Q&A: Manage Risks on Both Sides of Insurers’ Balance Sheets

With few reasons to expect interest rates to grow in the near future, including the possibility of negative interest rates, insurers are looking at risky, yet higher-yielding investments.

SAA’s President & CEO Alton Cogert spoke with Lori Chordas of A.M. BestTV to discuss where insurers are taking on more risks in their investments, as well as other opportunities they might consider in today’s market.

Below is a transcript of Lori’s questions and Alton’s responses. You can watch the full discussion here.

Q: How would you characterize today’s investment environment for insurance companies?

A: It’s probably the most difficult and unprecedented environment in modern history. Investment Grade Fixed Income is the life blood if an insurer’s balance sheet and certainly of their investment income. Interest rates have never been lower quite frankly and there’s few reasons to expect them to grow in the near future.

Q: Where are insurers finding yield in today’s market? What other opportunities might they consider?

A: Where companies are looking at is they’re trying to get their arms around what kind of risk they can take; additional risk. So they’re looking at risky, but more yield oriented investments like high-yield bonds and bank loans. Sometimes we go about, say, adding liquidity risk by investing in commercial mortgages or private placements, some companies go out to even consider emerging market debt, preferred stock, some of these asset classes in the past they may not have considered.

And then perhaps some real estate, global infrastructure, subordinated debt, the list goes on and on. And then there’s really, really creative and large companies that will invest in things like private equity, venture capital, different kinds of hedge funds, so it can get rather assertoric on the risk asset side. For the most part companies are focusing on risk assets that provide additional yield.

Q: Are negative interest rates a real possibility and how do insurers handle that situation?

A: Yes and with much difficulty. Certainly rates move up and down, but to say they can’t go even below zero in sort of a worst-case situation belies the fact that about 30 percent of sovereign debt globally is actually trading at negative yields right now. Think about it for a second; the worst is the U.S. goes into a recession.

It’s not the most likely case, but it’s the worst case. Then Fed ramps up their actions and all of a sudden we see rates on some government bonds going negative. The best way to handle that possibility, as you mentioned, is risk management. Specifically, stress testing the overall balance sheet and then deciding, “What are we going to do should we see negative interest rates?” The famous English economist Monty Python once said, ”nobody expects the Spanish Inquisition,” like nobody expects negative interest rates. There’s an outside chance.

Q: How should carriers approach risk management?

A: Well I think the first step is determining the company’s risk appetite. It’s no longer, “business as usual.” For the longest time we’ve heard companies’ say, “We take risk on the liability side, with reserves and the insurance side. We don’t take risk on the investment side.” Nowadays, we really have to take, manage and monitor risk on both sides of the balance sheet. What that means is quantitatively reassessing the risk appetite and developing and utilizing a robust enterprise risk management approach.

Q: Are insurers’ portfolios sufficiently diversified? How has that mixed changed?

A: First of all, insurer portfolios are never fully diversified. Why? That’s by design, because insurers need core fixed income, investment grade fixed income, for policy holder obligations and to have sufficient risk capital. However, the changing of that mix where they’re going out and taking a little more risk here-and-there is happening slowly and it’s happening unevenly in different companies, but change is occurring.

The question of, “what can we do about declining book yields in our portfolio,” is the question that we get a lot. Probably the number question we get from our clients, so that’s something I think that companies’ have to look at, ask their investment managers, “project where our book yield is going to be given rates the same today? Given rates might change in the future?”