A Hypothetical Actuarial Risk Case Study

Making investment moves in a dynamic world Jennifer Li

Photo: iStock.com/CatLane

There are various definitions of actuarial risk, one of which is the assessment of risks by actuaries where the outcomes deviate from expectations, which potentially may lead to insurance insolvency or result in a mispriced product. One of the objectives of assessing actuarial risk is to provide an understanding of the potential financial impact of uncertain events and develop appropriate strategies to manage and mitigate those risks.

This article delves into actuarial risks pertaining to investment and asset adequacy analysis (AAA) through a case study of hypothetical Company XYZ. Through this theoretical situation, we can glean insights into concerns that may arise.

Case Study Introduction

Company XYZ, a U.S. life insurer, invests in many asset categories, including U.S. treasuries, agency bonds, public noncallable bonds, public nonconvertible bonds, callable bonds, floating rate notes, municipal bonds, private placement bonds, agency mortgage-backed securities (MBS), nonagency residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), collateralized loan obligations (CLOs), asset-backed securities (ABS), and commercial and residential mortgage loans. It also heavily relies on private equity (PE) investment. Company XYZ has established an investment policy that outlines risk appetite, asset allocation strategy and risk management practice, and it is subject to certain investment constraints such as duration, convexity and asset quality.

Company XYZ is considering investing as a limited partner in an existing venture capital (VC) portfolio of funds focused on early-stage, high-growth technology companies with an emphasis on artificial intelligence (AI). The company prefers this approach over establishing its own VC arm, as a VC arm is resource-intensive and doesn’t align with its core competencies. To manage the risks associated with fluctuating interest rates, the company utilizes interest rate swaps. Additionally, Company XYZ purchases volatility-linked products to protect against extreme market events. To hedge against downside risk while maintaining upside potential in a volatile market, it uses a dynamic options collar with spread enhancement. Furthermore, Company XYZ currently is talking with a PE firm that has expressed interest in partnering with it.

Company XYZ has performed AAA, including compliance with Actuarial Guideline 53 (AG53). All assets supporting liabilities reflected in AAA have been reported along with a table of assets split by Guideline Excess Spread (as defined in AG53), a breakdown of equity-like investments and a reconciliation adjustment provided to align third-quarter assets with the fourth-quarter National Association of Insurance Commissioners (NAIC) annual statement. The regulatory disclosures are consistent with the actual practice. A significant percentage of the initial assets are projected high net yield (PHNY, as defined in AG53) assets, and reinvestment assets also consist of PHNY assets.

Regarding reinvestment, the gross and net yields are higher than those of the initial portfolio. The reinvestment asset allocation materially differs from the initial asset allocation, and the reinvestment strategy appears aggressive. A significant portion of the modeled assets consists of complex assets such as PE, private placement bonds, agency MBS, nonagency RMBS and CMBS, CLOs and ABS. The market value of affiliated assets represents a material volume of the initial assets. The assumed net yields for both initial and reinvestment equity-like assets exceed 7%, and the assumed net market spreads for both initial and reinvestment nonequity-like assets are all higher than 3%. Company XYZ assumes relatively low default rates for complex assets and higher default rates for other invested assets such as callable bonds and floating-rate notes. Default rates for all invested assets appear low.

Margins are identified in the modeling of assets, and additional conservatism is assumed in modeling risks such as liquidity and credit risk. Because of Company XYZ’s inadequate history with complex assets, multiscenario modeling isn’t performed for risk consideration. Instead, Company XYZ applies a flat margin to reflect a moderately adverse condition over the life of the business. To determine an asset’s fair value, Company XYZ categorizes its assets into distinct groups based on the valuation techniques employed to measure their fair values. Company XYZ performs price verification on a quarterly basis. The fair values for most invested assets are considered best estimates because those assets don’t have a market-quoted price. Furthermore, Company XYZ ensures adherence to sound governance and has implemented a well-documented procedure for determining asset fair values.

Valuation of privately traded assets follows Company XYZ’s internal valuation policy. The same investment expense assumption is made for all asset classes. Company XYZ closely monitors the financial strength of each reinsurer and evaluates the likelihood of collection. In the event that a reinsurer becomes insolvent, fails to make necessary payments or falls below a specific rating determined by rating agencies, Company XYZ will recapture any business previously reinsured with them. Reinsurance modeling considers the terms of reinsurance and counterparty risk. All reinsurance treaties have counterparties that conduct AAA. Company XYZ indicates that borrowing (or any other disinvestment strategy) is not modeled in AAA.

Exploring the Critical Risks

Company XYZ has a significant portion of PHNY assets, implying a higher level of risk that is often associated with significant uncertainty. It can result from a lack of diversification, and it increases Company XYZ’s vulnerability to market volatility, decreases its ability to mitigate risk and may lead to liquidity challenges or asset/liability mismatch. As mentioned previously, the assumed net yields for equity-like assets exceed 7% and the assumed net market spreads for nonequity-like assets exceed 3%, possibly implying that Company XYZ is inappropriately reflecting asset risk. It may be necessary for Company XYZ to lower both net yield and net market spread to reflect the assets’ risk profile in AAA.

The volume of affiliated companies’ assets is material—it can lead to a concentration of risk and increase risk of contagion. Valuing affiliated company assets can be challenging, especially if they are privately traded or lack market liquidity. In addition, it raises concerns about potential insider dealing or conflict of interest. It can raise questions about the objectivity and fairness of investment decisions if key individuals within Company XYZ have personal interests or ownership stakes in the affiliated companies.

The reinvestment strategy appears aggressive and differs from the initial asset allocation in AAA. Company XYZ should review the reinvestment strategy to ensure reasonable consistency with the actual practice that is expected to occur over the long term. Company XYZ assumes relatively low default rates for complex assets such as CLOs and higher default rates for other invested assets such as callable bonds. This difference in default rate assumption may be due to the assumed asset quality. If the bonds are rated BBB, they are considered to have a higher default risk than higher-rated bonds, such as the senior tranches of their CLOs.

The senior tranches of the CLOs have a higher priority of repayment and lower default risk than lower-rated tranches or the equity tranches, resulting in their high credit rating. Assumed low default rates for all invested assets can lead to reserve inadequacy. Company XYZ can conduct sensitivity testing on defaults and evaluate the results to determine whether relatively small changes in default experience could potentially lead to asset inadequacy. Company XYZ uses the same investment expense assumption for all assets regardless of asset complexity, which is unrealistic. This can result in misleading estimates of asset adequacy and potentially affect investment decision-making. The company’s actuarial memorandum and AG53 report should include the rationale for setting the investment expense assumptions and provide adequate communication to demonstrate that the modeled expense assumptions are sufficient in AAA.

Company XYZ can perform a thorough analysis of the investment expenses for each asset class in the portfolio and identify the specific costs and fee structures (e.g., expenses required to purchase or sell assets, commissions, fees paid to internal staff or external parties) applicable to each investment. Then, they must clearly communicate the revised approach regarding investment expenses to any other parties involved and make the necessary adjustments for AAA.

Regarding fair value determination, it would be beneficial if Company XYZ could identify consistencies or differences between assets reported at fair value in the NAIC annual statement and the assets reported at fair value for AAA. It is reasonable to conclude that Company XYZ considers reinsurance collectability in its modeling. The company’s actuarial memorandum and AG53 report should provide a discussion around the collectability of reinsurance proceeds, conditions that prevent collectability and any impact of each counterparty’s decisions; a robust process of evaluating counterparty risk, thresholds or metrics used for measuring counterparty risk or other analysis of analyzing the impact of counterparty risk; and a list of risks reinsured and risks retained, including treatment in modeling.

Regulators aim to ensure that reinsurers hold sufficient quality assets to cover reinsurance claims, even under moderately adverse conditions. By not considering a range of potential scenarios for complex assets, Company XYZ failed to demonstrate the ability to pay future claims if complex assets do not perform as expected. This omission can lead to inaccurate assessments of asset adequacy. Because Company XYZ has a significant portion of complex assets, there are concerns about the accuracy and reliability of the modeling. Complex assets often involve intricate structures, nonstandard terms and unique features that can make Company XYZ‘s modeling challenging.

Assuming no borrowing (or any other disinvestment strategy) means that Company XYZ expects that liability outflows won’t exceed cash on hand. The inclusion of borrowing that occurs within a projection year between reinvestment periods in AAA enables Company XYZ to address short-term liquidity needs. In the modeling approach pertaining to negative cash flow scenarios and disinvestment strategy, Company XYZ can improve its model by assuming that cash is borrowed at a predefined rate—up to a borrowing limit or a certain percentage of general account assets. Once the borrowing limit is reached, the assets can be sold proportionally. The rationale behind setting the borrowing formula or assumption and any borrowing limitations should be documented. The borrowing rate is not lower than the rate at which positive cash flows are reinvested in the same period.

The valuation of privately traded assets follows Company XYZ’s internal valuation policy. To demonstrate the accurate valuation of nonpublic traded assets for AG53 requirements, it’s suggested that Company XYZ provide a few key pages of valuation policy; detailed governance to ensure the valuation accuracy, including an oversight committee and its duties within the company; and detailed reliance statements for other people, teams and audit firms involved in the process.

The interest rate inversion since mid-2022 may raise concerns about the effectiveness of interest rate swaps. Simultaneously, the implementation of long-duration targeted improvements (LDTI) under U.S. generally accepted accounting principles (GAAP) for life insurers has created new requirements, including the concept of a market risk-benefit (MRB) liability. Moody’s recent analysis of the 2023 Q1 reports of companies with relatively large legacy variable annuity books revealed that reduction in reserves more than offset losses on the hedges. That is, there’s a divergence in interest rate sensitivities between the MRB and their hedging targets.

The NAIC Valuation Manual Chapter 30 indicates that the interest maintenance reserve (IMR) “shall be used in AAA and analysis of risks regarding asset default may include an appropriate allocation of assets supporting the asset valuation reserve (AVR).” These AVR assets may not be applied for any other risk with respect to reserve adequacy. IMR and AVR act like a smoothing mechanism to avoid large fluctuations in surplus when looking at the statutory balance sheet. For negative IMR under a rising interest rate environment, U.S. regulators who met at the 2023 Spring National Meeting voted to change how insurers should recognize interest rate-related losses and adopt actions to establish statutory accounting guidance specific to the INT 23-01: Net Negative (Disallowed) IMR, allowing insurers to realize some of these losses over time. The change would expire at the end of 2025 and could encourage insurers to take more risks when hedging interest rates.

Implementing a dynamic options collar with spread enhancement is complex, as it involves many instruments, adjustments and active management that require a deep understanding of options, market dynamics and risk management techniques. Each adjustment or rebalancing of the strategy involves transaction costs such as commissions and bid-ask spreads. These costs can erode potential profits and affect the overall effectiveness of Company XYZ’s hedging strategies. Appropriate options contracts can vary with market conditions, making accurate predictions and timely adjustments challenging in a dynamic environment.

Additionally, these hedging strategies may not work for privately traded investments. The volatility-linked products can change dramatically in value within an extremely short time. They typically are designed to track short-term volatility, so the effectiveness in capturing long-term tail risk may be limited. It’s necessary for Company XYZ to consult with professionals and conduct periodic reviews to assess the effectiveness of these hedging strategies and make necessary adjustments to ensure the strategies align with the desired risk-return profile.

Company XYZ heavily relies on PE assets. PE fees are always higher than other investments, and these costs can potentially diminish profits. The company’s investment history is a clue for the potential upward pattern to its growth. However, PE investments with lower entry requirements or lower investment thresholds typically do not have extensive or long-established track records or histories. PE investment also presents substantial modeling difficulties. Concerns include available and reliable data, selection of appropriate assumptions and inputs, lack of transparency, complex cash flow patterns, accurate assessment of risks and model validation difficulty. To overcome these challenges, Company XYZ can perform modeling using the third-party vendor’s PE model, as the third party has many years of PE industry data.

A reliance statement related to the projection of the cash flows for these PE assets should be included in the actuarial opinion. Engaging with an external vendor to assist in PE modeling introduces third-party risk to Company XYZ. To protect sensitive information, operations and reputation, Company XYZ should implement a comprehensive program to manage these risks, such as careful vendor selection, conducting thorough security assessments, establishing reliable contractual agreements, implementing ongoing monitoring processes and so on.

Company XYZ is considering investing in a VC fund with a focus on AI. While investing in a VC fund could provide Company XYZ with an opportunity for high returns, these investments are high risk and may not align with the long-term stability typically associated with Company XYZ. Startups often have a high failure rate and lack a solid history of financial performance, which makes it challenging to evaluate their viability and their technologies. It’s important to consider whether a startup’s technique is solid and can be commercialized. Company XYZ should be prepared for the possibility of losing the entire investment in some companies. These investments may require significant time and effort to manage, including understanding the fund’s documentation, objectives, strategy and associated risks. Overinvestment could affect Company XYZ’s ability to fulfill its primary obligations to policyholders.

Diversification into this nontraditional activity introduces complexities and risks that require careful consideration, such as illiquidity, uncertain cash flows, capital calls, timing and duration mismatch, valuation and projection risks, and regulatory and compliance risks. Company XYZ should seek expert advice and engage in dialogue with stakeholders to ensure informed decision-making. If Company XYZ enters the VC market for the wrong reasons or without a clear and sustainable plan to extract value, it inevitably will face failure.

Company XYZ recognizes the benefits of teaming up with AI startups. In the 2023 legislative session, at least 25 states, Puerto Rico and the District of Columbia introduced AI bills, and 15 states and Puerto Rico adopted resolutions or enacted legislation. Moreover, the NAIC membership voted to adopt the model bulletin on the use of AI systems by insurers during the 2023 Fall National Meeting. If Company XYZ plans to utilize AI through either internal development or collaboration with external AI providers or startups, it must establish sound internal controls and reporting mechanisms to meet regulatory obligations and mitigate potential compliance risks.

A PE firm is interested in partnering with Company XYZ that allows the PE firm to inject capital into the business. The PE firm may see strategic synergies and interest in Company XYZ’s liabilities, which aligns with its more risk-tolerant investment approaches. However, this partnership could alter Company XYZ‘s culture and lead to a shift toward riskier investments, which in turn could raise concerns among regulators. Company XYZ must maintain effective communication with regulators, prioritize prudent risk management practices, highlight financial stability, present a well-defined long-term strategy that aligns with Company XYZ’s core values and supports its mission of protecting policyholders and demonstrate a willingness to collaborate with regulators to address concerns and implement any necessary safeguards. According to the latest Global Financial Stability Report issued by the International Monetary Fund (IMF), PE-owned insurers take more asset risks than other insurers and have shown a propensity to evade U.S. regulatory scrutiny through their use of offshore vehicles.

The Road Ahead

“One of the biggest PE-driven growth areas has been in offshore, Bermuda-domiciled life reinsurance assets, which currently exceed over $1 trillion, about 4% of total life insurance assets globally and up from less than $200 billion 10 years ago,” says the Global Financial Stability Report. The IMF is advocating for increased international regulatory scrutiny and emphasizing the need for enhanced international cooperation.

The Global Financial Stability Report indicates that life insurers have started to offload government and corporate bonds, while nonlifers and reinsurers have maintained their focus on short-term bond investments. The report suggests that life insurers may start to buy bonds again once they are certain that interest rates have reached their peak, thereby securing more favorable returns. The report also found that life insurers’ investments in alternative assets have been growing, both in absolute terms and relative to total investment.

As new research from BlackRock reveals, public fixed income will continue to be a core part of insurers’ strategic asset allocation, and insurers are planning to increase their allocations to private markets despite increased yield now available in public markets. The research also found that insurers were showing a bias toward quality and being more selective in their approaches.

Additionally, CLOs have been a popular investment for insurers. It is crucial for insurers to establish and maintain a robust risk management framework and provide comprehensive and easily understandable documentation to ensure transparency. Regulators aim to ensure that insurers don’t depend excessively on prospective investment returns to cover future claims. From a regulatory perspective, disclosure remains the most important and common issue. Insurers should provide sufficient clarifications and communication in the actuarial reports following Actuarial Standards of Practice (ASOPs), such as detailed explanations in the AG53 report on rationales for the assumed default rates, investment expenses, liquidity risk, prepayment risk, asset complexity risk, modeling of complex assets and governance.

Recent macroeconomic indicators suggest economic activity has been expanding at a solid pace. Inflation appears to be easing but remains elevated. According to the Federal Open Market Committee at its December 2023 meeting, the Fed will continue to reduce its holdings of Treasury securities, agency debt and agency MBS—and maintain the target range for the federal funds rate at 5.25% to 5.5%—to achieve the 2% target inflation rate. The evolving landscape presents an uncertain and volatile future, necessitating adaptability and strategic planning in investment decisions. This hypothetical exercise suggests that insurers should be cautious with their investment allocation and portfolio reallocation in an uncertain and dynamic market environment.


I would like to thank reviewers Bruce Friedland, FSA, MAAA; Xinyi Elina Zhu, CFA, and others for their valuable time, expertise and insightful feedback, which greatly improved the accuracy and quality of this article.

Jennifer Li, ASA, FCA, MAAA, is chief life, accident and health actuary at New Hampshire Insurance Department. She is based in Manchester, New Hampshire.

Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.

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