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With the Federal Reserve’s interest-rate-hiking campaign nearing an end, meaningful yield is available in relatively safe investments. This revived environment for fixed income investing has seen a pick-up in activity for insurance companies.
Insurance companies rely on actuaries to assess risk, analyze data, and calculate premiums accurately, ensuring their financial stability and sustainability. According to the National Association of Insurance Commissioners (NAIC), the U.S. insurance industry took in $3.1 trillion in premiums in 2022, up 6.4% from 2021. Premium funding, which is primarily used to pay claims, can also make its way into the insurer’s surplus and reserves. Surplus is the capital left over after subtracting liabilities from the company’s assets and is a barometer for the overall financial strength and stability of the insurer. Reserves are specific funds set aside to cover future claims and obligations arising from the policies it has underwritten. Both surplus capital and reserves make up the insurance company’s general portfolio, which can be invested to strengthen the organization and ensure its long-term viability. In the U.S., there are 5,965 insurance entities, many of which do not have the in-house expertise to invest its assets. This presents an opportunity for financial advisors, consultants, and asset managers to demonstrate their expertise in investing, expand their market reach, and diversify their client base.
Success in this channel requires an understanding of the distinctive investment needs and regulatory considerations facing the insurance industry. I hope this high-level overview helps any advisor or consultant considering extending their services to this channel.
Differentiating insurance clients from traditional institutional accounts
Insurance companies operate within a unique regulatory framework and are subject to specific solvency requirements and risk management guidelines. Their primary focus is on policyholders, ensuring the ability to pay claims and support individuals during times of stress, such as accidents or natural disasters. Regulatory bodies and rating agencies closely monitor insurance companies to ensure their ability to fulfill these obligations, placing a significant emphasis on maintaining surplus. For instance, insurance company capital is scrutinized under what is known as risk-based capital (RBC) standards. The underlying assets are risk-adjusted based on price volatility, default probability, and the likelihood of a full return of principal. So, in essence, the surplus amount is adjusted based on the riskiness of the underlying assets. The domicile state’s insurance commissioner dictates if the adjusted capital is sufficient. There are control levels that must be maintained, or regulators will demand an action plan to get capital/surplus higher.
Advisors and consultants working in the defined-benefit or defined-contribution space may be familiar with the more predictable liability structure around retiree benefits. An insurance company’s liability structure is more diverse and complex, contingent upon future unplanned events, and often characterized by lumpy cash flows. The management of the general portfolio must consider the operational risks and align them with any investment risks it may undertake. This balance of risk is what I call the enterprise risk-management process. This process guides the insurer’s strategic investment plan.
Adding to the complexity is how an insurer must report to regulators. Rather than GAAP accounting, insurance companies use statutory accounting, where bonds are carried at amortized cost, and stocks are marked to market daily. So, the growth (or decline) in surplus is reflected in the income statement from bond interest and in the balance sheet for the appreciation or depreciation of stock investments. This constrained total return approach must be tailored to the insurer and aligned with their business strategy.
As it relates to investment gains and losses, limitations are imposed on insurance companies to maintain financial stability and ensure their ability to meet policyholder obligations. When investment losses occur, they directly reduce the insurer’s surplus, potentially impairing its financial strength and solvency. Consequently, insurance companies often employ risk-management strategies, such as asset-liability matching and diversification, to mitigate the impact of market fluctuations on their financial position. Additionally, regulatory authorities may impose specific requirements or guidelines regarding gain loss constraints to safeguard policyholder interests and uphold the insurer’s long-term viability.
Investment process
The investment process usually consists of an asset manager working with an insurer and its advisor or consultant to conduct a deep analysis of the following:
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Insurance operations: Evaluate operational cash flow and liquidity needs to ensure sufficient funds are available to meet policyholder obligations and manage day-to-day operations effectively.
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Financial conditions: Understand the insurance company's internal risk tolerance and surplus strength to assess its financial stability and ability to withstand market fluctuations.
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Regulatory structure: Review the regulatory framework and standing with rating agencies to ensure compliance with regulatory requirements and maintain favorable ratings, which can impact the company's ability to attract investors and policyholders.
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Actuarial outcomes: Determine liability and surplus duration targets by analyzing actuarial outcomes, including mortality rates, claims experience, and policyholder behavior, to align investment strategies with long-term liabilities and ensure solvency.
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Investment allocation: Review profitability trends and optimize portfolio allocation to maximize returns while managing risk within the constraints of the insurance company's investment policy and regulatory requirements.
Conclusion
The insurance market offers a compelling opportunity for advisors and consultants seeking to diversify their client base and drive business growth. The business tends to be sticky, and account sizes can grow quickly. But success in this channel requires a deep understanding of the unique needs and regulatory dynamics of insurance clients. By adopting a client-centric approach, partnering with insurance-centric asset managers, and offering specialized advisory services, advisors can position themselves as indispensable partners to insurance companies navigating the complexities of surplus management.
Don Miller is head of Madison Investments Insurance Solutions.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.