- Catastrophe PMLs
- Anticipated reinsurance recoveries (and timing)
- Strategic capital projects
- Required cushions or margins of error for the above categories
Cardinal’s Approach
Liquidity analysis and optimization of:
- Investment cash flows
- Underwriting cash flows
- Lines of credit
- FHLB membership
- Public securities at gains or losses
Insurance Assets
Inflation can impact claims but varies depending on how premiums and pricing lag within each line of business.
Heavy fixed income portfolios react poorly to inflation.
Impact on Investment Strategy
Asset classes with low correlations to inflation are desirable.
Asset classes with low correlations to interest rates are desirable.
Cardinal’s Approach
Diversification analysis helps to determine which asset classes counteract exposure to inflation and interest rates.
Insurance Assets
Conflicting investment objectives:
- Principal protection
- Stable income
- Surplus growth
Impact on Investment Strategy
Economic surplus should be optimized once all constraints are satisfied.
Cardinal’s Approach
Multi-variate optimization across:
- Total return
- Yield and investment income
- Surplus growth
- Downside risk