We spoke with Vanguard Institutional Investor Group to further discuss Bond ETF usage by insurance companies within their investment strategy. Highlights from the discussion include why ETFs are currently in the forefront, common challenges, and comparing insurance portfolio managers vs. bond ETF managers.
Kelly M. Sweppenhiser, CFA, CAIA
Head of Insurance General Account Solutions
Vanguard Institutional Investor Group
SAA: Why is everyone talking so much about ETFs, even though insurers have such a small portion of their portfolios invested in these products?
Vanguard: It’s true, today insurers invest a relatively small amount in ETFs, but recent investment regulatory changes for fixed income ETFs is behind why everyone is talking about these products and learning the many ways they can benefit portfolios.
Equity ETFs have been used in insurance portfolios for over a decade. From a regulatory capital and accounting perspective, equity is treated equally whether it is owned as shares of an individual stock or shares of a stock ETF.
This is not the case for cash bonds and bond ETFs. However, over the past few years, insurance regulators have changed guidance to allow more favorable capital and accounting treatment for fixed-income ETFs. Today, insurers can use bond ETFs that have NAIC designations in-line with the risk of the underlying bonds for fair capital treatment, and, more recently, a bond-like accounting methodology for statutory reporting (called systematic value).
Whether we are talking to one of 800 insurers who already use an ETF or the approximately 1,000 who do not, nearly all are interested in learning about the regulatory changes and how these tools add value.
SAA: What common challenges do bond ETFs solve for insurers, and, how does Vanguard typically see their products used to solve those challenges?
Vanguard: We see a number of common challenges that insurers use bond ETFs to solve. We see a number of common challenges that insurers use bond ETFs to solve. Three that currently stand out are:
- Low cash yields. Managing cash for normal or unforeseen business needs is a necessity, but earning income while maintaining risk and liquidity targets continues to prove a difficult task. Insurers are increasingly looking to ETFs as a way to earn more income than what they can earn in the bank or through buying short-term investments themselves.
- Difficulty sourcing bonds. It’s no secret that low bond inventories with historically low yields is making core bond management a huge challenge. Portfolio managers in this space are now using bond ETFs for targeted credit and duration exposure, creating a buffer to avoid forced sales of their best bonds, or maintaining market exposure while searching for the right public bond or negotiating the next private deal.
- Conservative surplus growth. Most insurers manage the majority of their portfolio for income, yet, if they are lucky to have meaningful surplus, they are also expected to earn higher returns on this bucket. We see bond ETFs being used as a complement to other surplus investments by providing easy access to higher yielding areas of the bond market like long-term corporates, high yield credit, and emerging markets debt. Or, insurers introduce strong diversifiers like investment grade, dollar-hedged international bonds that have traditionally exhibited negative correlation to other common risky assets like stocks.
A common scenario that combines the low cash yield and difficulty sourcing bond challenges usually sounds like this:
A property & casualty insurer is looking to increase portfolio income from the small portion of their general account they manage internally. They want to accomplish this while maintaining a high level of liquidity for unexpected claims or other possible corporate expenditures. They could maintain liquidity by buying short-term treasuries, but sacrifice yield. They could buy short-term investment grade credit, but sacrifice a lot of time doing research and still not be able to diversify appropriately. They could give the money to their external bond manager, but that would sacrifice control and liquidity.
SAA: How would you compare and contrast the perspectives in the bond portfolio construction process between insurance portfolio managers vs. bond ETF portfolio managers?
Vanguard: Both jobs are challenging. As we list a few key areas of their process, similarities and differences emerge.
- Insurance bond portfolio manager considerations: income targets, liability matches, taxes, regulatory guidelines, and credit research.
- Bond ETF portfolio manager considerations: tracking the benchmark index, efficient trading, index changes or rebalances, managing the in-kind share creation and redemption process, and minimizing cash drag.
A key contrasting area is within the bond selection process. Insurance portfolio managers often spend the majority of their time doing credit research. Rightfully so, given they almost always buy bonds with the intent to own to maturity. The bond ETF portfolio manager views the credit research process differently. Nearly all bond ETFs sample, not fully replicate, their target index due to the high level of fragmentation inherent in the bond markets. While credit decisions of one bond over another is important, especially in more illiquid bond markets where a higher level of sampling is necessary, the paramount objective of the bond ETF portfolio manager is giving investors the risk and return characteristics through tight tracking of the index.
That’s why bond ETFs can be a powerful tool to the insurance bond portfolio manager. Only they know what their specific general account need may be, and the bond ETF offers precise exposure to those areas in a diversified, liquid structure.
SAA: Is the bond ETF going to make the insurance bond portfolio manager extinct?
Vanguard: Absolutely not. Over the coming years, we envision the bond ETF will continue to gain acceptance as a valuable tool to help insurance bond portfolio managers and their consultants potentially add even more value, rather than diminish it. In other words, the relationship between a bond ETF and the insurance bond portfolio manager is not zero-sum where if one loses the other wins. The relationship can be complementary and we believe it will only become more so in the years to come.
Source: Strategic Asset Alliance, Vanguard Institutional Investor Group
The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.
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