The High Costs of Capital Misallocation
Key Takeaways
1. In the current low-interest rate environment, not managing capital efficiently could lead to money being left on the table. This was less true in the past, when interest rates were higher.
2. Our analysis of the P&C industry suggests that many companies are currently mis-allocating capital across their balance sheet. By switching to the correct capital allocation policy, many companies could increase total income (including investment gains) very significantly from current levels.
Allocating Capital Efficiently for P&C Companies: A Recap
In a previous post, we showed how capital can be allocated efficiently across all of a P&C company’s business lines and its investment portfolios. We showed that efficient capital allocation depends on its desired financial strength, and the company's operational characteristics. We also showed that the right asset mix in P&C investment portfolios will be different for different companies.
What if a company does not allocate capital efficiently? What are the costs of misallocating capital? To answer these questions, we will introduce some analytical tools.
Analyzing Different Capital Allocation Strategies
The efficiency of different capital allocation strategies can be best measured by estimating the P&C insurance company's return on Policyholder Surplus (or PHS), which is a measure of profitability.
To keep things simple, assume that there are 2 main asset classes: bonds (safe assets), and stocks (riskier assets). Assume also that the company wants to maintain the same financial strength regardless of its choice of capital allocation policy.
The Return on PHS for P&C insurance companies can be expressed as:
Return on PHS = [ f x (Stock Market return) + (1 – f) x (Bond Market return) ]
+ [ (Bond Market return – Cost of Float) x (L – 1) ]
= Return on investing PHS in Stock & Bond Markets + Return on Insurance Operations
where:
Cost of float is annual Underwriting Losses divided by Insurance Float
Stock market return represents the total expected annual returns from owning the S&P 500 Index.
Bond market return represents the composite interest rate of a very high-quality diversified Bond fund of medium duration, including Treasuries, Muni bonds, and high-rated Corporate bonds.
Investment Leverage L is Total Investments/PHS.
f is the fraction of PHS that is invested in stocks.
The Return on PHS in the above equation can be interpreted as follows.
[Return from investing PHS in Stock & Bond Markets] The first term within the square bracket is the return from investing the owners’ invested capital or PHS in the stock and bond markets in the proportions f and 1–f respectively.
[Return from Insurance Operations] The term within the second square bracket is the return from investing float in the bond markets, after accounting for the cost of float. This is the return of the stand-alone insurance operations.
Relationship between Investment Leverage and Stock Investments
A company that wants to maintain a desired financial strength regardless of its capital allocation policies will be constrained in its choice of its Investment Leverage L. In particular, the more the proportion of stocks in its investment portfolio, the less the Investment Leverage should for financial strength to stay the same. The exact relationship will depend on the P&C insurance company's operational characteristics and desired financial strength, and will be different for each company. But it will look something like the figure shown below:
Figure 1. Investment Leverage versus Stock Exposure
Therefore, for a desired level of financial strength, the Investment Leverage for the case when an insurance company has 0% in stocks will be higher compared to the case when it has more stocks.
We now have the tools in hand to quantify the consequences of mis-allocating capital in P&C companies. But before we do that, we digress to discuss the elephant in the room today…low interest rates.
Interest Rates have been Falling …
Interest rates have been falling for 30+ years. The figure below shows that yields on both the 10-year US government bonds as well as Moody’s Baa corporate bond index have been relentlessly falling. The rate on the 10-year US government bond is now less than 2%.
Figure 2. Interest rates have been heading down, down, down…
Falling interest rates are a global phenomenon, not just a US phenomenon. In fact, developed country bonds often yield even lower than their US counterparts. Japanese government bond yields have been near zero for years. Worldwide, nearly $15T worth of bonds have negative yields at the end of September 2021 (source: Financial Times).
We have written elsewhere about low-interest rates and about the lessons that P&C executives should draw from this.
The obvious way by which low interest rates affect P&C companies is via their investment portfolios. A significant portion of P&C companies’ investment portfolios is held in some combination of US government bonds and corporate bonds, with effective duration of less than 10 years. Therefore, investment income from these bonds have taken a huge hit due to low interest rates over the past few years.
But there is a subtle and more important way by which low interest rates can affect P&C company profitability. As we show next, a P&C company’s profitability is more sensitive to capital allocation policies in the low interest rate environment than in periods of higher interest rates. This has important consequences.
Misallocating Capital is Costly in a Low Interest Rate Environment
We now come back to our original question: How much money will a P&C company leave on the table if it misallocates capital?
Suppose that a P&C insurance company has a choice of two (polar opposite) investment strategies below:
A "bond-heavy" strategy with an Investment Leverage of 3.0 that leaves it with no exposure to stocks
A "stock-heavy" strategy (its opposite counterpart) with an Investment Leverage of 1.7 that leaves it with 100% of its PHS in stocks.
Assume that the choices of Investment Leverage above results in the company having the same financial strength with either strategy. We assume also that the Cost of Float for the company is about 1.5% (which we estimate to be the median level for the P&C insurance industry today).
The company's Return on PHS can be calculated from our earlier equation based on the investment strategy that it employs:
(“Bond-heavy” strategy) Return on PHS =
Bond Market return + 2.0 x (Bond Market return – Cost of Float)
(“Stock-heavy” strategy) Return on PHS =
Stock Market return + 0.7 x (Bond Market return – Cost of Float)
In the old interest rate environment (prior to 2008), bond markets would return about 5% annually and annual stock returns could be expected to be about 8%. In the current low interest rate environment, we estimate that bonds will return 1.75% annually, and annualized stock returns will be about 5.5% over the next 10 years. The following table shows the Return on PHS for the two different strategies.
Table 1. In Low Interest Rate Era, Investment Portfolio Management is Essential
As the table above shows, in the earlier interest rate era, P&C insurance companies could be relatively indifferent as to whether they were bond-heavy or stock-heavy; in fact, putting money in stocks was likely an afterthought considering that the Returns on PHS for the bond-heavy strategy was higher than that for the stock-heavy strategy. However, in today's low interest rate environment, the Returns on PHS could vary significantly depending on the choice of the investment portfolio.
The analysis above is necessarily simplified. What would happen if we were to perform a more complete analysis? What if we were to consider a wider variety of asset classes for the investment portfolio, such as preferred stocks, mortgage loans, real estate, etc.? What if we were to simultaneously allocate capital across business lines and the investment portfolio to maximize returns while maintaining desired financial strength? At Alpharay Insurance Services, we have indeed conducted such a thorough analysis for the US P&C insurance industry. And our empirical findings clearly support the main takeaways of this article.
To recap:
Prior to the low interest rate era, investment allocation had a relatively lesser impact on company profitability, and the company would not be leaving much money on the table with its choice of investment policy. In fact, the default strategy of putting all their investments in high quality bonds was the correct one for P&C companies.
However, in today's low-interest rate era, this no longer holds true. Investment portfolio management is essential to maximizing overall profits. Conversely, mis-allocating capital could prove to be costly in the low interest rate environment.
Based on our empirical analysis using data from public filings, we estimate that many P&C companies could increase net earnings, including investment gains, significantly (by 20% to 50%) if they were to allocate capital more efficiently across their balance sheet. For a few companies, the potential gains could be very large.
What this Means for P&C Executives
In today’s low interest rate environment, P&C companies could be leaving a fair amount of money on the table if they do not manage their investment portfolios properly. This could lead them to misallocate capital across their business lines, while saddling them with a sub-optimal asset mix in their investment portfolio. The foregone income (including investment gains) could be very significant.
Alpharay Insurance Services specializes in optimizing capital for P&C companies. We can help P&C management ensure that the investment portfolio has the right asset mix, that their Investment Leverage is optimal, and that other important factors are properly managed so that capital is correctly allocated across all levels of the enterprise. Contact us to learn more.
Sources: Company filings