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Hitting the Mark.

Insurers use performance benchmarking to influence asset manager behavior in support of the company's desired investment risk and return profile.

In the last few years, the stock market has delivered unprecedented double-digit returns. During this same time, interest rates reached their lowest point in decades, only to rebound several hundred basis points. The frenzy of the markets, combined with policyholder's willingness to assume more investment risk, has caused a significant sales shift from fixed to variable products. This shift has placed pressure on the investment returns of the underlying separate accounts, while displacing some pressure on the investment returns of the general account backing the fixed products.

This economic environment has caused many people to speculate on the future of fixed-account products. While sales of variable products recently have overshadowed the fixed-account products, consumer interest is likely to shift back to fixed products when the stock market cycles down or when the policyholders are no longer interested in taking on the investment risk. A shift back to fixed products will refocus attention on the performance of the fixed products--specifically, the return of the general account assets supporting the fixed products.

Investment performance is a crucial component of product competitiveness. How the investment performance of an insurance company's assets stacks up to another company's performance can be an important element of the sales process. The investment margin can be a major source of earnings for many life insurance companies. Furthermore, the composition of a company's assets are a major determinant in a rating agency's assessment of a company's financial strength rating.

It is understandable why insurance company executives want to evaluate the performance of the individuals responsible for managing the company's assets. But many companies have not adopted effective benchmarks for evaluating that performance. Why not? There is no shortage of formulas for calculating performance, yet many companies cannot point to investment benchmarks that are an effective aspect of fund management and company financial management.

Complex Exercise

Developing an effective performance benchmark for managers of life insurance assets is not only possible, but it is also an invaluable exercise for the successful and prudent management of a life insurance company But creating effective benchmarks for evaluating performance and creating the appropriate incentives for asset managers can be a complex exercise for a life insurance company.

All life insurance companies calculate the investment return of the general account. In turn, some companies have developed performance benchmarks by extrapolating from these investment-return calculations. Typical benchmarking approaches include total return benchmarks based on a public index or a composite of public indices, customized for the maturity characteristics of the liabilities. For example, a benchmark could be defined as the average return of Lehman Bros.' 10-year corporate bond index plus a spread. Another benchmark could be defined as a weighted average of Lehman's corporate bond index and Lehman's MBS [mortgage-backed securities] index plus a spread. These benchmarks can be calculated from published financial data and are simple to calculate.

The desire to establish a benchmark can be so great that some companies consider these approaches better than not having any benchmark, in spite of the many limitations. These benchmarking approaches do not fully recognize the integrated nature of life insurance company management and do not reflect the unique risks of an individual company s assets and liabilities. There is no assurance that a company whose investment management is guided by these benchmarks will be able to credit competitive rates or produce sufficient investment income to meet the company's financial objectives.

Benchmarking Goals

Simply stated, a company wants to use the benchmark to influence asset manager behavior. The company expects the asset manager to support the company's desired risk-and-return profile, as articulated in its investment strategy. The asset manager is expected to select assets whose future cash flows will fund the benefit obligations of the policyholders and respond to the changing needs of the company. Asset benchmarks should complement the performance benchmarks for product managers and should be consistent with the company's financial goals. Company management wants to use the benchmark to evaluate the contribution of the asset manager-how the asset manager contributed to company profitability and competitive objectives and how the asset manager's performance compares with that of other asset managers.

An effective benchmark must recognize the integrated nature of managing the finances of a life insurance company. The benchmark cannot be defined without directly recognizing the funding source of these assets-life insurance and annuity products. A life insurance company's asset portfolio cannot be evaluated solely by the returns generated; the asset portfolio must generate competitive returns and ensure the funding of the guarantees made to policyholders. The requirement to fund product guarantees adds a dimension of complexity to the development of a performance benchmark that does not exist for the asset managers of funds with no guarantees.

Developing a Benchmark

To develop an effective performance benchmark, it is important that the company's financial-management practices are solidly grounded in fundamental principles and financial results are a key component in the determination of the company's strategies. Ideally, a company's financial-management infrastructure includes the articulation of the company's risk/return propensity and financial objectives, an understanding of the risk profile of the assets and liabilities and procedures for measuring the performance of the assets and liabilities.

Articulate the company's financial objectives: The successful management of a life insurance company depends upon the joint efforts of asset, liability and corporate managers. Performance benchmarks will be more effective if developed within the context of enterprisewide financial management. "Best Practices" for enterprisewide financial management include an infrastructure with the following:

* an articulation of the company's capital-management policy (capital structure, level of retained capital, available free capital);

* an articulation of an investment strategy for assets backing product liabilities, required capital and free capital;

* an articulation of the company's tolerance for risk, as reflected in the investment, capital and product strategies;

* modeling capabilities to evaluate the financial impact of alternative investment, product and corporate strategies;

* systems to measure and evaluate actual results, including the determination of sources of profit and performance attribution; and

* a delineation of the primary and secondary accountabilities for capital, earnings and risk management between product, asset and corporate managers.

While not every company's financial-management practices can be described as following "Best Practices," most companies have an adequate financial-management foundation to develop benchmarks for their operations. The development of benchmarks is an opportunity to increase the dialogue between asset, portfolio and company managers on the risk/return tradeoffs of alternative strategies and strengthen the company's financial-management infrastructure.

Understand the risk profile of the products issued by the company: Company managers need to understand how the value of the company (assets, liabilities and economic surplus) changes with different economic scenarios and strategies.

Two graphs ("Typical Risk Profile of an Insurer's Assets and Liabilities," and "Typical Risk Profile of an Insurer's Economic Value," page 70) illustrate how a company's economic value changes as interest rates change, where economic value is calculated as the present value of asset and liability cash flows under different interest scenarios. There are other methods for calculating the economic value of a company however, the differences between methods have little bearing on the determination of a performance benchmark. The important point is that company managers must understand how their actions affect the economic value of their company, regardless of the paradigm used by a company in managing the underlying economic value.

It is apparent from these graphs that managing life insurance company assets and the development of an effective performance benchmark cannot be separated from the management of the liability portfolio. Asset performance must be evaluated relative to the requirements of the liabilities and the cost of capital.

Establish procedures to measure the performance of the assets: The most common measure used in evaluating an asset manager is total return. Total return measures vary, but generally, total return is a ratio of investment income and capital gains to market value. While the use of total return is widespread, total return is not sufficient to guide a company's investment strategy. Total return measures do not capture the risk associated with generating the return and do not reflect the unique risk profile or capital cost of the company.

Remember that the purpose of a benchmark is to direct the activities of the asset manager according to the investment strategy specified by the company. A better approach in setting a benchmark is to compare the excess returns generated by the asset manager with the risks assumed. These risks are assumed by the asset manager and the company through the execution of its product and corporate strategies. An adaptation of the basic Sharpe ratio would serve as a more effective basis for a performance benchmark.

Measuring Performance

The Sharpe ratio, developed by Nobel Laureate William Sharpe, attempts to measure how a fund performs relative to the risk it takes. The bigger the Sharpe ratio, the better a fund performed, considering its riskiness. In classic portfolio-management literature, the Sharpe ratio is defined in the box below.

The asset manager is expected to generate returns greater than or equal to the expected return on liabilities plus a specified spread. This specified spread is defined consistently with the company's financial objectives for earnings, growth and risk. Stated differently the expected return on liabilities represents the minimum threshold for asset performance.

The expected return on liabilities can be derived from asset liability modeling systems. A proxy for the expected return on liabilities can be developed by constructing a portfolio of synthetic assets with a similar risk profile to the liabilities. Depending upon the company's procedures for allocating capital to product liabilities, the expected return on capital can be included in this calculation. Designing a synthetic asset portfolio is based on the concepts of transfer pricing, as used in the banking industry but a complete discussion is beyond the scope of this article. The expected return on the actual assets backing the product liabilities can be compared with the return on the synthetic asset portfolio.

This approach allows for the development of a benchmark, customized for a company's unique risk profile and financial objectives. An example of a performance benchmark is to generate a total return on the actual asset portfolio in excess of the return on the synthetic asset portfolio and to produce an adjusted Sharpe ratio greater than the prior year's Sharpe ratio. If this result is achieved, the assets are generating a sufficient return to fund the company's guaranteed product obligations by assuming risk commensurate with the risk profile of the product liabilities. In addition, the assets are generating a sufficient return to support the company's growth objectives.

Action Plan

The development of an effective performance benchmark for the managers of life insurers' asset portfolios is an extension of a company's financial-management efforts. The development of benchmarks is an opportunity to leverage cash-flow testing systems, strengthen the financial-management infrastructure and, most importantly, establish a process for evaluating asset managers. Developing a customized benchmark can serve as a catalyst to analyze the company's financial models from a different perspective and determine if the investment strategies are properly aligned with product, corporate and the enterprisewide strategic plans.

With evolutionary expectations for progress, a company can develop effective benchmarks. The first step is to start with a simple benchmark that recognizes the risk profile of the liabilities and the cost of capital, to some degree. The second step is to create an open, nonthreatening forum to discuss how actual results compare with the benchmark. These discussions can be very informative for asset, product and corporate managers and will provide the basis for refining the benchmark and/or the company's investment and product strategies. These discussions will ensure that the evaluation of asset performance and the revision of the benchmark will be conducted within the context of an evaluation of the enterprisewide financial results. When folks are comfortable with the process and the results, the benchmark can be integrated into the compensation formula for the asset managers.

As the financial-services industry consolidates, the financial performance of life insurance companies will be compared to banks, thrifts and other financial institutions. It will be increasingly important for a life insurance company to provide asset managers with effective performance benchmarks that complement the company's financial strategies. While developing benchmarks for life insurance companies can be complicated, the activity can be invaluable in managing the company's financial position. The life insurance companies that invest the time in establishing effective benchmarks will be well-positioned to survive and prosper in the new era of financial services.

Nancy Bennett is a consulting actuary with the Avon Consulting Group, Woodbury, Minn.

Sharpe Ratio

In classic portfolio management literature, the Sharpe ratio is defined as follows:

Sharpe ratio = return on the asset portfolio - risk free rate/variance of the asset portfolio's return

The Sharpe ratio measures the additional return per unit of risk, where the risk-free rate is typically a Treasury rate. The Sharpe ratio has similar limitations to total return. The Sharpe ratio does not reflect the company's cost of capital or the risk profile of its product liabilities. However, it can be modified to evaluate an insurance company's investment strategy and the asset manager's performance. Using the company's expected return on liabilities as the risk-free rate, the Sharpe ratio can be redefined as follows:

Sharpe ratio = return on the asset portfolio - expected return on the liabilities/variance of the asset portfolio's return
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Article Details
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Author:Bennett, Nancy
Publication:Best's Review
Article Type:Brief Article
Geographic Code:1USA
Date:Oct 1, 2000
Words:2238
Previous Article:Routine Maintenance.
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