Insurers’ actuarial and investment teams often work in silos, and have little in common when it comes to professional vocabulary. As a result, actuaries often deliver a simplistic view of complex liabilities to investment teams, without the detail that’s vital for effective portfolio management.
The answer is for the two functions to take a more integrated and collaborative approach in five key areas.
1. Asset and liability management (ALM)
ALM involves projecting the balance sheet of an insurance company forward in time, modelling the complex interactions between assets and liabilities and is a key tool for defining the company’s strategic business objectives. Investment managers should be intimately involved in this discipline as they have the expertise to define credible economic scenarios, set realistic expectations for investment returns and deliver a more granular and sophisticated model for asset behavior, which better reflects the organization’s actual activities. A collaborative effort on ALM will also help keep investment strategy in line with the business strategy – and consequently drive better outcomes for the investment portfolio.
2. Liability-driven investing
In a liability-driven investment approach, the investment portfolio is split into two components: a growth portfolio and a hedging portfolio. The hedging portfolio is typically managed against a liability benchmark. Through this approach, the investment management team can meet the key objectives of helping reduce capital requirements and deliver superior investment returns. To achieve these, it is clear that the investment management team must have a detailed and granular understanding of the insurance liabilities, which can only come from higher levels of collaboration with the actuaries.
3. Proxy modeling
For actuaries, modeling an insurer’s liabilities can demand a “heavyweight” calculation that will struggle to meet investment managers’ need for real-time position keeping, risk and profit and loss (P&L) calculations. Fortunately, advanced actuarial platforms will deliver a workable alternative – a “lighter” proxy model whose behavior closely replicates that of the liability profile. It is important that investment managers and actuaries collaborate to choose a proxy model that reflects both the complexity of the liabilities and the sophistication of the chosen hedging strategy, but also to ensure that investment managers understand its limitations and the range of applicability.
4. Liquidity risk management
The way that investment teams manage liquidity has a significant impact on their ability to enhance returns. On the one hand, life insurance liabilities are long dated and insurance companies can earn a liquidity premium by investing in illiquid asset classes such as real estate and infrastructure, whose cash flows can match those of their long-term liabilities. But on the other hand, cash management is critical, especially when handling liquidity events such as collateral and margin calls. Holding too much cash can place a long-term drag on investment returns, while holding too little cash can lead to a detrimental “fire sale” of assets. It is clear that investment managers and actuaries need to collaborate to understand the optimal level of liquidity the investment portfolio must support to meet both short-term tactical needs and long-term strategic needs.
5. Regulatory compliance
For many European insurers, market risk can represent over 60 percent of their total capital requirements. Allocations to capital efficient asset classes, using downside protection, moving to an internal model or making use of the matching adjustment are all activities that could help capital efficiency. And nowhere is it more important for actuaries and investment managers to collaborate than in the drive to meet regulatory requirements. Here, the interaction must go beyond a well-worded and detailed investment mandate to an ongoing dialogue about more than merely compliance. The long-term goal will be to add value, by optimizing risk-adjusted returns on investment capital.
To support collaboration in these five areas, today’s insurers need a robust, end-to-end technology platform which seamlessly integrates modules for actuarial modeling, ALM and investment management. With a modern toolkit of this kind, firms can foster a stronger working relationship between traditionally siloed functions – and take risk-adjusted returns to new heights.
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