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Why is this experience
significant - what are insurance industry practices to control risk?
(Excerpt - Water Street Advisers Form ADV Part 2 – Schedule
F – Methods of Investment Analysis 4(a))
The
worth of an investment portfolio is in its “investment performance” -- the average value it generates for a contiguous series of periodic investment returns
(average return) relative to the volatility of that series of periodic returns (investment risk).
A minimum level of expected investment performance can be documented as a series of points on a two-dimensional graph -- a "mean-variance" graph -- forming a straight, upward-sloping line where the level of average returns (y-axis) increases in proportion with the level of returns volatility (x-axis).
Property casualty insurers are judged by investors, rating agencies and regulators on their ability to generate a level of reported investment earnings (investment income and realized gains) whose quarterly volatility does not vary significantly from that of a 90-day Treasury Bill. Managing to this result each quarter requires the accumulation and use of a reserve of unrealized investment gains over time -- and that requires an insurer to control both the level and quarterly stability of their total investment returns (investment income, realized gains and unrealized gains) to generate and maintain this reserve.
On a mean-variance graph, the industry-average for this minimum level of total investment performance can be drawn as an upward sloping line through the points of risk and return for a 90-day Treasury bill and the industry averages of total investment risk and return. The slope of this line --"insurers' risk" -- marks the chance that the total investment returns for a quarter will fall below that of the reported yield of a 90-day Treasury bill for that quarter.
Although this industry standard will change over time in response to market conditions, for the time period illustrated below -- January 1992 to March 31, 2010 -- the slope of the insurers' risk line marks that this chance was 0.25 -- the average insurer managed the risk of their portfolio so that its total investment returns could be expected to fall below the quarterly yield on a TBill less than once in every four quarters over this time period.
The graph below also includes a second line -- a "market line" -- made of the average performance for the five primary sectors of the global securities markets over this time period and demonstrating the level of conservatism necessary for the average insurer to have met industry performance standards.
The slope of this market line for the three points of the equities market sectors (S&P500, MSCI-EAFE and NASD market indices) is 0.46 -- for this period, there existed a 50:50 chance that the statutory returns derived from investing in these sectors would have dropped below the 90day TBill yield in any given quarter. Insurers ignored the higher returns available in these sectors because their levels of returns volatility made them a foolish bet for maintaining a meaningful accumulation of unrealized gains from which to manage their reported investment earnings.
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