By Scott Daniels
Most investors construct portfolios using the traditional asset classes of cash, fixed income, equities and tangible assets. An alternate approach starts with risk factors rather than asset classes.
A risk factor approach has potential advantages, including better diversification, greater awareness of overlapping risk factors, and greater efficiency in portfolio construction.
Risk factors are the individual elements of risk that drive the behavior of assets. An investment grade corporate bond is actually a collection of different risk factors that affect its value, including economic, credit, capital market and geopolitical factors.
Diversification
Insurance portfolios consist largely of investment grade fixed income and public equity, with relatively small allocations to other asset classes. This results in concentrations of interest rate, credit-related, inflation, and liquidity risks. Accounting standards and regulations constrain insurers, but most insurers fail to diversify fully even within those constraints.
An asset class-centric approach to portfolio construction encourages investors to evaluate asset classes as separate and distinct, rather than with multiple overlapping risk factors. As a result, insurers tend to overweight “safe” assets and underweight “risky” assets, while failing to see that safe and risky change in the context of the overall enterprise. By focusing on risk factors rather than asset classes, investors can better evaluate how non-core asset classes may fit into their risk profile; a “risky” asset can actually reduce enterprise risk if it offers diverse risk factors.
The granularity of a risk factor approach to portfolio construction could bring greater efficiency to the optimization process. It offers investors greater control over their investment risks and allows investors to focus on the risks that will drive future returns.
Better diversification can be especially important in a financial market crisis. Correlations among asset classes increase during severe market downturns – exactly the moment investors would benefit from diversification. During normal market conditions, the secondary risk factors underlying many asset classes are not major drivers of price movements. During a crisis, these shared factors become much more important.
Enterprise Financial Modeling
Incorporating investment risk factors offers synergies with risk management programs. A successful program results in an awareness of risk across all operations. Risk factors are an effective way to accomplish this within the investment function, and facilitate efforts to identify compounding risks in liabilities and operations. A robust enterprise financial model projects how shared risk factors will affect investments, reserves, and future premiums and losses.
Challenges for Investing
Risk factors offer a useful way of evaluating a portfolio, and are critical to sophisticated financial modeling. However, implementing a risk factor based portfolio entails significant challenges.
Identifying all Risks: Cash, fixed income, equities and tangible assets define the investable universe from an asset class standpoint. There is no consensus on a standard, universal set of portfolio risk factors.
History of Risk Factors: There is limited historical data on many risk factors. This complicates attempts to develop forward-looking assumptions for risk-factor based portfolio optimization.
Intersecting Factors: Most investments contain multiple risk factors; a simple investment grade bond encompasses at least a dozen major risk factors. Investing in specific risk factors may require derivatives or short selling, and are often imprecise, ad hoc constructions.
On the Horizon
Interest in risk factor investing will continue to grow due to trends in the insurance and financial markets.
Enterprise Risk Management (ERM): Regulators and rating agencies are putting increasing emphasis on risk management. Identifying risk factors in the investment portfolio is an important part of a robust ERM framework.
Regulatory: The NAIC’s Own Risk Solvency Assessment requirement requires sophisticated financial modeling and risk analytics. International accounting convergence and FASB’s deliberations regarding accounting and revenue recognition for life insurance contracts will increase the need for risk factor investing. In addition, A. M. Best Company is making significant changes to its quantitative assessment of capital adequacy, adding stochastic modeling and a more granular approach to portfolio risks at the end of this year.
Financial Innovation: Liquid alternative investments attempt to track hedge fund performance by replicating the risk factors employed by hedge fund managers. Liability-defined investing encompasses risk factor concepts.
Low yields have led some companies to adopt higher risk tolerances. Both the p/c and life industries have substantially raised exposure to lower quality bonds. Interest rate risk and credit risk have been two familiar ways adjust risk/reward profiles.We believe this trend has largely played out. Insurers should adopt at least some aspects of a risk factor-based approach, and give greater consideration to non-core assets. This is particularly important as we enter the late stages of the credit cycle.
Scott Daniels is a managing director and head of investment advisory at Conning
