Experienced investment managers should understand the importance of defining an appropriate benchmark for their portfolios. The passive investment portfolio, as represented by this benchmark, should defease (pay off or retire) the liability cash flows, profit margin and expenses. The portfolio’s guidelines should generally reflect the risk/return metrics of the benchmark as well as its “investability,” which refers to the investment manager’s ability to replicate the benchmark.
The process of designing benchmarks for insurance portfolios, in particular, should seek to meet three key objectives:
In our experience, benchmarking practices in the insurance industry run the gamut from using nothing at all, to combinations of off-the-shelf standard benchmarks such as the Barclays Capital U.S. Aggregate Index, which covers the investment grade U.S. fixed rate bond market, to complex derivatives-based replication portfolios.
At PIMCO, we endeavor to collaborate with an insurance company early in the relationship to establish a benchmark that satisfies those three key objectives. We strive to do this efficiently and effectively while incorporating each client’s risk tolerance, regulatory constraints and return objectives.
Linking Assets to LiabilitiesInsurance liabilities come in many different forms, each with a unique risk profile. While health and property and casualty liabilities often contain lower interest rate sensitivity than their life insurance counterparts, they can exhibit higher risk exposures in other areas, such as inflation. Thus, including inflation-indexed assets (such as U.S. Treasury Inflation-Protected Securities (TIPS)) in benchmarks for health and certain property and casualty portfolios, such as workers compensation programs, may be appropriate.
Life insurance liabilities, on the other hand, can range from short to long duration, from significant policyholder behavior risk (e.g., rate-reset annuities) to little or no policyholder behavior risk (e.g., structured settlement annuities). The permutations of risk characteristics are nearly endless.
Determining the interest rate sensitivity, or duration, of the liabilities may help appropriately capture their path dependencies. Most companies assess duration using actuarial projections – such as stochastic (probability-based) cash flow projections or deterministic stress tests. In addition, these projections should reflect factors specific to the type of insurance business:
For life insurers, PIMCO typically advocates a straightforward benchmark with a duration profile that matches the liability, and with a current yield consistent with the rate credited on the portfolio. Property and casualty companies can use the benchmark to set limits on tax-exempt securities where appropriate and add inflation-sensitive assets to partially offset their liability risk. Ideally, the convexity profile of the benchmark should be directionally the same as the convexity profile of the liability to forestall unnecessary changes in the benchmark. Convexity is a measure linked to duration, and helps assess systemic and market risks. For example, deferred annuities are typically highly convex. A significant benchmark allocation to negatively convex assets such as mortgage pass-throughs can result in duration drift markedly different than their liability profiles.
Some insurers and consultants advocate the use of derivative-based benchmarks, particularly for path-dependent life insurance liabilities. These types of benchmarks can be good at mimicking the liability and can be more efficient to recalculate than re-projecting the liabilities. At the extreme, though, they can be difficult to maintain and often not investable due to mark-to-market issues and regulatory rules limiting derivative use. To help improve overall utility, a second step should be taken to translate the derivative-based benchmark into an investable-securities-based benchmark. Furthermore, highly path dependent risk can often be managed more efficiently at the enterprise level. Attempting to manage the most complex risks at the portfolio level can be costly and may ignore offsetting exposures in other lines of business.
To provide a more meaningful link between assets and liabilities, we believe the benchmark should represent a long-term target. This is not to say a benchmark should never be adjusted; rather, it should be adjusted when long-term needs have changed reflecting changes in the book of business, or material changes in the nature of the liabilities due to significant changes in financial markets. Often insurers seek to tactically change benchmarks to reflect short-term views on items such as interest rates or specific asset classes. We believe tactical views are best reflected via active management relative to the benchmark. The benchmark itself should be a stable, long-term foundation for the portfolio rather than a moving target.
Consistency with the Client’s Risk and Regulatory ProfileFactoring in liability characteristics is an important step, but not the only step. Insurers contend with a host of regulatory requirements and accounting considerations that should ultimately be reflected in investment guidelines as well. In fact, the combination of benchmark and guidelines should fully articulate investment objectives and risk appetite. Even if other information is limited, we believe an investment manager can effectively manage a portfolio given a well-constructed benchmark and appropriate guidelines.
Most regulators impose limits by rating, by country and by sector. Insurers may also have other unique risk limits. These limits must be reflected in the guidelines and the benchmark – otherwise, the passive portfolio represented by the benchmark will not be investable.
Consider the following example: An insurance regulator limits non-U.S. exposure to 15% of an insurer’s portfolio. However, the insurer selects the Barclays U.S. Credit Index, a U.S. corporate fixed income index with approximately 30% non-U.S. securities. This benchmark’s components would not be entirely investable – the portfolio will always have at least a 15% structural underweight to the sector, resulting in a risk mismatch between the insurer’s benchmark target and the portfolio manager’s guidelines.
A final note on guidelines – one size does not fit all. For highly certain liabilities, such as guaranteed investment contracts (GICs) or structured settlement annuities, tightly defined guidelines without much room for deviation from risk targets can make sense. On the other hand, guidelines for less predictable liabilities, like fixed account cash flows in variable annuities, should allow greater discretion. The risk targets themselves are far from precise – imposing narrow bands around these targets can therefore be counterproductive.
Evaluating PerformanceArguably, the easy part is to evaluate a manager’s performance. Once a benchmark is established with an appropriate sensitivity to interest rates and a commensurate risk profile, a consistent comparison can be drawn between the investment manager’s performance and the passive benchmark. Establishing the right risk profile for most insurers generally produces benchmarks and guidelines that are more conservative than those of most other investors. As such, investment discretion tends to be somewhat limited. It is therefore important to calibrate return expectations accordingly.
ConclusionThe process of selecting a portfolio benchmark is a critical step for investors seeking to articulate and reach risk and return objectives. For insurance companies, this process is complicated by the presence of unique asset-liability risk, regulatory and accounting considerations. It is important to strike a balance between competing priorities – what is desirable theoretically and what is achievable practically. We believe that doing so can help improve the chances for long-term success, because a well-constructed benchmark serves as a sturdy, necessary investment foundation.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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