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There are a number of challenges facing insurers in 2021, but none is likely greater than the persistence of low interest rates. When I joined Knights of Columbus in September 2005, the 10-year Treasury was yielding 4.0%. We obviously are a long way from those days and have seen rates driven down and held down by several forces.
First, we have had massive Fed intervention in the form of Quantitative Easing (QE) dating back to the financial crisis in 2008-2009. Also, as uncertainty about the unevenness of the global economy was then met by Covid-19 - we not only had the continuation of central bank intervention, but we also significant market technicals focused on the large demand for safe haven assets.
Indeed, as we come into 2021, with rates low and credit spreads tight, insurers find it increasingly difficult to buy investment grade assets at yields above 2.0%, even when looking at 10-year BBB assets as I did on the morning of January 19th (Bloomberg BS189 BBB 10-year industrials).
The challenge arises because life insurers need to satisfy several competing factors. First, there are crediting rates associated with whole life insurance and fixed annuities where income is needed to satisfy the crediting rates of those products.
Second, insurers, particularly higher rated insurers, cannot simply load up on below investment grade securities as both rating agencies and regulators will certainly have something to say about that.
Lastly, there is the issue of managing the duration mismatch. Both ratings agencies and regulators like to see the duration of assets closely aligned with the duration of liabilities. So, these are several of the challenges in search of solutions.
As we begin to think about low rates throughout the investment grade product set, one could consider blending short duration assets with convertibles and floating rate instruments to protect against rising rates.
“Higher rated insurers cannot simply load up on below
investment grade securities.”
In an insurance setting this typical fixed income strategy is problematic for a life insurance book because the yield on all three of these categories is quite low and the combined duration of limited maturity bonds, convertibles and floaters would not likely come close to approximating the liability duration of a typical life insurance company with a blend of whole and term life. So, then we are left with the option of a duration mismatch to not “memorialise” these low rates for the next 30 years.
Certainly, part of the issue with the duration mismatch is associated with the asset/liability modelling systems and process. I will admit this is a bit of hyperbole, however, in 2008-2009 I remember discussing the model output on the liability side and it seemed to me that the models were assuming that the low rate environment would mean that no one would ever surrender an insurance policy or an annuity at anytime for any reason. We are in that precise modelling situation now because rates are exceedingly low once again.
We have employed a process of buying a mixture of longer dated paper and shorter dated paper, so we do not abandon our asset/liability process, but we avoid holding very low yielding paper for extended periods. We are also blending yield oriented alternative investments to provide incremental portfolio income. Ultimately, it is about bond yield, but it more about aggregate investment income.
Our approach in this area comes from the context of a highly rated insurer that is seeking to maintain our rating. This means that we are limited as to how far we can go in either below investment grade or alternative investments, but the use of senior secured loans, private mortgages, mezzanine debt, infrastructure debt and other lending opportunities in the alternative arena have provided our portfolio with incremental portfolio income.
“Our approach in this area comes from the context of a highly
rated insurer that is seeking to maintain our rating.”
One challenge with delving into these alternative investments is the impact on capital. Most of these investments receive a rating of 6 by the National Association of Insurance Commissioners (NAIC) and thus have a 30% capital charge. We are seeing new structures that are bifurcated such that a portion of the investment receives the traditional NAIC 6 capital charge and another portion receives an investment grade rating.
In this way, the blended capital charge is lower than 30% and the rated debt portion can be part of Schedule D as opposed to Schedule BA. This, however, is not a panacea, but rather a way to use alternative structures as a means of increasing portfolio income.
Largely, you are taking on differing types and amounts of credit risk in exchange for liquidity. I have been investing in many of these strategies working with clients dating back to the early 1990’s and we began implementing our alternative investment strategy in 2005. It has now grown to our intended size, so we are focused on maintenance and asset allocation within alternatives as opposed to a major deployment of capital.
Ultimately, we think a blend of shorter and longer dated bonds coupled with selected yield opportunities in either the public or private/alternative markets is the best way of helping insurers focus on income generation without abandoning the need for asset/liability management.
“If the vaccine and herd immunity lessen the impact of Covid-19,
we believe we will see rates rise”
The growth in alternatives has been met with greater research and knowledge on the part of the rating agencies and this has given rise to the bifurcated structured. With the likely coming increases in fiscal spending and increased economic activity, if the vaccine and herd immunity lessen the impact of Covid-19, we believe we will see rates rise.
However, any rate increase from fiscal policy will be met by the continued demand for haven assets -until they aren’t - and also the continued open market operations by the Fed that will likely limit significant increases in yield until we see higher employment. We take the Fed at their word that they will allow the economy to run “hot” for a while, but we also believe they will be vigilant if inflation does come back in a major way.
My predecessor called me the night I accepted my job at Knights of Columbus in July 2005 and wanted me to know that sometimes insurance company bond management could be boring. Of course, he started there in 1979, saw rates peak in the early 1980’s and had large yields and reasonably wide spreads as the condition through most of his career. He was also one of the best credit analysts I ever met to be entirely honest.
That all said, I wouldn’t mind a little boredom right about now.
