Justin Muzinich: One of the foremost challenges affecting insurance portfolios currently is liquidity. Underwriting results have been volatile. This has been driven by severe weather events, inflation, and the intensely competitive market, and has resulted in less stable cashflows. This volatility is exacerbated by unrealised loss positions in bond portfolios that have resulted from higher interest rates. This creates a situation where companies are hesitant to sell assets and realise losses. Additionally, many insurers are still funding outstanding commitments to alternative investments, adding yet another layer of complexity to their liquidity management.
The good news is that post-financial crisis companies have become much better at managing liquidity. Whilst there are several liquidity headwinds, it doesn't feel like it did after the last financial crisis. There are challenges, but they're being managed, and many companies can take advantage of compelling long-term investment opportunities.
"Collateralised Loan Obligations have seen a consistent uptrend,
with some insurers allocating more than 10% of the portfolio."
Another significant challenge that insurance companies are currently facing is the impact of inflation. Inflation poses a dual threat as it affects both underwriting and investments. Thus far, claims costs have outpaced policy rate increases. Simultaneously, inflation has eroded the real returns on investment portfolios. Managing the impact of inflation involves a delicate balance of investment strategy, risk mitigation, and pricing adjustments on the underwriting side. Insurance companies must carefully assess their asset allocation to ensure their strategy is supporting the overall enterprise in an inflationary environment. That said, the unrealised losses on fixed income that I mentioned before limits investment flexibility to an extent. On the positive, the pace of both inflation and central bank policy response, appear to be slowing. This will give insurers the opportunity to stabilise.
The last challenge I’d mention is interest rate volatility. Prior to the recent Federal Reserve tightening cycle, floating rate assets were a growing part of the insurance investment portfolio. Notably, Collateralised Loan Obligations (CLOs) have seen a consistent uptrend, with some insurers allocating more than 10% of the portfolio, although the average allocation remains around 5%. As interest rates increased in 2022, CLOs were one of the few asset classes that posted a positive return. We expect this trend to persist, with insurers recognising the value of floating rate private credit as an even more attractive option. Private credit investments allow insurers to secure higher floors while base rates are elevated, benefit from the illiquidity premium, and mitigate credit risk through more robust deal structuring compared to broadly syndicated loans.
Justin: We do think there's a reasonable chance of an economic slowdown. Given what's happened with rates, it takes time to filter through the economy – and I think the economy will slow.
But what I think is overhyped is the scenario that we're going to enter a large default cycle if the economy slows. Now, just to separate this into public and private – on the public side, balance sheets are pretty strong by historic standards and, also, this is a well-telegraphed slowdown. When you have economic difficulties that lead to severe recessions, it's typically because of a surprise, whereas in this market, people understand what the Fed is trying to do, and they understand that they need to slow the economy and people are preparing for it.
Public issuers have been pushing out maturities and trying to be smart about their capital structure. Companies are modelling what cash flows look like in a higher rate environment as bonds roll when they have to refinance at higher rates.
"There is a lot less competition to underwrite the deals so leverage levels
are much lower – half or less of what you see in the sponsored space."
Companies have had a lot of time to prepare for this scenario, and they’re going into it in pretty decent shape. They went through COVID, and Chief Financial Officers (CFOs) became conservative, which means there has been a good year or two of cash flow coming out of the pandemic, and they can use that to put their balance sheets in better shape.
That’s the public side. On the private side, there have been a lot of funds raised to finance large cap private equity deals, and leverage levels are high.
There have been a lot of deals done. But we think there are excellent opportunities in the lower mid-market space, and especially the non-sponsored space. There is a lot less competition to underwrite the deals so leverage levels are much lower – half or less of what you see in the sponsored space – and you can structure transactions in ways to protect creditors. So, whilst on the private side there are risks in these highly levered deals, there are also excellent opportunities to lend at attractive rates in the lower mid-market, non-sponsored space.
Justin: It’s worth reiterating that inflation and Fed policy will be huge drivers. Another thing to watch in 2024 will be the regional bank situation.
"As this regional bank stress plays through over the course of 2024,
it will definitely have broader implications."
When we look at regional banks, they have a lot of commercial real estate exposure; something around 6% of bank portfolios are in directly held commercial real estate for large banks, whereas for more regional banks, it's close to a third of their portfolio. It will be interesting to see how that plays out.
This has caused regional banks to pull back on lending to corporate clients because they're trying to preserve their balance sheets. That is creating interesting opportunities for what we do in the lower mid-market space, and it's creating excellent risk-adjusted returns.
So, as this regional bank stress plays through over the course of 2024, it will definitely have broader implications.
Justin: It's tough to say whether we’ll see more failures, but we will see a pullback in lending. Banks have to finance corporate clients, because of the stress, and that's already clear to us.
We see that happening already and we're following the regional banks situation closely.
If you pull back in lending in the broader economy, it contributes to a slowing of growth. You’ll then see private credit stepping in, to some degree, to fill the gap – but not all of it. Many private credit funds aren’t set up to work with regional banks; they’re more focused on financing large private equity deals. Some funds, however, can do it, and they’ll see good opportunities and be important for the economy. Small businesses are the heart of the US economy, and it’s important they’re financed.
Justin: I hope that the race is as substantive as possible and that candidates can engage on policy issues that make a difference in people's lives. It’s typically difficult to get meaningful legislation done during an election year.
"What's happening with the slowdown, with the Fed, and with how the Fed
is reacting to the environment will be key drivers."
That could mean 2024 sees more rhetoric than policy changes – so I don't expect there to be a dramatic impact on portfolios. Depending on who's elected and whether or not that person is seen as pro-growth and pro-market will affect how markets react.
The primary driver next year will be the economic cycle. Investors are typically good at filtering noise from substance. Therefore, what's happening with the slowdown, with the Fed, and with how the Fed is reacting to the environment will be key drivers.
Justin: There are many important policy issues today that affect the lives of Americans every day. The less rhetorical the dialogue, the better for the country.
From our perspective as managers, especially with credit, we want to be repaid regardless of who wins an election and regardless of the rhetoric. We’re doing our work to make sure that happens.
As a manager, you want to underwrite businesses that can prosper regardless of the economic or political cycle. But I'd say especially on the public side, that volatility is good for active managers, because if you have views on what fair value is and which companies will make it through, then you can use volatility as a way to build positions. Volatility creates apprehension.
That's also not a bad thing on the private side, because it allows us to be more creative in structuring protections around what we do and gives us more leverage.
