In the previous blog entry, we discussed financial repression and the biggest investment challenge for insurers in the last thirty years – low nominal, and, in many cases, low real interest rates. For more on financial repression, we refer you to an article in the IMF’s Finance & Development magazine, Financial Repression Redux.
As noted last time, in the US we are at halftime, watching the FED marching band, as presciently sung by Don McLean in “American Pie”:
“The marching band refused to yield.
Do you recall what was revealed,
The day the music died?”
And what is being revealed to insurers is the impact of lower rates on their core fixed income portfolios. Even if rates remain unchanged, portfolio yields will undoubtedly be re-priced lower.
As we have been discussing for some time in various conferences and with our clients, there are basically four possible investment related responses (or some combination thereof) to financial repression:
1 – Change Risk Profile (credit, duration, liquidity, etc.)
2 – Use non-Core Fixed Income as a source of additional income
3 – Decrease Risk – waiting for more attractive yields
4 – Do Nothing substantially different
A Few Choices
Some of the different mostly non-Core Fixed Income assets that are being discussed among managers and insurers alike (as well as some very initial related thoughts):
1- Private placements (covenant protection and some yield premium due to illiquidity, and several of these bonds are investment grade)
2- Commercial mortgages (a ‘beaten down’ asset class, but be careful about underwriting, sourcing, collateral type, etc.)
3- Emerging market debt (usually sovereign debt, these assets are typically similar to high yield in quality and historical returns, with less than comparable historical volatility)
4- Bank loans (an asset class that has also seen better days, and requires superior underwriting, sourcing, etc., and we would recommend that the originating bank participates…although credit default swaps – never disclosed – could be hedging the banks’ exposure)
5- Non-agency RMBS (as housing markets recover, oh so slowly, the ability to separate the wheat from the chaff and top quality modeling and monitoring is a key…see the latest sales from the Fed)
6- High yielding dividend equities (US and foreign; but there are many reasons why an equity has a high dividend yield, and not all of them are indicative of a healthy company)
Each of these asset classes have their advantages and disadvantages and they are all designed to provide some additional income beyond the usual mix of equities that one finds in most insurer ‘risky buckets’. And there are others, but we wanted to highlight a few of the most common ‘alternatives’ being discussed.
But, should your company consider one or more of these?
The answer lies in two basic dimensions: Risk appetite and the Strategic versus Tactical Decision.
A solid understanding of risk appetite means first, a risk management culture at your company, and second, the ability to successfully review actionable analytics, that help define risk for your company.
Begin by asking if senior management and the Board are primarily focused on yield/return or on risk, to what extent and why. Then start defining risk for your company – we can almost guarantee that it is not standard deviation, but probably has something that starts with ‘don’t lose any money’ and is tied, to some degree, to the accounting model. Next, develop the analytics to quantify risk along the lines you have already defined. Consider the alternative investment strategies and show how risk quantification changes.
All of those activities are quite a tall order, but then the really hard part begins: a frank discussion amongst senior management and the Board on quantifying and qualifying their risk appetite.
There are many analytical tools for performing these tasks, but the most complicated and important tool is how to conduct and nurture the requisite human interactions in order to help define, quantify and determine risk appetite.
Strategic v Tactical Decision
Once you have mastered the risk appetite discussion as it applies to investment strategies, it is time to discuss another difficult question: Are we making a strategic or tactical decision?
In most cases, the decision made with regards to lower portfolio book yields is based upon long-term historical relationships. In other words, it is a decision based upon careful consideration of the potential risks and rewards, risk appetite, etc. over a long time frame (typically three to five years).
Quite frankly, the bright side of financial repression is that it causes all of us to rethink investment strategy. That new desirable investment class may fit within our risk /reward parameters and risk appetite, but may not have been considered had it not been for financial repression.
However, although this may at first appear to be a strategic decision, you must answer this question:
“Would we make this portfolio change if we were not facing lower portfolio book yields?”
If the answer to that question is “no,” then you are probably really making a tactical decision. If “yes,” you are indeed making a longer-term strategic decision.
And, it is very important to consider how you will be implementing your new investment strategy.
If a strategic allocation, you can carefully make a good decision along the lines of passive versus active management, after tax and fee comparisons, expected manager service levels, etc.
However, if a tactical allocation, those decisions made for a strategic allocation are further complicated by other important ones, such as: How do you know when you should reverse or change your tactical decision? By how much should the change be made? Who has the responsibility to make those decisions (many times awaiting Board action can be slow and counterproductive in tactical situations)?
In other words, a tactical decision requires another tactical decision, or an overriding strategic decision to follow. This is unlike a strategic decision, which merely requires another (typically annual) strategic decision.
As many of you know, our firm has a very disciplined approach to the Investment Process Value Chain, finding areas where ‘best practices’ can lead to improved financial results. And, this entire subject of financial repression and how insurers should react is one that must be customized to each insurer and its own unique goals, objectives, circumstances and constraints.
Some insurers we speak to have already made changes to their risky bucket to take advantage of higher income alternatives (For example, SAA has noted the importance of high dividend strategies for some time). Others have asked themselves the question of “Would we make this portfolio change if we were not facing lower portfolio book yields?” and have answered with an unequivocal “no,” deciding to maintain their present course.
Different decisions are most appropriate for different insurers, facing the same threat of financial repression.
In fact, several of our speakers at the upcoming Insurer Investment Forum will be discussing this issue (we have less than a handful of seats left).
But, whether you can attend or not, it is vitally important that you begin the process of developing a successful investment strategy in the world of financial repression.
We started the previous blog with a reference to the Chrysler Super Bowl ad, featuring Clint Eastwood. But, now we find ourselves quoting one of Mr. Eastwood’s characters, “Dirty Harry” Callahan, who, pointing a gun at the bad guy’s head, said, “you’ve got to ask yourself one question: ‘Do I feel lucky?’”
The Fed, in essence, has pointed a gun at investors in general, and insurers specifically. It is time for all insurers to meet this, their most difficult investment challenge in thirty years, by asking the tough questions.