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A Real Fix for Credit Ratings

August 8, 2014 Comments off

A Real Fix for Credit Ratings
Source: Brookings Institution

The failure of credit ratings agencies to do their job – warn investors of the true risks entailed by the subprime mortgage securities they rated – was at the heart of the financial crisis. Policy makers since have wrestled with how to “fix” the ratings process going forward. Although the Securities and Exchange Commission has required the agencies to disclose more of their methodology, the ratings process is still less than transparent. The issuer-pay rating agency business model has been criticized as a central cause and new agencies designated by the SEC after 2008 moved away from this model, though they have since moved back. Various additional ideas to fix the system have been put forward but none has been adopted: randomizing the choice of ratings agency, or replacing private ratings with those of a public agency, such as the Securities and Exchange Commission.

Faulting the issuer-pay model for the Crisis, which has been in continuous use for more than 40 years cannot explain the sudden explosion and subsequent collapse of the securitization market, which occurred over a much shorter period. We offer a different approach here: by showing how the absence of a single, numerical, public structured credit scale to serve as a yardstick of structured credit quality in the U.S. debt capital markets provides a more plausible explanation for the problems in structured finance in particular. Transparent, numerical benchmarks of credit risk relating to structured credits should not only fix structured finance going forward, and ideally help resuscitate the market but in a more sensible fashion. In addition, we will argue that such benchmarks also are a necessary component to a prudent system of capital regulation and for accurately informing investors of true credit risk, just as speed limits are a necessary component of vehicular traffic regulation.

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Source of Weakness: Worrisome Trends in Solvency Regulation of Insurance Groups in a Post-Crisis World

August 8, 2014 Comments off

Source of Weakness: Worrisome Trends in Solvency Regulation of Insurance Groups in a Post-Crisis World
Source: Brookings Institution

The regulation of insurer financial strength in the United States historically has focused on a fundamental principle: that the premiums and capital of any insurer are meant to pay the claims of that insurer’s policyholders and not to be drawn on to rescue a failing affiliate within the same group. This is a customer-centric approach, based on the individual insurance contract that is issued by a separately capitalized insurer for a specific period of time, in which the premiums charged are regulated based on that issuer’s solvency position and the risk assumed under that contract.

Since the financial crisis, however, international financial bodies, including the EU, have been pressing U.S. policy makers to adopt the EU’s very different approach toward insurance regulation for globally and systemically important insurers, and potentially for all insurers, borrowing from the banking industry the notion of “group capital” regulation. This latter approach ignores the legal separateness of the different entities belonging to the same group and makes all parts of a banking group financially responsible for each other, through the so-called “source of strength” doctrine for holding companies and “cross-guarantee” requirements for bank subsidiaries. In effect, group capital regulation is creditor-centric, and potentially ignores the specifics of individual insurance contracts.

Insurance Megatrends

August 5, 2014 Comments off

Insurance Megatrends
Source: Oxford Economics

Insurance carriers today face a significantly transformed claims environment, one in which tech-enabled consumers, rising customer expectations, and increased regulatory scrutiny are demanding that companies respond even faster to customer claims. The aftermath of Superstorm Sandy on the East Coast vividly demonstrated that carriers that respond quickly and comprehensively to catastrophic incidents can boost their reputation in the marketplace, gain market share, and retain customer loyalty.

This paper, produced in collaboration with Sutherland Global, documents how the growing “need for speed” in claims processing can increase pressure on people, systems, and back-office processes, and suggests actions and tools to help contend with the quickening demands of the insurance marketplace.

Free registration required to access report.

Practical Considerations for Factor-Based Asset Allocation

August 5, 2014 Comments off

Practical Considerations for Factor-Based Asset Allocation (PDF)
Source: McGraw-Hill Financial

Much has been written about the shortcomings of the traditional approach to asset allocation. Traditional asset allocation policies can typically be characterized by relatively static asset allocation and by diversification across asset class building blocks. As asset class returns are largely driven by common risk factors such as growth and inflation, traditional balanced portfolios can be poorly diversified, with a pro-cyclical growth bias that may lead to significant drawdowns and losses in the event of market turmoil. Against this backdrop, there has been an emerging shift, especially among institutional investors, toward more dynamic asset allocation, hinged on diversification across risk factors.

This being said, most investment portfolios are still constructed on the basis of direct asset class exposure and, as yet, it may not be feasible for investors to apply a factor-based asset allocation framework to implement their policy-level decisions. For this reason, more practical solutions are needed in order to allow investors to potentially incorporate risk factors in the portfolio construction process while accommodating their constraints and existing investment processes.

Exactly how risk factors should be included in the portfolio construction process is still a nascent area of research and is fiercely debated among practitioners. While there are numerous research papers that explore this topic, they tend to be theoretical, and it is for this reason that this paper has a stronger focus on the practical aspects of implementation. Rather than provide definitive answers here, we aim to share our reflections on this topic, following feedback from practitioners and discussions that took place in client roundtable events S&P Dow Jones Indices organized to promote dialogue with industry experts.

In this paper, we review three approaches of risk-factor-based portfolio construction and, using stylized case studies, discuss the investment rationale of the approach and remark on the issues that should be given consideration. First, this paper analyzes the use of risk parity on the asset class level as an approach to potentially reduce the concentration of equity risks in a traditional, balanced portfolio. Next, we examine how returns may potentially be enhanced or how risk may potentially be reduced by adopting alternate beta strategies—that is, strategies designed to capture both beta exposure from individual asset classes and systematic factors (such as value). Following that, we assess the feasibility of using risk premia portfolios, which involves taking long-short positions, to target systematic factors—a strategy used by some investors as a low-cost alternative to other absolute return strategies. Finally, we summarize our reflections on the trends in this area.

PwC and IRRC Institute Release New Cybersecurity Report; Offers Investors Strategies to Evaluate Risk Amid Opaque Corporate Disclosures

August 4, 2014 Comments off

PwC and IRRC Institute Release New Cybersecurity Report; Offers Investors Strategies to Evaluate Risk Amid Opaque Corporate Disclosures
Source: PricewaterhouseCoopers

A new report from PwC US and the Investor Responsibility Research Center Institute (IRRCi) indicates that while companies must disclose significant cyber risks, those disclosures rarely provide differentiated or actionable information. The report examines key cybersecurity threats to corporations and provides information to investors struggling to evaluate investment risk, business mitigation strategies and the quality of corporate board oversight.

The report suggests that investors focus on corporate preparedness for cyber attacks, engage with highly-likely targets to better understand corporate preparedness, and demand better and more actionable disclosures (though not at a level that would provide a cyber-attacker a roadmap to make those attacks).

The study suggests investors ask the following key questions:

  • Does the company have a Security & Privacy executive who reports to a senior level position within the company?
  • Does the company have a documented cybersecurity strategy that is regularly reviewed and updated?
  • Does the company perform periodic risk assessments and technical audits of its security posture?
  • Can senior business executives explain the challenges of cybersecurity and how their company is responding?
  • What is the organization doing to address security at its business partners?
  • Has the company addressed its sector-based vulnerability to cyber attack?
  • Does the organization have a response plan for a cyber incident?

The study also outlines common motivations for cyber-attacks, by industry sector, based on PwC experience…

New From the GAO

July 29, 2014 Comments off

New GAO Reports and Testimonies
Source: Government Accountability Office

Reports

1. USDA Farm Programs: Farmers Have Been Eligible for Multiple Programs and Further Efforts Could Help Prevent Duplicative Payments. GAO-14-428, July 8.
http://www.gao.gov/products/GAO-14-428
Highlights – http://www.gao.gov/assets/670/664671.pdf

2. 401(K) Plans: Improvements Can Be Made to Better Protect Participants in Managed Accounts. GAO-14-310, June 25.
http://www.gao.gov/products/GAO-14-310
Highlights – http://www.gao.gov/assets/670/664392.pdf

3. National Flood Insurance Program: Additional Guidance on Building Requirements to Mitigate Agricultural Structures’ Damage in High-Risk Areas Is Needed. GAO-14-583, June 30.
http://www.gao.gov/products/GAO-14-583
Highlights – http://www.gao.gov/assets/670/664517.pdf

4. Medicaid Financing: States’ Increased Reliance on Funds from Health Care Providers and Local Governments Warrants Improved CMS Data Collection. GAO-14-627, July 29.
http://www.gao.gov/products/GAO-14-627
Highlights – http://www.gao.gov/assets/670/665076.pdf

Testimonies

1. Screening Partnership Program: TSA Has Improved Application Guidance and Monitoring of Screener Performance, and Continues to Improve Cost Comparison Methods, by Jennifer Grover, acting director, homeland security and justice, before the Subcommittee on Transportation Security, House Committee on Homeland Security. GAO-14-787T, July 29.
http://www.gao.gov/products/GAO-14-787T
Highlights – http://www.gao.gov/assets/670/665067.pdf

2. Budget Issues: Opportunities to Reduce Federal Fiscal Exposures Through Greater Resilience to Climate Change and Extreme Weather, by Alfredo Gomez, director, natural resources and environment, before the Senate Committee on the Budget. GAO-14-504T, July 29.
http://www.gao.gov/products/GAO-14-504T
Highlights – http://www.gao.gov/assets/670/665090.pdf

3. Federal Real Property: Better Guidance and More Reliable Data Needed to Improve Management, by David J. Wise, director, physical infrastructure issues, before the Subcommittee on Government Operations, House Committee on Oversight and Government Reform. GAO-14-757T, July 29.
http://www.gao.gov/products/GAO-14-757T
Highlights – http://www.gao.gov/assets/670/665086.pdf

4. Tobacco Taxes: Disparities in Rates for Similar Smoking Products Continue to Drive Market Shifts to Lower-Taxed Options, by David Gootnick, director, international affairs and trade, before the Senate Committee on Finance. GAO-14-811T, July 29.
http://www.gao.gov/products/GAO-14-811T
Highlights – http://www.gao.gov/assets/670/665082.pdf

5. Medicaid: Completed and Preliminary Work Indicate that Transparency around State Financing Methods and Payments to Providers Is Still Needed for Oversight, by Katherine M. Iritani, director, health care, before the Subcommittee on Energy Policy, Health Care and Entitlements, House Committee on Oversight and Government Reform. GAO-14-817T, July 29.
http://www.gao.gov/products/GAO-14-817T
Highlights – http://www.gao.gov/assets/670/665070.pdf

6. Combating Nuclear Smuggling: Past Work and Preliminary Observations on Research and Development at the Domestic Nuclear Detection Office, by David C. Trimble, director, natural resources and environment, before the Subcommittee on Cybsersecurity, Infrastructure Protection, and Security Technologies, House Committee on Homeland Security. GAO-14-783T, July 29.
http://www.gao.gov/products/GAO-14-783T
Highlights – http://www.gao.gov/assets/670/665073.pdf

Retirement — How Much Should People Save?

July 29, 2014 Comments off

How Much Should People Save?
Source: Center for Retirement Research at Boston College

The brief’s key findings are:

  • The National Retirement Risk Index framework is used to address how much working-age households need to save for retirement.
  • A typical household should get a third of its retirement income from a savings plan, with the low income needing one quarter and the high income one half.
  • A typical household needs to save about 15 percent of earnings, with the low income requiring less and the high income more.
  • For those with a savings shortfall, the necessary savings hike is much more feasible for younger households than for older households.
  • Starting to save early and retiring late dramatically reduce a household’s required saving rate.
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