The Biggest Concern
Despite rising interest rates and a healthy economic outlook, insurers see few solutions for the prolonged low rate environment.
- TBA - Writer
- March 2018
The consultant did not need time to think.
Andrew Coupe did not hesitate.
After all, the top investment concern for insurers has not changed, the NEPC insurance specialist said in response to a question. The prolonged low interest rate environment, and the resulting earnings pressure it continues to exact, undoubtedly remains the insurance industry's most vexing issue in 2018.
And despite rising rates, the investing climate may not change for the foreseeable future as allocation options dwindle.
Moderate rate increases and macro forces such as a healthy job market, soaring equity markets before the February correction, pro-growth regulation, an anticipated rise in inflation and a lower corporate tax rate have and will aid the industry. However, they are not a respite in the near-term for beleaguered returns, observers say.
"The low rate environment is the primary risk that insurers have," said Coupe, a senior consultant for NEPC, an independent investment consulting firm with $984 billion in assets under administration. "Life insurers especially need to hit return targets to match policies. A low rate is certainly the biggest concern for them."
Although rates continue to rise--the 10-year rose to a four-year high of 2.89% in early February--they are nowhere near the levels needed to compensate for the low rates that resulted from the financial crisis.
Insurers are struggling to recover the margins of even a few years ago due to the roll-off in portfolios. Some projections indicate that the back end of the yield curve will increase only moderately in 2018. There is mounting concern that the bull market in bonds is ending or even has already ended and a bear market could be on the near horizon.
And investment options have shrunk dramatically after insurers shifted allocations to a broader range of asset classes to increase yield and maintain profitability since the crisis.
Those factors will force carriers to maintain their hunt for yield, observers say. That means continuing to push further out on the yield curve as well as dropping down in bond credit quality and exploring even deeper into alternative assets.
Rich Sega, Conning's chief investment officer, called rising rates "a relief valve, but it's not a solution to the problem."
"It's not really a sigh of relief because the challenge is still there, but it's definitely a step in the right direction," he said. "Even if rates rise, they're still at low levels compared to history. There's still downward pressure on the average earnings rate as the roll-off in the portfolio continues.
"This has been an asset side problem--the lack of investment income to support operations--but it really requires an enterprisewide solution," he said. "You have to continue to look for operational efficiencies, better underwriting results, distribution improvements. Our client base will be happy if rates rise and they are able to buy risk at a better price. But they're not looking at that as a panacea for the earnings pressure they feel."
The U.S. Federal Reserve's decision in December to raise rates for the fifth time since the crisis and the third time in 2017 does provide some optimism. And two to four more increases are predicted in 2018.
The Fed rate hikes help short-tail investments for some property/casualty companies. And a Dow Jones industrial average soaring above 26,000 before the market correction dropped it below 25,000, coupled with other macro forces are expected to increase yields in insurers' long-term investments.
However, yields in the bond market remain at depressed levels, a significant threat to the life insurers' fixed-income investments, capital and reserves and rate-sensitive products, such as fixed annuities and universal life.
Until rates rise markedly, insurers will have to continue their long-standing search for return.
"The stance that we've seen in the recent past--push, push, push for more yield--doesn't change," Sega said. "It's not going to recover the margins that were there pre-crisis certainly or even a few years ago when there were higher rates from old money in the portfolio. The pressure for yield will still be there even as rates rise."
Investing strategies have evolved by necessity since the crisis.
Insurers no longer can simply park their investments in highly rated, low-risk corporate bonds. Carriers have grown more comfortable with risk and broadened the range of asset classes they target in the search for yield.
For example, a shift to BBB-rated bonds has been widespread throughout the industry and represents a further credit risk concentration, according to a 2016 Conning study, Life Insurance Industry Investments: Where Are the Return Levers?
"There's been a progression from a fairly conservative, smaller asset class range to a much broader spectrum," Sega said. "As rates continued to fall, people pushed further out on the curve and dropped down in credit as far as they could go without taking too much risk. Then you look for the next thing.
"Core, general account portfolio assets were high-grade corporate bonds matched to your duration target. The bond market in general is lower rated now. BBBs are a much bigger portion of the index than they were 20 years ago. What's the next thing after extending duration and going down in credit? Well, it's spreading out across asset types."
The problem is many insurers already have exhausted potential levers.
Few untapped allocation options remain that meet insurers' risk profiles. And each time investors discover the next promising asset class, global demand drives up prices and pushes down return.
As a result, it takes increasingly higher levels of asset earnings rates to keep investment income and operating earnings flat.
"There's not a lot more places to go," Sega said. "I don't really see the next place to go after this. We pretty much got all of the various levers that we can, moved. We moved them to the point where we wait for a reversal in the cycle and do it all over again."
The new investment strategies are here to stay in the short-term--and maybe beyond. Insurers' risk profiles have changed. And rating agencies have recognized the demand for income and improved their risk measures to assess carriers' ability to take those risks, Sega said.
"Every basis point increase in yield, specifically for the life insurers, is a relief," Coupe said. "Our rate advice to insurers is any dry powder that you have, take advantage of. And any increase in yield should be jumped on because we're not projecting that there will be a long-term increase in interest rates."
Coupe pointed to 2017 as "a great example" of how insurers have exhausted most options.
"Look at structured securities. Look at real estate debt. Those are two examples where there was some value in the market and that have ground tighter over 2017," he said. "We expect that to continue. The plain vanilla beta-type exposures, those levers are really starting to run dry now.
"Some insurers have taken a toe-in-the-water approach," Coupe continued. "They would get involved in high yield, and then that maybe progressed to bank loans and that maybe progressed to additional equity and finally to some alternative credit-type assets. Those simple opportunities now are very, very difficult to find."
But options do exist.
Collateralized loan obligations still offer good yield for their relative duration, Sega said. High dividend equity, private placement bonds, private equity and emerging market debt and equity also present opportunity.
Meanwhile, interest continues to rise in commercial real estate among smaller insurers, whether through direct ownership of property or through a commercial lending operation.
"We are speaking to clients about the more tactical opportunities and things in the true alternative and private markets space," Coupe said, "where insurers really do need to understand what they're investing in, and it's not a simple decision to pull the trigger.
"It is possible there will be short-term dislocations and some movement in the market," he continued. "And insurers should be ready to jump on those opportunities as they arise. It's actually one of the thematic points that I would want to make to clients: One of the most important things when it comes to investing is ensuring that insurers have the governance policies in place that will allow investment teams to take advantage of any of the dislocations."
Despite rather flat rates on the long end of the yield curve, pro-growth forces are in place that likely will drive them up, Sega said.
He predicts a wave of regulation reform soon will hit the financial and banking sectors. A healthy job market carries its own benefits: Every new position brings with it insurance demands such as health and life.
The long-discussed federal infrastructure package also could be a boon. However, it would require significant government backing, such as the Build America Bonds program, which produced long-tailed, high-quality bonds in the aftermath of the financial crisis.
And if the economy continues to grow, Sega sees an opportunity in removing some risk from portfolios at a relatively low cost by injecting capital into shorter durations. Such a strategy would better position insurers when rates rise.
"People seeking yield the last few years have been seeking duration and gone down in quality," Sega said. "This is an opportunity to pull in those reins without costing too much. The curve is pretty flat, so by putting new money in place at shorter durations, you don't give up a lot.
"It's pulling back on that risk lever, which I think is a good idea and will put us in a good position over time. The questions are: How long does it take? How much earning pressure is there in the meantime?"
However, concern does exist over sluggish inflation, that flattening yield curve and just how much longer the three-decade-old bull market in bonds will last.
Some Fed policymakers pointed to inflation once again failing to meet its 2% target. However, that concern has abated a bit.
Meanwhile, geopolitical threats in North Korea and the Middle East, opposition to the Trump administration's pro-growth agenda and the potential for a populist backlash could dampen optimistic economic outlooks, Sega said.
The flattening yield curve was another concern raised during recent Fed meetings.
In December, A.M. Best noted it creates the "potential for asset and liability management mismatches given the disincentive to match duration as the curve flattens," it said in Best's Briefing, Market Segment Outlook: Life/Annuity. In the briefing, A.M. Best affirmed its negative outlook for the U.S. life/annuity industry. "The trend of declining portfolio yields continues with a decline of roughly 59 basis points in 2016 and a further decline anticipated for the full year 2017."
Another complication is the growing concern that the bull market in bonds may already have ended.
A Treasury sell-off in October drove the yield on the 10-year U.S. Treasury note to a seven-month high of 2.44%, further fueling the potential that a bear market could be on the near horizon. Then in February, yields on the 10-year rose above 2.8%.
Of course, the yield was 4.7% at the start of 2007.
Coupe noted that while the government's intervention in the market has buoyed the post-crisis credit cycle longer than normal, history shows that developed economies typically don't go much longer without another credit event.
NEPC has advised insurers to "be very wary of credit exposures at this point" and reevaluate "where they have moved down in quality in recent years to ensure that they're not surprised in an adverse credit event," Coupe said.
Sega agrees the bond market may be in transition.
"When that turns, if it turns--we might be on the verge of that now--how do people deal with that?" he said. "Up to now, portfolios mostly marked above water, the trades have continued to go down, the credit spreads have been at generational tights or near for a long time. Insurers will have to change their mode of management a little bit.
"So if we get into a situation where credit starts to back off a little bit, credit spreads start to widen, how do people manage that risk on their balance sheet? We're very sensitive to credit fundamentals, and I think that's the kind of market we're going to be in once rates start to rise."
However, Sega does not think the flattening curve is a precursor of recession. Instead, he says it is the result of the central bank's careful "engineering" of the economy since the crisis.
Recent tax reform could provide a boost to capital spending. Although each insurer's individual situation will dictate the impact, the corporate rate reduction from 35% to 21% will help many.
"There is an opportunity to participate in better growth and better yields" with the Fed shrinking its balance sheet, Sega said.
By Jeff Roberts, senior associate editor: firstname.lastname@example.org