Where Investing for Float Makes Sense

This framing helps to capture additional value from insurance liabilities.

An insurance contract collects premiums and pays out benefits when a claim occurs. The insurer invests the proceeds, called float, bound by ALM and/or liquidity constraints but often managed separately from the liabilities. It has similar financial impact to taking out a loan for the insurer. Insurers have reserve and capital requirements, directly from regulators and indirectly to obtain a desired rating, with leverage defined as the assets under management (AUM) divided by economic capital. Policyholders in the US receive partial solvency protection from state-based guaranty associations who assess solvent insurers when an insolvency occurs. For an investor who can earn excess returns, insurance float can be a successful strategy.

Benefits and risks of float vary based on the type of insurance. For example, an auto policy collects premiums for a six-month period and pays out claims as they occur. A life insurance policy may collect premiums every year until death. The duration of the assets backing a block of these life policies is much greater than for a block of auto policies. Thinking of it like a loan, the cost of float is the underwriting loss (combined ratio above 100%), and an underwriting profit allows some insurers additional investment flexibility.

Short Duration Insurance

Property and health insurance reprices frequently so premiums collected are held for only a short time as claims are typically paid within a year. Reserves for future claims are not discounted with interest. Investments for a single policy need to be of short duration, but once the insurer has built a stable block of policies the law of large numbers allows investments to be longer while remaining liquid for conservatism if a rash of claims occur. A strategic focus on float makes sense. Typically, health insurers invest very conservatively, focusing on their specific expertise to manage liability risks.

Smaller firms, especially if they are geographically concentrated, buy reinsurance to offset large aggregate claims from a hurricane, fire or earthquake, but this leaves a smaller amount to invest so profit is based on liabilities rather than float. A large insurer or reinsurer has more assets under management and greater diversification from liabilities so can invest in more esoteric asset classes and accept greater ALM, credit or equity risk. Float may be key to their success.

The other investment strategy twist for short duration products is if their combined ratio is regularly less than 100%, creating an underwriting profit and implying less competition. Property insurance data for large insurers is credible for several years into the future, although climate change is driving claim trends higher. Investments for this type of business have more flexibility to break from ALM constraints and manage assets separately from liabilities. Most insurers continue to use high-quality fixed income but some take on more risk. This can be ALM (duration), credit or liquidity but stress tests can determine limits to this strategy that will maintain a sufficient cash flow stream.

Life Insurance and Annuities

Life insurers and long duration health and property writers typically write a variety of general account policy types. Annual renewable term life insurance has similarities to short duration property liabilities, but longer duration general account contracts like whole life have different characteristics. Premiums are typically level, so exceed what is needed in early years with a reserve liability set up. Policyholders have liquidity options using cash surrender values, leaving insurers susceptible to a run on the bank.

For life blocks, ALM becomes more important. Investment cash flow amounts and timing are key, so credit, liquidity and interest rate risks need to be managed. Solvency can be threatened by mismatched asset and liability cash flows, especially when leveraged. Models must consider assets with no cash flows until maturity, uncertain timing and amounts of cash flows, uncertain defaults and recoveries, and liquidity challenges. Assumptions should be conservative and not hide behind actuarial judgement when challenged. Net expected spreads (post defaults) for new asset classes that have not completed a credit cycle should not exceed those of similarly rated bonds. There is no free lunch. Higher spreads likely means that markets have identified a new risk. To protect policyholders float for life insurance blocks have tight ALM constraints so are poor candidates for aggressive investment strategies based on float or leverage.

The content of this newsletter is meant to be educational and thought provoking. Nothing in it should be interpreted as investment advice.

Fixed annuities convert a single premium into a stream of fixed payments. A product offered by new entrants and existing insurers offers pension risk transfer contracts that replace an employer sponsored defined benefit plan with a standard annuity contract. Since there are no incoming cash flows after issue, tight constraints to manage interest rates and conservative practices around credit risk are important. There are limited liquidity options for the policyholder. These products are fragile to longevity improvements and have high leverage due to a combination of high AUM and low capital requirements. This creates an incentive to seek out regulatory arbitrage opportunities, where capital lags the risk so returns appear outsized, and an interest in investing for float where both the risks and opportunities are high for the insurer.

Deferred annuities often collect a single premium and, marketed as alternatives to CDs, are expected to roll over into a new contract when the surrender charges expire. Annuity pricing is highly competitive, so the policyholder gets the benefit of investment expertise. Float as leverage has less benefit unless outsized risk is accepted via duration, credit or liquidity risks. Tight ALM constraints tied to product pricing makes it risky to make speculative investment bets using credit risk or timing risk from asset backed securities.

Where Does Float Make Sense Strategically

Large insurers with short duration business, especially those who generate underwriting gains from property/casualty business, can use float as an investment strategy to add value to shareholders. Life and health blocks, along with deferred annuities, are not good candidates. Due to the high leverage ratio associated with payout annuities (lots of AUM and little capital held) investors who believe they can anticipate interest rate movements could accept enterprise duration mismatches, thus making a bet. If correct they receive hefty bonuses, but if they are wrong it leaves policyholders reliant on guaranty associations. When new competitors introduce risky strategies that incumbent insurers need to mimic to remain in the market, insolvencies could lead to reputational risk for the industry. These practices increase fragility and are not resilient practices. For an industry that relies on client trust, reputational risk is systemic.