Solvency Assessment and Management (SAM) has been a topical discussion since the regulations went live in June 2018. The purpose of this document is to generate a methodology to apply when designing investment solutions for insurance companies that not only consider the traditional risk-return approaches but also factors in:
- the amount of capital to be held against an investment strategy, and
- the cost (opportunity cost or otherwise) of implementing the investment strategy.
Once we have a view of these we can apply the new framework to a range of existing products both traditional, such as collective investment schemes, as well as customised segregated portfolios.
Within this document we apply the framework specifically to short-term insurance companies and analyse our results to draw some conclusions with regards to the additional information we note.
For long-term insurers, we position a more general discussion on SAM efficient optimal solutions, how the framework would apply and finally conclude with a summary of the findings.
SAM Efficient framework
In the discussion that follows we aim to enhance the “traditional” risk-return approach to investment management. Ashburton Investments has designed a framework that allows insurance companies to assess potential investment strategies from not only a risk and return perspective but also in terms of the efficient use of their capital. The factors to be considered in the framework are outlined below.
In Figure 1, we have graphically depicted the final framework. It considers three different
measures regarding investment strategies, namely;
Figure 1: Graphical depiction of framework (Source: Ashburton Investments)
- Expected return;
- Economic risk (for insurance companies we proxy this dimension using the SAM model1 – the assumption being that the capital requirements are a fair reflection of the risks inherent in investment strategies; and
- Cost of capital – this is different for each insurer.
The rationale for this approach
Capital is a scarce resource, so we should ensure it is deployed effectively (whether it is used for investment portfolios or other business activities – hence the opportunity cost associated is key).
Once we have these three measures, we can then adjust the expected return for the implied amount and cost of capital each potential investment strategy incurs and then compare on a like-for-like basis within each category.
The mathematics at this stage is simple2. Below we have defined the formulae as well as the assumptions we will be using to make the adjustment.
- Capital held against the investment strategy earns the risk-free rate; and
- The cost of capital across the industry c. 14.5%.
The implication here is that there is a drag between having to hold the capital versus the return we obtain on it.
The final framework for adjusting the gross returns for the cost of capital is as follows:
Adjusted return = Gross return – SCR capital as a percentage of assets x (14.5% risk-free)
With this information we can determine which solutions appear to be superior under this framework and test the results for intuitive accuracy.
Figure 3: Traditional approach (Source: Ashburton Investments)
Next, we move on to the different styles we are considering and begin with cash/money market solutions as a starting point.
1 The SAM models provide a useful measure for risk as it considers the quality and nature of the asset portfolio relative to the liabilities as well as any nuances that may exist, for example in addition to the quality of the assets.
It also considers portfolio level concentration which a more traditional measure such as expected loss fails to do
2 The model can be improved to add additional complexity, but this is beyond the scope of the discussion at this stage
Application: Short-term insurers
For short-term insurance companies, liquidity (usually solved through cash solutions) is key and as such, that will be the focus of discussion within this section.
Cash solutions represent an investment strategy that focuses on maximising liquidity as well as minimising the potential for capital losses. Liquid assets are key (for short-term insurers in particular) to meet claim payments as they fall due but are also a function of the uncertainty of the claims profile.
Traditional risk/return analysis
Below we have defined a few possible options – once we have defined the products we can then look at applying our framework to assess which solutions perform the best:
- SAM Efficient portfolio (1) – Invests in a combination of government T-bills and diversified short-dated (70% of portfolio maturing within a year) corporate Investment Grade (IG) credit.
- Ashburton Money Market Fund – Invests in a combination of bank issued floating rate notes (FRNs) and IG corporate credit – follows the relevant regulations for money market funds.
- “Big 4” Money Market Fund – Invests in purely short-dated FRNs in order (no other credit risk) –follows the same regulations as the Money Market Fund under BN90.
- SAM Efficient portfolio (2) - Invests in a combination of bank issued FRNs and IG corporate credit – the fund aims to extract the value of term premium and as such has a weighted average maturity profile of c. four years.
- Ashburton Stable Income Fund - Invests into a combination of bank issued FRNs, IG corporate credit and sub-IG corporate credit – the fund aims to extract the value of term premium in the credit markets and as such has a weighted average maturity profile between three and five years.
Let’s first consider the different options based on expected (gross return) relative to the risk measure we have chosen, namely the SAM model for capital:
In Figure 2 we see the output depicted graphically. We can make the following observations based on this initial data.
- It appears the SAM Efficient Investment Solutions outperform the more traditional money market approach – in fact the “Big 4” Money Market solution is incredibly inefficient under this risk measure (we have shown an arrow representing it being off the chart).
- We note the SAM Efficient Investment Solutions seem to appropriately demonstrate increasing gross returns as we increase the risk profile (forming an indicative efficient frontier).
- We also note that the Ashburton Stable Income Fund appears to sit on this efficient frontier at first glance.
Ashburton Investments’ framework (Traditionally adjusted)
Below we have incorporated the third dimension, namely the cost of capital through adjusting the expected return3.
In Figure 3, we note some key information which we can derive from the data, which is worth noting at this point:
Figure 3: New approach (Source: Ashburton Investments)
- The efficient frontier we observed in the previous analysis appears to remain intact.
- This efficient frontier has, however, moved lower as we would expect after adjusting for the cost of capital to be held.
- The relative return under this measure has affected the “ranking” of the solutions. For example, previously the SAM Efficient portfolio (1) only showed materially superior risk numbers relative to the money market funds but under this measure it shows superior results in both dimensions.
- Under these new measures the “Big 4” money market strategy return measure has drifted into the region of overnight cash rates (making it even less attractive).
3 This framework is purely an application of the formulae presented earlier
Rationale for results
Frequently asked questions that will address some of the results and queries that would arise.
1. Why does the “Big 4” bank solution appear to stack up so poorly compared to the rest?
The rationale for investing in this type of solution is typically that the “Big 4” banks are considered safe.
Rather than get into the debate of the appropriateness of this assumption we note that the SAM Model acknowledges the systemic risk associated here.
As a result, it is quite penal from a capital perspective with regards to the concentration that arises, and this drives the results above.
2. Why does SAM Efficient portfolio (1) outperform a standard money market fund on this basis?
This is a more complex issue; the two funds are trying to achieve different outcomes.
The SAM Efficient solution specifically considers an insurer’s capital requirement, whereas the money market fund does not have this luxury as it needs to consider a range of different investors.
A simple example would be the use of T-bills. If T-bills yield more on a capital adjusted basis than a negotiable certificate of deposit it is more suitable for an insurance company, however this logic would not extend to a pension fund investor.
It’s these nuanced considerations that drive the different results. It is important to note that the SAM and capital perspective as defined in the document is only relevant to insurance companies.
3. Why does the Ashburton Stable Income Fund appear to perform well under both measures?
The answer here is simple: diversification.
Although the Ashburton Stable Income Fund has similar constraints to the traditional money market fund it does have one major advantage. Its universe of assets to select from (due to the nature of its mandate) is larger than the money market fund.
As a result, the Ashburton Stable Income Fund achieves natural diversification – the SAM Efficient model and implied capital calculations treat diversification quite favourably.
This results in the Ashburton Stable Income Fund based strategies being efficient both in a traditional as well as in a capital conscious framework.
4. Why is the SAM Efficient portfolio (2) relevant, why not just use the stable income strategy?
This is a valid question and the answer here is related to investor risk appetite.
The SAM Efficient portfolio (2) is constructed to meet a specific client risk appetite while the stable income strategy relies on Board Notice 90 to set the risk parameters.
One of the specific risk restrictions that has been applied in the SAM Efficient portfolio (2) is that it should exclude the use of sub-ordinated or sub-IG debt instruments. This results in both a lower capital requirement but in addition a lower return result.
In summary, both solutions are efficient under either framework, but they serve different purposes (risk tolerances and appetite).
5. You mention that liquidity is key – how do the solutions stack up on that basis?
The requirement for liquidity is largely dependant on the nature of the claims profile. The short answer is that pooled vehicles do tend to lend themselves better to liquidity than a segregated customised solution (for example, money market and stable income funds guarantee daily liquidity to their investors which is something a segregated fund can’t do).
However, if the nature of the claims profile is well understood and can be reasonably estimated the segregated portfolios can be constructed to meet these requirements.
6. What is the key takeaway from the analysis?
The application of this framework can result in a better assessment of the performance of investment strategies.
Although in certain cases, existing strategies will turn out to be efficient (such as the stable income fund strategy) in other instances some quick wins can be detected (such as money market funds versus tailored solutions).
Lastly, when viewing the investment universe through this lens it might become apparent that the existing investment strategy does not tie up with risk-appetite and clients may wish to forego some yield to free up some capital (example is SAM Efficient (2) versus stable income solution).
However, it is worth noting that liquidity is naturally better handled in a Collective Investment Schemes (CIS) vehicles as opposed to a segregated portfolio – this is a key consideration when making decisions in this space.
Application: Long-term insurers
As mentioned previously in this section, we point out some important investment considerations that are applicable to longer-term insurers.
Potential differences to short-term insurers
One of the key potential differences between short-and long-term insurers relates to the nature of their liability profiles. In the simplest example, long-term insurers tend to have long term stable liabilities versus the shorter volatile liability profiles experienced by short-term insurers.
A consequence of this is that long-term insurers tend to be more sensitive to changes to interest rates (i.e. they have interest rate duration in their liability profiles).
Proposed process to be followed
When using Ashburton Investments’ framework, we tend to note that taking interest rate risk (relative to a liability profile) is quite capital intensive for the insurance companies. The goal for long-term insurers, in our opinion, should be to get their asset managers to follow an asset liability management (ALM) approach and hedge this risk with the appropriate mix of assets to minimise the capital held against it (interest rate SCR requirements).
Once this is done the investment strategy should then seek to optimise a growth asset portfolio as done above for the short-term asset strategies i.e. the asset manager should be tasked with:
- Engaging with the insurer to understand:
1. Insurers appetite for risk
2.Amount of capital the insurer is willing to deploy for a strategy
- Following an ALM approach which would involve:
1. Understanding the nature of the liability profile (purpose of the asset portfolio)
2. Investigating potential investment strategies that could solve for the requirement
- The output from these two exercises should then be combined to optimise the outcome to meet the needs of each insurer.
We have proposed a framework for assessing the performance of investment strategies for insurance companies (applicable to both long-term as well as short-term insurers). The Ashburton Investments framework focuses on return versus risk (proxied by the SAM Model) as well as the cost of capital associated with each investment strategy.
We have applied this framework alongside a traditional approach to a few shorter-term investment strategies and the key takeaways are:
- The application of the framework does give better insight into potential and existing investment strategies; and
- Even in instances where existing strategies are efficient they may not coincide with a insurers risk appetite and adjustments may be required (this is the benefit of considering capital in the analysis).
We also discussed potential takeaways for long-term insurers which involves following ALM principles alongside the framework with the goal of achieving superior outcomes.
We conclude by noting that although Ashburton Investments’ framework is being implemented on behalf of numerous clients, it is by no means complete. We continually work on it and look to enhance/refine our framework to provide the best outcome for insurance companies.