Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of economic losses due to adverse changes in the estimated fair value of a financial instrument as the result of changes in equity prices, interest rates, foreign currency exchange rates and commodity prices. Our consolidated balance sheets include assets and liabilities with estimated fair values that are subject to market risk. Our primary market risks have been interest rate risk associated with investments in fixed maturities and equity price risk associated with investments in equity securities. We do not have material exposure to foreign currency exchange rate risk or commodity risk.
Interest Rate Risk
Our fixed maturity and preferred stock investments and borrowings are subject to interest rate risk. Increases and decreases in interest rates typically result in decreases and increases, respectively, in the fair value of these financial instruments.
The majority of our investable assets come from premiums paid by policyholders. These funds are invested predominantly in high quality corporate, government and municipal bonds with relatively short durations. The investment portfolio has an average duration of approximately 4.0 years at December 31, 2021, and fixed maturity securities and preferred stock investments in the portfolio have an average rating by at least one nationally recognized rating organization of “AA-”. See Note 2 to the Notes to the Audited Consolidated Financial Statements for disclosure of contractual maturity dates of our fixed maturity portfolio. The changes in the estimated fair value of the fixed maturity portfolio classified as available-for-sale are presented as a component of shareholders’ equity in accumulated other comprehensive income, net of taxes.
We work to manage the impact of interest rate fluctuations on our fixed maturity and preferred stock portfolio. The effective duration is managed with consideration given to the estimated duration of our liabilities. We have investment guidelines that set targets for average duration and maturity.
Our investment manager employs a model to estimate the effect of interest rate risk on the fair values of our fixed maturity and preferred stock securities and our bank loan participations. Our bank loan participations are primarily floating-rate debt, so their fair values are less sensitive to changes in interest rates than our fixed maturity and preferred stock securities. The model estimates the impact of interest rate changes on a wide range of factors, including duration and prepayment. Fair values of borrowings are estimated based on the net present value of cash flows, using a representative set of possible future interest rate scenarios. The model requires that numerous assumptions be made about the future. To the extent that any of the assumptions are invalid, incorrect estimates could result. The usefulness of a single point-in-time model is limited, as it is unable to accurately incorporate the full complexity of market interactions.
The following table summarizes our interest rate risk and shows the effect of hypothetical changes in interest rates as of December 31, 2021. The selected hypothetical changes do not indicate what could be the potential best or worst case scenarios.
As of December 31, 2021
Estimated
Fair Value Hypothetical
Change in
Interest Rates
(bp=basis points) Estimated
Fair Value after
Hypothetical Change
in Interest Rates Estimated
Hypothetical Percentage
Increase (Decrease) in
Fair Value
($ in thousands)
Total fixed maturity and preferred stock investments $ 1,741,173 200 bp decrease $ 1,879,827 8.0 %
100 bp decrease 1,818,093 4.4 %
100 bp increase 1,663,436 (4.5) %
200 bp increase 1,585,701 (8.9) %
Bank loan participations $ 156,043 200 bp decrease $ 156,147 0.1 %
100 bp decrease 156,114 — %
100 bp increase 155,275 (0.5) %
200 bp increase 154,502 (1.0) %
Senior debt and junior subordinated debt $ 358,848 200 bp decrease $ 317,351 (11.6) %
100 bp decrease 338,099 (5.8) %
100 bp increase 379,596 5.8 %
200 bp increase 400,345 11.6 %
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Equity Price Risk
A portion of our equity securities portfolio is invested in common stocks, which have historically produced higher long-term returns relative to fixed maturities. The changes in the estimated fair value of the common stocks in our equity securities portfolio are recognized in net income .
At December 31, 2021, our common stock investments were concentrated in terms of the number of issuers and industries. Such concentrations can lead to higher levels of price volatility.
The following table summarizes the equity price risk related to common stock and shows the effect of a hypothetical 35% increase or decrease in the fair value of the common stocks in our equity securities portfolio as of December 31, 2021. We believe that this range represents a reasonably likely scenario, as the largest annual increases and decreases in the S&P 500 Index in the past twenty-five years were 31.0% (1997) and (38.5%) (2008), respectively. The selected hypothetical changes do not indicate what could be the potential best or worst case scenarios.
As of December 31, 2021
Estimated
Fair Value Hypothetical
Price Change Estimated
Fair Value after
Hypothetical
Change in Prices
($ in thousands)
Equity securities - common stock $ 44,798 35% increase $ 60,477
35% decrease 29,119