P/C insurers have an opportunity to increase book yield as short-term rates rise.
- Jeff Roberts
- November 2018
- Attractive Option: Floating rate assets such as collateralized loan obligations offer attractive yields and interest rate hedge.
- External Managers: Insurers continue to outsource to lower their expenses and to obtain expertise in asset classes they don’t have.
- Cyber Fears: The interconnectivity between markets and companies makes a cyberattack one of asset managers’ top fears—even if it’s among the least discussed.
The time for reinvestment is now if you're a property/casualty insurer.
Short-term rates are rising. Spreads are widening—at least a little. And while a flat yield curve potentially harbors bad news on the horizon (or maybe doesn't, depending on who you ask), there is finally the potential to increase book yield.
“For the first time in a decade—for sure on the P/C side and maybe a little less on the life side—we've got the opportunity to stabilize book yield or even increase book yield based on where reinvestment rates are today,” said Bill Rotatori, chairman and CEO of New England Asset Management.
Goldman Sachs Asset Management's Michael Siegel agrees.
“For property/casualty companies in particular, the flattening of the yield curve is beneficial with short-term rates rising,” said Siegel, global head of insurance asset management for GSAM. “So they're seeing their yields rise, which is good when they put new cash flow to work.”
But concerns remain beyond persistent low rates. Chief among them are the potential for an overly aggressive tightening policy by the Federal Reserve, an escalating global trade war and the threat of a cyberattack.
But the outlook remains largely benign for U.S. P/C insurers. Gross yield on invested assets in 2017 duplicated the 3.4% it recorded in 2016.
Rotatori and Siegel were among the panelists on a Best's Review P/C asset manager roundtable—joined by Randy Brown, chief investment officer of Sun Life Financial; and Lennart Carlson, managing director and portfolio manager at Conning—discussing rising rates, the approaching end of the economic cycle and the allure of floating rate securities.
What is the investing “state of the union” for P/C insurers?
Siegel: The investing environment continues to be benign. For property/casualty companies in particular, the flattening of the yield curve is beneficial with short-term rates rising. So they're seeing their yields rise, which is good when they put new cash flow to work.
The credit market also continues to be fairly benign. Credit spreads have widened out a bit, which is also good for reinvestment. Credit quality remains good. And given the strength of the U.S. economy—and it looks like it will continue to be a very good economy—we think credit quality will remain strong.
We see a continued movement toward private equity and real estate. We think that will continue. The monies moving to private equity are in part because companies are getting a lot of realizations or cash coming back from prior investments that they are simply redeploying into the market.
The final thing I would say is the flow of capital into the property/casualty industry continues. It's helping to promote continued merger activity, and we're seeing that activity. We think that that activity will continue. Just as an example: Last year was the worst year ever for claims expenses incurred by the global property/casualty industry. It's barely made a dent. It's just a sign of how well- or how overly capitalized the industry has been.
Bill Rotatori, New England Asset Management
For the first time in a decade… we’ve got the opportunity to stabilize book yield or even increase book yield.
What are the top investing trends you're witnessing among P/C companies?
Brown: Most P/C insurers are looking for incremental spreads in their asset portfolios. They typically are well-capitalized with a strong cash flow, but with competition on the liability side, many are looking for investment returns. So you're seeing very opportunistic investments such as alternatives to investment-grade fixed income. The story remains very much the same as we've seen for a while. But we're getting later in the cycle, and we're seeing more and more signs of late-cycle behavior both by issuers and by borrowers. Weak covenants. Heavy issuance. A lot of M&A and share buybacks. More strain on the credit metrics.
Carlson: Private securities exposure has increased a bit on the P/C side. Going forward, we're going to see shifts in the portfolio composition due to the tax law changes. We expect to see a pretty considerable decline over time in the tax-exempt municipal component of the portfolios. Historically, that's been about a third of P/C portfolios on average. And this will drop. That will be replaced by credit, structured and other taxable investment strategies.
With shorter duration P/C portfolios, we may actually now be approaching an inflection point for portfolio book yields. In this rate environment, the reinvestment rates on new investments are at least close to and in some cases exceeding the yields of some of the investments that are rolling off portfolios. It's reflective of the environment that we have been in and are still in right now.
Rotatori: We've had this 10-year erosion in book yield in both the life and P/C industry. For the first time in a decade—for sure on the P/C side and maybe a little less on the life side—we've got the opportunity to stabilize book yield or even increase book yield based on where reinvestment rates are today. We calculate the book yield in the P/C industry at about 3.25%, and on the life side it's about 4.25%. With the 10-year [Treasury note] hovering around 3%, there is a good opportunity to reinvest at rates that can stabilize that book yield or increase it.
Are insurers outsourcing more of their assets to external asset managers? Significantly so?
Siegel:The trends that we see toward outsourcing continue. We see companies moving to investment management platforms because they can lower their cost of investing or get into asset classes that they don't have the internal capability for.
Given today's economic climate, what specific investment strategies make sense for P/C companies?
Carlson:The floating rate characteristic of CLOs [collateralized loan obligations] can be attractive for P/C companies. And some companies may like that interest rate hedge or that inflation hedge. It's encapsulated in that floating rate security. With the combination of the rise in short-term rates—LIBOR [London Interbank Offered Rate] specifically—as well as attractive spreads in the CLO market, these offer relatively attractive yields.
Rotatori: We've seen pretty good value in the preferred stock market for P/C clients, but even for life clients as well. The issuers are dominated by banks, so it's mostly financial services companies that are issuing these securities.
You are down in the capital structure, so you're below the senior debt and subordinated debt at the preferred stock level, so the ratings tend to be low investment-grade to high below-investment-grade. But today we're looking at yields of 5.75% in an environment where the 10-year U.S. Treasury is hovering around 3%. We think it's pretty good value for that credit risk. They've really increased their Tier 1 capital since the financial crisis. So we feel the credit cushion is significant, and yet you're still being paid reasonably well to take that risk.
Siegel: We continue to like floating rate assets for our property/casualty clients. Those would be high-grade CLOs, bank loans, middle-market loans and other asset-backed securities that are priced off the short end of the curve. With the yield curve being so flat, they're really not giving up much at all by being at the short end. And they have the advantage to have the yields rise as the Fed raises interest rates. On a relative basis, they just look much more attractive than other assets out there.
We've been talking about low interest rates for 10 years, but here we still are. How much pressure does the low rate environment continue to inflict on P/C insurers' portfolios?
Rotatori:It's been a decade of dealing with lower rates and the pressure it's putting on portfolios. And insurance companies have been fighting a losing battle. In response to this yield environment, in the last 10 years, the P/C industry has taken their BBB and high-yield allocation from less than 10% to greater than 20% of their portfolio. And at the same time, they've taken their equity and [Schedule] BA asset allocations from around 20% to about a third of their portfolio.
Michael Siegel, Goldman Sachs Asset Management
Cyber in the financial markets is probably the greatest risk that’s least discussed. I think given the tremendous interconnectivity between the various firms and the central marketplaces, it’s quite susceptible to bad actors.
How important have ETFs and smart beta funds become for P/C companies?
Siegel: We see a greater adoption by the P/C companies in ETFs. I wouldn't call it dramatic, but it's definitely a trend that is gaining traction.
What is the biggest concern for insurers' portfolios? What keeps their asset managers up at night?
Brown: I'd say the biggest concern is the persistency of low rates. The secondary would be the relative tightness of spreads.
Carlson: There are a variety of concerns as we talk with our insurance clients. It's a combination of longer-term worries about being later in the cycle and potential recession down the road. At the same time, it's worrying about rising rates and having a portfolio that's properly positioned for that. Risk premiums are relatively fair to full across most risk asset classes. So it's very important that investors remember the need to stay disciplined and have diversification in their portfolios and the risk assets that they're investing in.
Rotatori: If we focus our thoughts on what really is the biggest risk out there and what we lose sleep over, it's the Fed. We're coming from an extraordinary level of accommodation, and now are seeing the reversal of that accommodation. We're going from quantitative easing—the program that took the U.S. Fed's balance sheet to over $4 trillion—and if we look at the big four central banks, their balance sheets collectively grew to over $16 trillion. That's just unprecedented levels of buying. And remember, that's an uneconomic buyer. And the Fed has begun to reverse that—quantitative tightening. The Bank of England is on hold. The European Central Bank is likely to be on hold by the end of the year, and the Bank of Japan is still buying. At some time this year, it will be the first time in at least five years where the central bank balance sheets of the big four are not in aggregate growing. We'll reach a point where that uneconomic buyer is more neutralized, and we worry about the reverse. Everyone called it an experiment on the way up. We're going to find out what kind of experiment it is on the way down.
Siegel: All asset classes are expensive, meaning that companies are not getting adequately paid for taking equity risk. They're not getting adequately paid for taking credit risk. Whenever you take on mispriced risk on a longer-term basis, it's not a healthy thing to do. The things that we're concerned about are what's going on in trade and whether that's going to have broader implications for the markets. We continue to watch inflation, because if inflation picks up, that will lead the Fed to raise rates more rapidly. And we continue to watch economies outside the U.S., Europe and China in particular—both the developed and the emerging markets.
What important issue is least discussed or understood?
Carlson: Cyberrisk, whether it's cyberterrorism, potential disruption of the banking system or major infrastructure systems. Businesses continue to deal with this constantly. But it is an issue that I think the investment community does not well understand, is not involved in closely and therefore has a hard time incorporating into their process of thinking about risks in the market. And it's also very difficult to price this. These large-scale cyber events may be a tail risk, but that does not mean they're not there. But it's also very hard to price into the markets on a day-to-day basis. It's both the probability and the severity of these events that make them very difficult to price.
Siegel: I think the impact of cyber on a company or on a market is understated. We game-plan for it, but we haven't really seen what it could really look like in a material way. It's just something that we continue to be concerned about and make sure that our own internal systems are strong. But it's not only us. It's the marketplace. Cyber in the financial markets is probably the greatest risk that's least discussed. I think given the tremendous interconnectivity between the various firms and the central marketplaces, it's quite susceptible to bad actors.
What's coming next? Where is the landscape headed in 2019? 2020?
Brown: Right now I see a benign environment. It's status quo until you get some exogenous shock that comes into the market. I'm not sure what the triggering event will be. But we do feel there will be one. It could be as the Fed raises rates. If you see inflation, that could lead to it.
Being late in the credit cycle, inflation, the Fed, spreads and alternative assets are the themes in the market. The other one to watch is foreign demand for U.S. securities. A big source of demand for U.S. fixed income has been non-U.S. buyers, and the reason was you had trillions of dollars in assets that were trading in negative yields in Europe and Asia. So they came into the U.S. market buying fixed income like government bonds and corporate bonds. You saw that die off a lot, and then it's rebounded a little bit. That's an important one to watch.
Carlson: We're still optimistic about the next couple of years. While growth will likely be a bit slower in 2019 and 2020 than 2018, we do think the U.S. growth story is intact.
Globally, the IMF is expecting 2.4% growth this year, a little bit slower next year—2.2%—and additional declines the year after . And there are certainly plenty of domestic and international issues that can and will likely inject some volatility into the markets. But we believe the fundamental backdrop remains supportive.
Siegel: We continue to think that this year and next year are going to be relatively benign. We think the economy is strong. And as long as the economy is strong, you're going to get good earnings, which are going to support equity values. And with a strong economy, companies are going to have strong cash flow, which is going to support credit.
But we continue to wait to see when that peters out, and when either inflation starts to rise or growth starts to slow significantly. That is when we think portfolios will need to be repositioned.