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Russell proposes volatility management for insurers
Russell Investments has suggested that with a more integrated approach to asset liability management, insurance companies should be able to increase profitability, as there is significant value to be added by quantifying and tailoring their investment strategies.
In their research paper Squeezing the Lemon, Russell comments on the headwinds within the insurance sector, and their profitability, given the present volatility and murky investment landscape.
They state in the research that "dis-alignment has been creeping into the industry and is holding back on profitability". 'Dis-alignment' includes a myriad of business risks, but at the investment level, it refers to the management of the assets of the business and its review processes. It includes such areas as counterparty, key person, and style risk. It also includes, for example, the outsourcing of the investment function by Australian subsidiaries to a global parent.
They maintain that a review of risk models is timely at this point in time, and that a dynamic model should be adopted which is more forward looking. Their suggestion is an investment liabilities interface would help "connect those key investment parameters to internal decision variables which are under management control". The interface would also help "indicate the direction of change in those decision variables called for by investment market development".
Based on their research and perceptions of the current market conditions, they highlight two possible strategies that insurance companies should consider - managed volatility investing and managed futures.
Using simulated back-tests, the research shows "low volatility strategies offer the prospect of a return premium at low levels of risk". The other "natural fit for an insurance company" is managed futures as a way to trade market volatility and change their asset profile over time.
In addition, their US macro economic research indicates that the economy is in the "sweet-spot" of the economic cycle (the period in the early years before an expansion), and to help boost insurance profitability they make a series of recommendations - including insurance companies should look to lift equity ratios above 20 per cent, favour credit over sovereign exposure, and calibrate risk models to be forward looking.
However, as the report also states regarding insurance profitability: "the basic business model is to charge to accept customer risk/volatility" and scrutinise costs.
AUTHOR
Keith Griffiths
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