This article was originally written for and published in the Fall 2022 edition of AASCIF News, the quarterly newsletter of the American Association of State Compensation Insurance Funds. Learn more about AASCIF at www.aascif.org.
Reinsurance capacity challenges.
2022 has been another taxing year for the insurance sector, and state funds are by no means exempt from these challenges. With the rise in inflation driving liabilities up while interest rates are driving fixed income portfolio values down, the spotlight is shining even brighter on asset-liability management strategies in many finance departments. The multitude of pressures has many wondering what the best strategy is for their investment portfolios and what can help them determine that strategy. Capital models can be important tools to guide state funds in making those decisions.
On March 16, 2022, in response to the rising inflation, the Federal Reserve approved the first interest rate hike in more than three years and followed with additional hikes that increased the federal funds rate by a total of 3% between March and September. Annual inflation as measured by the Consumer Price Index (CPI) hit a high of 9.1% in June 2022, a level not seen in 40 years. While medical cost inflation was only 5.6% for the 12-month period ending August 2022, this is a substantial increase from 2.9% in March 2022. Increases in medical costs lag behind other sectors, primarily due to negotiated prices and reimbursement rates that are set in advance. Likewise, wage inflation for the 12-month period ending June 2022 was 5.1%. When compared to a 2.9% wage inflation rate for the 12-month period ending June 2021, the magnitude of the current inflationary environment becomes clearer. Rising wages and medical costs will impact both the costs of future policies and the current loss reserves of state funds.
Compounding the issue are rising interest rates that are driving fixed income portfolio values down. Combined with challenging stock market returns, state fund investment managers may be looking to make changes to their portfolios in response. Capital models can help management determine the potential impact on surplus of alternative investment portfolios or stress test investment performance against future short- and long-term adverse scenarios.
Where does a capital model come in?
A Data-Driven Modeling Approach Toward Guiding Management’s Decisions
Capital models have long been a tool utilized by insurers to evaluate investment strategies and ensure alignment with insurance liabilities, among many other applications. Their usefulness is further enhanced during these current times when pressures are coming from multiple directions.
At a high level, a capital model is a simulation-based tool that models financial balance sheet/income statement variability based on the key risks of the state fund. Generally, those risks include:
- Adverse reserve development (i.e., reserve risk).
- Inadequate funding for future claims (i.e., pricing risk).
- Investment underperformance (i.e., asset risk).
The current inflationary environment and resulting interest rate hikes are increasing volatility within all three of these risks. A capital model can help quantify these risks in a number of ways.
For insurance risks, liability durations are often longer than asset durations, exposing companies to interest rate risk. Workers’ compensation claims can remain open and active for decades. As such, liability durations are often multiple years, whereas assets supporting the liabilities are often in shorter-term maturities. The larger the gap between the claim duration and the supporting asset maturities, the larger the risk.
While state funds can purchase longer fixed-income portfolios that generate higher returns and minimize interest rate risk, this can create liquidity concerns. State funds need enough liquid assets available to cover short-term losses.
A capital model can be used to assess this risk/reward tradeoff. Without a capital model, state funds will often take a heavily conservative approach to investments, which leads to suboptimal asset returns. In these situations, a capital model can evaluate multiple investment portfolio strategies to identify an optimal portfolio that can optimize returns relative to risk tolerance constraints such as capital variability, interest rate risk, and liquidity requirements.
Food For Thought
As a basic case study, take for example a state fund with an asset allocation that is heavy in short- and long-term fixed income, holding only a small amount in equities and money markets. Through the use of a capital model, portfolios with different asset allocation strategies could be evaluated that still achieve asset-liability duration matching but provide superior investment returns (e.g., through increased equity holdings) with limited or no increase in surplus volatility or requirements. This phenomenon is not magic but is simply the result of the diversification benefit of combining asset and insurance risks, which are relatively uncorrelated. Conversely, if a state fund is concerned that it is exposed to too much investment risk, capital models can help evaluate multiple portfolios that can minimize asset return volatility without unduly sacrificing investment returns.
To conclude, capital modeling can analyze reserve, premium, and asset risks to provide guidance on how to best balance the asset portfolio to support the insurance liabilities. Without an in-depth analysis, the assets may either be invested in a portfolio that is not optimizing returns or invested in a way that would not provide the needed liquidity. A capital model can provide that in-depth analysis to guide investment decisions.
Co-authored by Molly Stark.