A Fog of Uncertainty
Participants in a Best’s Review investing roundtable view the prolonged low rate environment as continuing to put pressure on portfolios. Everything else is anyone’s guess.
- Jeff Roberts
- December 2019
- Stagnant Yields: Net yields remained largely static in 2018 for life insurers, falling to 4.65% from 4.66%. But property/casualty gross yields rose slightly to 3.7%.
- Rate Pressure: Low interest rates continue to exert pressure on portfolios, and there seems no end in sight.
- Convergence: Low rates, tax changes and tight spreads are forcing life and P/C companies to target many of the same asset classes.
The time of uncertainty has dawned.
As 2019 winds down and 2020 approaches, many insurance asset managers face the unknown within the markets and on a macroeconomic level.
The longest expansionary period in the history of the U.S. economy is more than a decade old. Interest rates remain historically low and continue to fall. And a contentious presidential election awaits in November 2020.
What will all that mean for insurers' portfolios? Asset managers wish they knew.
“The biggest headline is uncertainty,” said Alton Cogert, president and CEO of Strategic Asset Alliance, an independent insurance investment consulting firm. “The next biggest headline in the U.S. is the potential for even lower—and possibly negative—rates. Those are the key things that hang over us.”
He was among the experts participating in a Best's Review roundtable discussion in October who expect plenty of uncertainty in the months ahead as the hunt for return continues to challenge asset managers.
According to AM Best data, net yields on life/health insurers' invested assets in 2018 remained largely static, falling to 4.65% from 4.66%, and remain well below the 2013 mark of 4.98%.
On the property/casualty side, gross yields on invested assets rose to 3.7% in 2018 from 3.4%.
In addition to Cogert, this year's panelists were: John Simone, managing director and head of the Insurance Solutions Group for Voya Investment Management; and Jeb Doggett, managing director with Deloitte Consulting and a founding partner of Casey Quirk. They discussed overall investment trends for insurers and what keeps them up at night, such as those lower-for-longer rates.
Uncertainty is good because that means risk, and with risk, comes return.
Strategic Asset Alliance
What are the investing headlines for life insurers and for P/C insurers as we head toward 2020?
Simone: It's somewhat depressing with the 10-year [Treasury note] at a little over 1.50% today [closing at 1.537% on Oct. 8]. We thought rates were going to be climbing, and they've come back down. It's almost like the old saying, “Just when I thought I was out, they pull me back in.” In terms of a headline, it's low for longer. It just continues to grind lower in terms of yields. It's quite upsetting to insurance companies because they were starting to model out higher yields, and things have fallen back to Earth.
Cogert: There's always uncertainty. Uncertainty is good because that means risk, and with risk, comes return. That's the way it works in finance. But it just feels like, at least in the short run, increased uncertainty is the headline for a host of reasons.
And then with about a third of global debt being in negative interest rates and our interest rates being unusually low—by design I would underline—it makes you think, “Can they go lower?” And then of course you start thinking about what would happen in a negative rate environment, certainly for the least risky of securities, the Treasurys and so forth. If you're going to stay up at night worrying, those are the kinds of things that you'd be worrying about.
Doggett: There's pricing pressure, overcapitalization and overcapacity. There's a low organic growth rate and there's the low interest rate environment. All in all, it's a challenging environment for insurers of all types. The No. 1 strategic concern of chief investment officers is no surprise: the low rate environment. Even six to eight months ago, things were looking better. And now it's as bad as ever. What do they do? Views on rates have key implications for how CIOs think about asset allocation.
Not surprisingly, we are seeing increased allocations to alternatives, private fixed income and real estate. This is not a big change, but the momentum is continuing. Most of the allocation increases are coming from lower allocations to public fixed income.
What poses the greatest macroeconomic risks to insurers' portfolios? What keeps asset managers up at night?
Simone: It's policy mistakes, and what's going to happen with China. Will it be a hard landing in terms of what they're doing over there? Overall global growth is a concern. Europe has been in a pretty bad spot for quite some time. The trade war is creeping into more and more of the newsfeed and creating a lot more volatility.
But overall, insurance companies have to manage their assets against specific liabilities and have to put money to work and underwrite underlying investments. A lot of that is bottom up as opposed to worrying about macro issues. Obviously they have to look at sensitivities to industries in the macro environment. It's something to be aware of and consider when investing, but strong, bottom-up underwriting of the asset that they will be purchasing will make a lot of clients comfortable and keep investments reasonably healthy.
Have we reached the tipping point in the U.S. where a near-term recession is inevitable? If so, when?
Simone: We don't think a recession is around the corner, frankly. A lot of people said 2020. We just don't see it. It looks like the U.S. economy is still quite strong. But that doesn't mean when you're talking to clients and their boards they're not getting ready for it. They don't know the timing. We look at it this way: If you can get strategies that generate attractive yield and provide a defensive mechanism should we get into a recession, do it. It definitely pays to start thinking that way.
When we're advising a client, we're trying to not only improve yields, but also we're trying to address that future situation. We also tell folks, “When you get into a recession, middle market lending becomes a very attractive place to be because the banks become even more restrictive, and then you're lending to very high quality companies at very attractive rates.”
What you need to do is have a plan in place, so when that happens you can react. We're working with clients to basically take investment-grade mandates and add the ability to go below investment grade with that optionality, should an opportunity arise to take advantage of it. It's almost an accordion-type strategy. It's the most prudent thing clients need to be thinking about.
Another idea along the accordion is, if you're investing in very high-quality, investment-grade [collateralized loan obligations], consider an accordion approach of adding other [asset-backed securities] and [commercial mortgage-backed securities] to your allocation. Become more diversified.
These are some of the things that we're telling clients. If you like infrastructure investing and you understand that asset class and take the time to learn about it, think about extending into specialized areas like renewables, as an example. You can still pick up a very attractive yield in the mezzanine piece, but also have an off-take on that type of deal to investment-grade quality utilities taking that type of power, if it's wind and solar for example.
Cogert: We've seen storm clouds on the horizon for years. Years. We've could have had a discussion about recession on the horizon five years ago. “The average expansion lasts x years ….” The economy just keeps rolling along here. Economics is a social science—underline social. It is not a science no matter how hard economists try to tell you it is. It's not like physics or chemistry or biology. You can't test and get reproducible results. We can't say, “What would have happened if the Fed didn't drop rates?”
I don't think anything's inevitable. There's so much that can go on as well as things the Fed can do.
We don’t think a recession is around the corner, frankly. A lot of people said 2020. We just don’t see it.
Voya Investment Management
What are the top investing trends you're witnessing in life and in P/C?
Simone: Folks are looking at things they can invest in through cycles. They're looking for more diversification, more levers to pull and also looking at more areas of the market that are more recession-proof. For larger clients, we're looking at strategies that we manage that are quite unique, that have a low correlation to various spreads and interest rates. It's really alternatives that provide diversification. But at the same time, these alternatives have to be cost effective, transparent and held on the balance sheet in such a way that they're capital efficient. Capital is still something that folks want to be cognizant of in that a strategy doesn't consume too much capital.
Cogert: Let's just say there's talk of [pulling back and jumping into safe harbor assets]. But I don't see any of our clients saying, “Oh, we have to pull back.” Up until recently, we've seen companies saying, “Hey, can I take a little more risk and get a little more return? Can I diversify a little bit and take advantage of diversification?”
It's really activity at the margins. It's not a huge sea change in philosophy. That's because if you have a group of folks on an investment committee or on a board, as long as that group doesn't significantly change, you're going to have similar risk appetites. So any changes you might see are related to looking for additional yield, certainly, and looking at ways to further diversify the portfolio at the margin.
Doggett: What we're seeing is a substitution across the public fixed-income bucket into other asset classes that can deliver a slightly higher yield, whether that's real estate, securitized, privates or origination. Those are areas where there's real evidence that allocations are increasing.
[Origination] is an area that is not commoditized. Many large insurers have significant resources and commitment to loan origination, and for that matter, real estate. And those capabilities are hard to replicate. Insurers have an advantage in accessing those asset classes, although it's getting more competitive.
If you look at the competition for those assets, it's coming from the independent asset managers now, both traditional as well as the more alternative-oriented. Because, it is not only insurers that are struggling in a low return environment, it is also the pension plans, foundations and endowments. They're all facing the same need for higher returns. However, new entrants may have eroded the return premium over time because more dollars are chasing a limited opportunity set. In addition, if you have a capability that is highly differentiated, you can charge a premium fee. But we see massive fee pressure across the investment management business.
The Fed has made three interest rate cuts since July. What kind of pressure is the lower-for-longer environment putting on insurers?
Simone: Everyone would agree we're even farther in the credit cycle. So the trend of getting a little bit more defensive and cautious will continue to grow. But that's also countered by the fact that people need income based on their liabilities. It's this balance between those two different types of pressure that we're going to continue to see.
What we've been talking about for the past few years is going to continue. There's no getting around the need for private assets. The need for more diversification beyond just corporate credit to securitize. The need for looking at alternatives as a source of excess return. And the need for companies to look at different types of fixed income asset classes that they might not have historically looked at to generate attractive yields. It all has to come under the guise of stringent underwriting to make sure that no one is chasing yield and steps on that rake, so to speak.
Quite frankly, it's wind in our sails in terms of offering alternative credit for clients to address this. In the last five years of low rates, we've added 30 insurance clients and have grown our business significantly from zero. But it's not something we take lightly. We really feel for our clients' predicament. We're in the same one. We have a general account ourselves.
Cogert: Low rates are a threat as they stand. They impact a host of issues, especially for the interest-sensitive writers. It also brings up the issue of the closer you get to the zero level, you start thinking, “In other countries, it's negative and what would that mean for us?” It does turn a lot of financial concepts on their head. Continued low rates are a threat to investors everywhere.
Doggett: It's a significant pressure. Life insurance is a spread business, and insurers may have business on the books that assumes a higher rate of return. If they are reinvesting at lower rates, it will directly hurt margins.
Jeff Roberts is a senior associate editor. He can be reached at email@example.com.