The Role of Risk Modeling in Volatile Financial Markets

Despite today’s formidable economic challenges, insurers and alternative investment managers must continue to increase and protect yields. Considering the uncertain future of interest rates, geopolitical pressures and other unforgiving economic conditions, insurance portfolio managers may be reassessing and revising investment strategies.

One approach to reassessment and revision is to focus on risk modeling, which allows investment managers to proactively and transparently solve for the most complex challenges in financial risk management. Rafa Mendoza-Arriaga, Ph.D. Director, Financial Risk Quantitative Research for SS&C Algorithmics, discussed this topic as it relates to the evolving investment environment during a recent webinar, where a distinguished panel discussed interest rates, emerging pressures on the economy and strategies for insurance investors to succeed through it all.  Here is a summary of Rafa’s comments on risk modeling and private credit for insurers and alternative investment managers.

 “We believe there will be an incentive to take a larger position into core fixed assets because some alternative assets may experience high risk, given the current uncertainty,” he begins.

“For example, say you have a real estate portfolio and interest rates go up. This is going to increase financing costs, especially for those portfolios based on floating rates. Some properties will have to be sold, and we may see an over-offering of real estate properties, so the price of properties may go down.

“This creates a lot of complex structure around how the market would move, so we need to be aware of some considerations that come from rising interest rates:

1. Increased uncertainty reflected in volatility: The Fed may increase rates and then take a wait-and-see stance, which can add to volatility — even without the Ukraine situation and the risk of a COVID resurgence.
2. Complex structural changes reflected in correlation: When interest rates are rising, collateral values may decrease, especially if the collateral is bonds. The value of the collateral will go down, requiring more collateral. That causes some liquidity frictions, so you also need to control some liquidity risks. Overall, given all of these complications, you need better collateral modeling—better risk management tools—including liquidity risk both in the funding liquidity and the market liquidity to help control these risks.
3. Modeling for inflation-linked securities: Another aspect we foresee is that usually during inflation many investment managers try to ‘catch’ inflation by acquiring inflation-linked securities.  However, the models for the dynamics of inflation are sometimes poor or nonexistent.  Inflation has been low and constant for a long time, so the evolution of these inflation grades—or levels—is hard to model. To succeed, we need better models to understand the impact of abrupt changes in rates and/or inflation. We also need better models to describe the dynamics of interest rates and how this affects different asset classes and credit risks coming from not being able to liquidate positions in time.”

For the full discussion, featuring expert commentary from leaders at Cardinal Investment Advisors, Apollo Global Management, Premera Blue Cross, and AEW Capital Management, access the full recording of “Rates are on the rise: How interest rate hikes may impact insurance and alternative investment strategies and portfolios.”