Aaron Diefenthaler: My role as Chief Investment Officer is to drive investment strategy for the company’s general account assets.
Like many carriers, we have two engines of earnings: one from the portfolio and the other on the underwriting side. We have been fortunate to have a consistently profitable record of accomplishment on the underwriting side, which offers a fairly flexible foundation for our investment strategy.
My role primarily drives that strategy and day-to-day investing. We run about half of the portfolio with our in-house team and utilise third-party asset managers in core fixed income or specialist asset classes.
Away from the portfolio, I'm the corporate treasurer and run point on banking relationships and capital markets activity. I also head our corporate development and investor relations efforts.
As an underwriting company, we are focused on underwriting profitability first, and the invested assets are a support mechanism for insurance operations and long-term growth in book value. On the investment side, we need to be in a position to pay claims and fulfil our promise to policyholders, which governs the fundamental level of risk we can take in the portfolio.
In terms of our focus, we prefer that our effort be rather unremarkable. We do not want the portfolio’s results to be garnering significant attention for the franchise. Investment headlines for insurers often come alongside negative surprises, something I’m trying to avoid. That means our primary orientation is toward high-quality income-based strategies. Our largest allocation is in investment grade (IG) bonds which ensures adequate capital exists to pay the claims we know about and the ones we maybe don't know about – while being a backstop to catastrophe exposure, as well as a support to the broader operation.
"We haven't looked at price-orientated return allocations in private markets, and
anything in the private space is still somewhat yield-orientated for us."
Away from that, our goal is to grow book value over time and through cycles. Our primary allocation in that effort is to public equities, which we define as a surplus-facing risk asset. We feel that this is the right return-seeking allocation for us because it's easily understood and we have the flexibility, as I referenced earlier, to ride through cycles of price volatility. Those cycles have been established and well-known over time, and we think equities are the right instrument for our surplus-facing allocation.
Although stocks are the primary risk asset that we have in the portfolio, we do have some limited partnerships and BA assets, but that's an allocation in the single-digit percentages.
Historically, we have not looked at price-orientated return allocations in the private market space, and anything in the private space is still somewhat yield-orientated for us. Likewise, we haven’t engaged classes that are locked up for a long period in which you're dependent on significant levels of price appreciation to garner a proper return.
Aaron: We wouldn’t want to spend a significant amount of time explaining a surprise in our financial results due to an allocation in the portfolio.
At times you will see carriers miss expectations, simply based on a mark-to-market event for a certain asset class. The further you get down the illiquidity spectrum for certain asset classes, valuations can be opaque and mark-to-market events can be sudden. Often it takes some broader catalyst or stress in traditional markets for those valuations to come down. That’s when they then show up in the financials as a surprise.
As I mentioned earlier, we identify ourselves as an underwriting company, not an investment company, and we do not want to erode that messaging with either undue risk or surprises from the asset side of the balance sheet.
Aaron: IG fixed income offers a proper return and, alongside that, short-term assets down to cash are an investable asset class again.
If you roll the clock back to 2020 or earlier, you have a decade where the yield curve was rather steep, and you weren’t getting paid at the short end. So, you consistently had to cast your next marginal dollar out of the curve to earn a proper yield. That's not the case today.
We've been really resolute in overweighting high-quality assets in this portfolio. Some of that was based on the anticipated macroeconomic environment in the US. This well-telegraphed potential recession was based on monetary policy getting tighter and tighter over the last 18 months. Maybe that assumption has changed with the idea that a soft landing or no landing is now in play for the US.
"Equities continue to run and credit spreads are much tighter over the last year,
but we are comfortable with the optionality we have added."
We felt it was the right option to orient toward high-quality assets, IG, and even treasuries in the portfolio – and overweight those sectors. This offers a backstop in the portfolio in case you do get that slowdown or recession. It gives you dry powder to pivot toward wider credit spreads or risk assets like equities.
Unfortunately, the quality bias that we've had has technically been the wrong call. Equities continue to run and credit spreads are much tighter over the last year, but we are comfortable with the optionality we have added.
With our portfolio positioned like this, we’re still earning a proper return. However, it’s likely we need to add some durability to the income profile by layering in duration. All in, the portfolio is still offering an accretive stance to operating earnings because the yield – even on high-quality assets – has been attractive relative to a decade-plus of lower rates.
Aaron: We have a more balanced relationship between underwriting income and investment income today. The industry has experienced firm underwriting conditions in a number of areas. With both engines contributing nicely over the last couple of years, there is an opportunity to grow earnings.
"You could see insurers taking the stance that they can earn more on the
portfolio and, therefore, can take less margin on the underwriting side."
I would never recommend that investment income supersede underwriting; for us it's a much more balanced equation.
If you go back to lower interest rate years, there were times when underwriting income exceeded investment income. What you could see play out – and we do get this question occasionally – is if higher investment income changes appetite on the underwriting side for the industry.
That's the second derivative of this attractive rate environment for insurers. You could see insurers taking the stance that they can earn more on the portfolio and, therefore, can take less margin on the underwriting side. Thankfully to date, the industry has remained fairly disciplined.
Aaron: We invest very little outside the US. We're a domestic company, so we’re all US dollar in our revenues, and we don’t consider investing internationally in local currencies.
However, broader global economic growth does have an effect on US issuers. Many of those are multinational companies, and that plays into the investment thesis for a given company that may be exposed to the global economy.
So, we are considering global growth and the potential for that to decline. You've seen monetary policy tighter in many markets to get in front of inflation, which has implications for things like emerging markets. You are seeing the markers of a slowdown in China right now, and that has carry-on effects for a number of other economies. You have to be alert to where you sit in the global sphere and the impact regional growth has on your exposures.
Aaron: We're always mindful of what our primary regulator – the Illinois Department of Insurance – says, or of pending changes that may be forthcoming. There's nothing specific on the horizon (or a hot-button issue) right now.
There are, however, other de facto regulators for our industry – for example, the rating agencies – and the primary evaluation mechanism is their capital model, which does have an impact on how we view the capital that we need to run the business. There are definite implications for corporate strategy.
"This is top of mind for us when we talk about our regulatory frameworks; what
are the implications of an asset class around the rating agency models?"
The industry is going through a model change with S&P. That's something we're incorporating in our thesis around capital. These models have an impact across the business; it's not just on the investment side. An important part of the rating agency models is the fact that you get a benefit from the diversification in the businesses that you may be involved with on the underwriting side and how you are allocated in the asset portfolio.
This is top of mind for us when we talk about our regulatory frameworks; what are the implications of an asset class around the rating agency models? What would that mean? And how much capital is being used in those models, depending on the allocation?
Aaron: High-quality fixed income offers you a proper return through higher yields. Although we've reached a steady state for US Federal Reserve (Fed) policy, this is probably going to change at some point, be that in 2024 or later.
"It's always hard to predict the timing of these transition points,
but we're glad to be on the conservative side for now."
The next move is not likely to be higher interest rates; it's likely to be lower rates, and that will have an influence, especially on the shorter end of the curve. Of course, all of that is based on how the trajectory of inflation plays out and how comfortable the Fed is with loosening policy.
If ever we got to this slowdown or recession, it would likely put in for a sell-off in credit and equities. Again, going back to our setup, a high-quality bias over the last 18 months, we feel we are in a good position to pivot some of our allocations. It's always hard to predict the timing of these transition points, but we're glad to be on the conservative side for now.
