OCTOBER 7, 2013 PERSPECTIVES Enterprise Risk Management: Seeking Improved Profitability MARK WHITFORD, FSA, CERA, MAAA Senior Insurance Investment Risk Strategist Lead, Insurance Risk Advisory Practice Franklin Templeton Investments This information is intended solely for institutional investment management consultants interested in Franklin Templeton institutional investment advisory services. Various account minimums or other eligibility qualifications apply depending on the investment strategy. This material is not an offer to buy or sell securities or an offer of investment advisory services and is not intended to be, nor should it be used as, investment advice; it may not be copied or distributed without the prior written consent of Franklin Templeton Investments. Opinions expressed are current opinions as of the date appearing in the material only. The services described herein would be provided to insurance companies or accounts of, or affiliated with, insurance companies; such services would not provide any insurance or guarantee for the subject asset principal value will fluctuate and may be lost. All investments are subject to risks and investment strategies may not achieve the desired results. Investments with greater potential for return typically have more risk. EXECUTIVE SUMMARY Health insurance providers are under intense pressure to maintain margins and profitability in the face of increasing competition and anticipated regulatory changes. Moreover, because for-profit companies had the lowest medical loss ratios prior to the Affordable Care Act (ACA) minimum medical loss ratio (MLR) requirements, we believe they stand to be most affected by the changes. With liability durations of only one to three months, for-profit insurers will need sufficient cash on hand to pay claims. Investment portfolios can sometimes provide up to 40% of profitability, but in the current low interest rate environment, generating even the same amount of investment income as in the past has become a challenge. The goal for our enterprise risk management (ERM) analysis is to help health insurance providers improve the efficacy of their investments by providing an in-depth analysis of risk on both the liability and asset sides of the balance sheet. Our ERM analysis of for-profit insurance providers has led us to believe there is ample room to increase potential income levels by selectively adding risk to investment portfolios. For-profit companies typically invest a greater proportion of their asset base in cash and bonds rather than equities; however, as the invested asset base grows, there tends to be an increase in allocations to riskier asset classes along with a corresponding decrease in the average portfolio rating. With bond yields in decline over the last decade, opportunities to invest for yield have diminished. If this trend persists, we believe investment income levels could decline further unless risk tolerance levels are re-evaluated and the credit quality of investment portfolios is adjusted accordingly. High-yield corporate bonds, bank loans, securitized mortgages or income-producing equity securities may represent an attractive option for potentially improving current income while remaining within a targeted risk spectrum. As companies increasingly rely on income from investments to maintain margins and profitability, we suggest that the need for proper evaluation of the composition and risk level of their investment portfolios is becoming more urgent. We believe companies in the health insurance industry should consider the potential benefits of ERM as they seek to enhance margins and meet the financial and regulatory challenges that lie ahead.
FRANKLIN TEMPLETON INVESTMENTS PERSPECTIVES 2 THE PROFITABILITY SQUEEZE Increasing competition and expected regulatory changes in the health insurance industry are placing significant pressure on margins for providers. The challenge lies in finding ways to improve margins while maintaining appropriate liability coverage and capital ratios. While increasing the asset base may seem like a daunting task, we believe enterprise risk management (ERM) analysis can provide valuable insights and a path toward implementation by employing a holistic view of risk that includes both the asset and liability sides of the balance sheet. Our ERM analysis of health insurance companies leads us to believe they have an opportunity to potentially increase investment income by selectively raising risk tolerance levels. Our methodology and results are set out in this paper, which focuses primarily on for-profit health insurers. THE FOUNDATION Risk-Based Capital We suggest ample room exists to potentially increase income levels by selectively adding risk to investment portfolios. Our analysis is based on an initial review of risk-based capital (RBC). The importance of RBC ratios is twofold: Insurance companies must maintain a minimum amount of capital on the balance sheet to remain in business and avoid increased regulatory scrutiny. Comparing RBC ratios across a competitive set provides a measure of risk tolerance, particularly when evaluating a company relative to other insurers of similar size and type. Since 2011, the industry has on average returned to pre-2008 RBC ratio levels. As shown in Figure 1, for-profit companies target the lowest RBC. Ratios, as defined by invested asset base, vary by company size, with larger for-profit companies tending to have higher RBC ratios than smaller companies. Figure 1: RBC Ratios RBC Ratios by Year RBC Ratios by Company Type 800 775 750 725 700 675 650 625 600 575 550 525 500 2006Y 2007Y 2008Y 2009Y 2010Y 2010Y 2011Y 2011Y 2012Y 2012Y For-Profit Nonprofit BCBS Companies 1,300 1.200 1,100 900 800 700 600 500 400 Below $100M $100M $250M $250M $500M $500M $1B $1B $2B $2B $5B $5B For-Profit Nonprofit BCBS Companies In the 2010 National Association of Insurance Commissioners (NAIC) report on RBC results for health insurers, underwriting risk was not surprisingly listed as the largest component of the ratio at 79.4%. More intriguing from our perspective, however, was the discovery that investment risk, which accounts for a significant portion of total income, comprises a much smaller component of total RBC only 4.3%. Another unexpected finding was the contribution breakdown. Fixed income, in which the majority of invested assets is held, contributes less than 1% of RBC as opposed to 1.62% for common stock and 1.70% for other assets. HO Affiliate Asset Risk 13.9% H1 Invested Asset Risk 4.3% H2 Underwriting Risk 79.4% H3 Credit Risk 0.3% H4 Business Risk 2.1%
FRANKLIN TEMPLETON INVESTMENTS PERSPECTIVES 3 We next considered the liability side of the balance sheet and possible implications for the invested asset base. LIABILITY RISK ANALYSIS Medical Loss Ratio Medical loss ratios (MLRs) tend to differ by company size, resulting in varying levels of risk tolerance. The average MLR of for-profit companies is 86%. Analysis of liabilities-related risk management activity focuses on the MLR. In 2010, the Affordable Care Act established minimum MLR requirements, providing further incentive for companies to devise methods for offsetting the loss in underwriting margins and mitigating the increase in associated risks. From the perspective of enterprise risk management, a higher MLR indicates lower underwriting margins, suggesting to us: Greater reliance on investment income for profitability or pressure to lower administrative expenses. A higher probability of writing business at a loss, which can heighten liquidity and operational risks. Figure 2 compares MLRs of for-profit companies of various sizes over the past seven years. For the majority of companies surveyed, MLRs in 2010 and 2011 were lower than the previous four-year average. In 2012, we saw an increase in the MLRs. Figure 2: Medical Loss Ratio (%) For-Profit 94% 92% 90% 88% 86% 84% 84% 82% 80% 78% Below $100M $100M $250M $250M $500M $500M $1B $1B $2B $2B $5B $5B 2006 Y 2007Y 2008 Y 2009Y 2010Y 2011Y 2012 Y Capital and Surplus Ratio MLR and RBC ratios vary by company size and type. Our analysis shows that a meaningful relationship appears to exist between company size and the amount of liabilities written for a given level of surplus. We observe a meaningful difference in the level of business companies are willing to underwrite or generate for a given level of capital and surplus (Figure 3). Liabilities consisting primarily of claim reserves related to the amount of business written by a company range mostly between 80% and 100% of capital and surplus. The largest companies tend to write even greater amounts; for example, a company with $100 million in assets and $50 million in liabilities would have $50 million remaining for capital and surplus, equating to a 100% ratio. In general, capital and surplus ratios increase with company size. Ratios for smaller companies tend to hover around 80% or 80 cents in liabilities for every dollar of capital on the balance sheet. Larger companies with ratios near 105% assume additional risk; however, they appear comfortable with writing relatively more business and holding relatively less capital for protection against adverse deviations in claim reserves.
FRANKLIN TEMPLETON INVESTMENTS PERSPECTIVES 4 Figure 3: Liabilities/Capital and Surplus (%) 160 150 140 130 120 110 100 90 80 70 60 0 100M 100 250M 250 500M 500M 1B 1B 2B 2B 5B 5B and Turning to the asset side of the balance sheet, ERM analysis focuses on the risks inherent in investment portfolios, including liquidity and credit characteristics as well as the composition of the invested asset base. Liquidity Risk Larger companies appear to have a greater tolerance for holding more illiquid assets than do smaller companies. Health insurance companies are justifiably concerned about managing liquidity risk. Health care is considered a short-tailed line of business; liability duration tends to be less than two months, with net cash flows premiums and investment income less claims and expense close to zero or even negative at times. To manage this risk, companies often maintain two portfolios, one for operations and the other for investments. Asset duration for the operations portfolio, which handles day-to-day cash needs and manages liquidity, is typically three months. In contrast, the investment portfolio tends to have a much longer duration of three to four years. Several factors must be considered when measuring liquidity risk, but we believe two are especially important for health insurance providers: Type of business written: For example, to our knowledge, health maintenance organizations (HMO) claims settle much more quickly than preferred provider organization (PPO) and point-of-service (POS) claims. Growth in claim reserves: Claim reserves generally grow on an annual basis, due in part to annual medical rate increases and growth in membership. Monthly fluctuations can sometimes lead to declines in reserves as deductibles and out-of-pocket maximums are satisfied. Companies with year-over-year growth of reserves tend to have lower liquidity needs, as cash inflows to pay future claims generally surpass cash outflows. 1 Credit Risk We believe for-profit companies are likely to invest a greater proportion of their asset base in cash and bonds, rather than equities. Credit risk can have a major impact on total investment returns for health insurers, as was demonstrated in 2008 at the height of the global financial crisis. When evaluating credit risk, it is important to remember that health insurers base their investment strategies partly on the objectives of their stakeholders. For-profit insurers tend to consider shareholders and stock analysts, who prefer companies with steady growth in net income and low earnings volatility. Consequently, companies are likely to invest a greater proportion of their asset base in cash and bonds, rather than equities. We categorize risky asset classes as high-yield bonds, common stock, real estate and other investments that typically include amounts invested in hedge funds, bank loans and private equity. Figure 4 compares the percentage of surplus that health care companies invest in these riskier asset classes. Figure 4: High Risk Assets as a % of Adjusted Surplus For-Profit Companies 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 0 100M 100 250M Unaffiliated Common Stock 250 500M 500 1B 1B 2B 2B 5B 5B or more Real Estate High Yield Other Invested Assets Investment Risk Comparison For-profit companies typically invest primarily in bonds, followed by a move into equities and other investments. As the invested asset base increases, there tends to be a corresponding increase in allocations to riskier asset classes and a decrease in investment in cash and bonds. 1. Our analysis of risk tolerance levels related to liquidity showed that larger companies tend to have lower current liquidity ratios (calculated as cash and liquid assets as a percent of liabilities) than smaller companies.
FRANKLIN TEMPLETON INVESTMENTS PERSPECTIVES 5 In addition to evaluation of liquidity and credit risks, a review of investment portfolio composition also reveals several interesting themes. Figure 5 compares the asset allocation decisions of health insurance companies by size. Figure 5: Asset Allocation (%) For-Profit Companies 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 0 100M 100 250M 250 500M 500M 1B 1B 2B 2B 5B 5B and Cash, Cash Equivalent and Short Term Assets (%) Bonds (%) Mutual Funds (%) Equities (%) Other Investments (%) Bond Allocations The average portfolio rating tends to decrease as the invested asset base increases. Examination of bond portfolios in isolation provides further evidence of the relationship between risk tolerance and invested asset base (Figure 6). As the invested asset base increases, the allocation to NAIC1-rated bonds (AAA through A) declines, while the allocation to NAIC 2 (BBB) and NAIC 3 through 6 (high-yield) bonds rises. Figure 6: 2012Y Bond Rating Distribution (For-Profit Companies) 100 90 80 70 60 50 40 30 20 10 0 0 100M 100M 250M 250M 500M 500M 1B 1B 2B $2B $5B 5B and NAIC 1 NAIC 2 NAIC 3 6 IN SEARCH OF YIELD Recent capital market trends may drive further changes in asset allocation decisions and risk tolerance levels. Opportunities to invest for yield have diminished. With the exception of the 2008 crisis period, bond yields have declined meaningfully over the last decade. Prior to 2008, an AAA-rated security yielded approximately 4%; today, the same security would yield closer to 2%. If this trend persists, we believe investment income levels could continue to decline unless risk tolerance levels are re-evaluated and the credit quality of investment portfolios is adjusted accordingly. Health insurers seeking to boost investment income in an environment of diminishing yields may benefit from a shift in asset allocation to potentially higher-yielding opportunities such as high-yield corporate bonds, bank loans, securitized mortgages or incomeproducing equity securities, which may produce yields ranging from 3.5% to over 7%, though they present greater risk. We believe these asset classes may represent an attractive option for improving current income while remaining within a targeted risk spectrum. UNCOVERING OPPORTUNITIES WITH ERM Against a backdrop of increasing pressures on profitability spurred by growing competition and regulatory changes, health insurance companies face the challenging task of improving margins while maintaining appropriate liability coverage and capital ratios. As companies rely more on income from investments to meet the financial and regulatory challenges ahead, we expect the need for proper evaluation of the composition and risk level of investment portfolios to become more urgent. Our ERM analysis has led us to believe there is an opportunity to increase profitability by selectively adding risk to the investment portfolio just one demonstration of how ERM s holistic approach can provide a suggested path forward. The process of balancing the drivers of both assets and liabilities can be challenging. In skilled hands, however, enterprise risk management holds the potential to support the evolving needs of growing companies, particularly in a dynamic financial and regulatory environment. We believe companies in the health insurance industry should consider the potential benefits of ERM as they seek to enhance profitability and meet the financial and regulatory challenges that lie ahead.
FRANKLIN TEMPLETON INVESTMENTS PERSPECTIVES 6 Increasing Liquidity and Profitability with Federal Home Loan Bank Borrowing Programs To reduce allocation to low-return cash-equivalent investments and increase investment income, many health, life and property and casualty (P&C) insurers manage their liquidity requirements through Federal Home Loan Bank (FHLB) funding. Formed in 1932, the government-sponsored Federal Home Loan Bank provides a readily available, low-cost source of funds in a wide range of maturities. Currently, more than 282 insurance companies are members of the FHLB, with aggregate borrowing in excess of $54.5 billion. 2 Advances to member institutions are based on the security of collateral pledged, typically government securities and mortgagerelated assets. To be eligible to borrow, a financial institution must first become a member and purchase FHLB stock. Shares are nonmarketable and dividend rates vary. Because the stock is redeemable only at par (subject to a waiting period, it is not subject to market volatility and typically carries a lower ratingagency risk charge. 3 We feel that FHLB funding, compared with Treasuries, enhances both the size and risk level of the invested asset base (Figure 7). Figure 7: FHLB Fixed-Rate Advance and Treasury Curve 6.0% 5.0% 4.0% Yield/Rate 3.0% 2.0% 1.0% 0.0% 0 5 10 15 20 Duration FHLB Advance Rate Treasuries Source: FHLB Boston, Treasury.Gov. Some rates linearly interpolated. As of 7/10/13. 2. Source: Federal Home Loan Bank, Combined Financial Report for the Quarterly Period Ended 6/30/13. 3. Source: Federal Home Loan Bank Office of Finance, Lending and Collateral Q&A, published 8/13/13. IMPORTANT LEGAL INFORMATION This article reflects the analysis and opinions of the author as of October 7, 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided are valid only as of October 7, 2013. The commentary does not provide a complete analysis of every material fact regarding any country, market, strategy, industry or security. An assessment of a particular country, market, security, investment or strategy may change without notice and is not intended as an investment recommendation nor does it constitute investment advice. Statements about holdings are subject to change. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Franklin Templeton Investments One Franklin Parkway San Mateo, CA 94403-1906 (800) 530-2434 www.franklintempleton.com DEALER USE ONLY/NOT FOR DISTRIBUTION TO THE PUBLIC 2013 Franklin Templeton Investments. All rights reserved. ERM_PROFIT 09/13