Catching Up on the Investment Landscape for
Insurance Companies & Risk Pools

With several ongoing and moving pieces in the investment landscape, we spoke with AAM - Insurance Investment Management to get an update on the trends and topics that are most top-of-mind for both insurance companies and risk pools. Topics include expected cuts by the Fed, short-term cash needs for insurers, as well as the factors that go into (potentially) realizing losses.

Dan Byrnes, CFA | Senior Portfolio Manager | AAM – Insurance Investment Management
dan.byrnes@aamcompany.com | Learn More >>

SAA: In AAM’s view, what are the biggest takeaways for portfolio allocations in today’s current environment for insurers? Given the state of Money Market yields, is holding cash a viable short-term opportunity?

AAM: Given the market moves in early August, “today’s current environment” seems to be changing by the day. While yields have decreased from the highs of fall 2023, they remain relatively high compared to the periods during and before the COVID pandemic. Although the economy is slowing down, we anticipate continued economic expansion and a decrease in inflation. Given this, we expect the Fed to cut rates several times this year, leading to a fall in short Treasury yields in line with the Fed's moves while longer-term yields will decrease to a lesser extent.

Credit spreads had been near multi-year tights prior to the August sell-off, particularly for corporate credit. Credit spreads for other sectors such as MBS, ABS, and CMBS had been near long-term average levels. Volatility re-emerged quickly in early August causing spreads to widen. We do not advocate aggressively adding risk to portfolios at this point in the cycle, but we are still active in credit markets adding high quality securities at spreads that are wider than they were a few weeks ago.

We have observed the longest yield curve inversion ever. While the inversion ended very briefly intraday in early August, we remain inverted as of this writing. As a result, some insurance companies and risk pools are inclined to hold cash, especially those that have experienced significant increases in claim frequency and/or severity. A common notion is that there is no yield loss in holding cash.

Our recommendation to these clients is to hold the cash necessary to meet operating needs with a buffer, but not to hold excess cash. If the Federal Reserve does begin to cut the Federal Funds rate, as anticipated, money market rates will be the first to see a decrease in yields. Consequently, investing in longer-term options today can enable investors to secure stable investment income for the next several years.

For anticipated short-term needs, companies may want to consider building a laddered portfolio of short maturities to meet those needs. This holds especially true for risk pools, which often collect premiums once a year and make claims and expense payments throughout the year. It is conceivable that the Fed may reduce the Fed Funds rate by 50 to 100 basis points over the next few meetings. By estimating expected cash needs and building a ladder of short, high-quality investments to meet those cash flow requirements, risk pools can mitigate the risk of erosion in the earning power of cash due to potential near-term rate cuts.

It appears that the window before the Fed cuts rates will start closing soon. This is an opportune time for insurance companies and risk pools to reassess their cash flow expectations and ensure they are not holding excess cash.

SAA: With daily headlines on the topic of ‘Commercial Real Estate,’ does AAM have any particular views on the sector and how it may/may not impact insurer’s portfolios?

AAM: The commercial real estate stress, particularly for office space, is like the train coming down the tracks that you can see for a long way. While there are some obvious properties that have issues or have already defaulted around the country, it is difficult to know how wide-spread or how severe commercial real estate issues will ultimately be. It seems the insurance industry’s direct exposure to commercial real estate through commercial mortgage loans and CMBS is generally positioned to weather the storm reasonably well.

Specific to CMBS, as of year-end 2023 both the P&C industry and the Life industry only had between 3.5% and 4.0% of their investments allocated to CMBS¹. Of those CMBS investments, the majority of holdings have the highest possible ratings. There was a headline earlier this year that a bond originally rated AAA absorbed a loss of principal² which caused some consternation. This was a single asset, single borrower transaction backed by one loan for an office tower in Manhattan with 77% of the building leased to one tenant. After that tenant left, the building could not re-lease enough space. We expect most senior single asset, single borrower bonds will be repaid in full. However, as loans approach their maturity date, several are being extended. So, while investors will likely ultimately be repaid, it could be two or three years later than originally anticipated. One mitigating factor in this could be a decline interest rates. If rates do fall, it should make it easier for transactions to be completed.

In conduit transactions, where there are pools of several loans backing the bonds, we expect the senior, AAA-rated bonds will largely fully repay, and the risk of maturity extension for senior bonds is mitigated by the large number of loans in the transaction. Per a recent analysis there were 103 CMBS AAA classes issued from 2011 through 2014 that have hit their maturity date recently. Of those 103 bonds, 83 paid at the scheduled maturity date and 9 paid off within a month of the expected payment date. Seven fully repaid within a few months, and 4 securities are still paying down³.

With insurers’ limited exposure to CMBS overall and concentration in senior classes, we do not expect wide-spread issues for the industry. If an insurance company or risk pool has a high allocation in subordinate CMBS bonds, those companies may be at greater risk of meaningful capital impacts due to losses from commercial real estate.

One area insurance companies and risk pools will want to keep an eye on is any exposure to small banks. Smaller banks tend to have higher concentration in commercial real estate loans relative to larger peers. Median exposure to commercial real estate for banks with assets above $100 billion is 7% of assets. For banks with assets under $100 billion the median allocation to commercial real estate is 25% of assets⁴. So, while an insurer’s direct exposure to the sector through their own lending or CMBS investments may be limited, they may be subject to commercial real estate stress through their bank holdings. Though insurance company investments in small banks are typically quite low, it is a good idea to assess the commercial real estate exposure of any bank investments on the balance sheet so insurers and risk pools are not surprised. The train is coming down the tracks, it would be better to know if anything is tied to the tracks before the train arrives.

¹Source: S&P CapIQ as of 12/31/2023 for insurers with invested assets less than $4 billion

²Source: Bloomberg

³Source: Deutsche Bank

⁴Source: Barclays

SAA: For many insurers, tackling the issue of realized vs. unrealized losses in the fixed income portfolio persists. How should insurers and risk pools view the idea of realizing losses in today’s environment?

AAM: Treasury yields are down from their peak in the fall of 2023, but many securities in portfolios remain at unrealized losses. A question many insurance companies and risk pools grapple with is whether to sell bonds that were added a few years ago and have low book yields, realize losses, and then reinvest in securities that will provide more investment income in the future. At AAM we use the concept of a pay-back period to help consider the benefit of selling and reinvesting. Simply, we determine how long it will take for the future increased income to recoup the loss realized today. An acceptable pay-back period varies for each client, with some preferring only those bonds with a pay-back period of 2 years or less and others more comfortable with a longer pay-back period. There are many factors in the decision to execute this trade including the client’s current level of surplus, potential sale requirements to fund operating needs, tax status and regulatory requirements.

For P&C companies, life companies and risk pools, the regulatory regime differs which can impact the decision. For P&C companies, selling at a loss today triggers an immediate decline in surplus. Smaller scale sales are typically not an issue for clients, as long as the pay-back period is acceptable. However, if companies are looking to maximize future income, the realized loss may be material. Clients want to ensure the surplus impact does not materially impact RBC or other key ratios. For life clients, the ability to use the Interest Maintenance Reserve (IMR) to spread out the loss over time reduces the near-term impact to surplus. The NAIC temporarily altered rules around negative IMR which allows more life companies to take advantage of this opportunity to bolster future investment income. A word of caution, NAIC rules regarding allowance of negative IMR are set to expire at year end 2025, and as of this interview, it is unclear how the NAIC will proceed. Life insurers may consider exercising caution in pushing their IMR too far into negative territory until there is clarity on this issue.

For both P&C and life companies taxes play a part in the decision as well. Most clients have an allocation to equities or equity-like instruments like convertible securities. With the significant rise in equities the past few years, any sales in the equity allocation have generally resulted in taxable realized gains. Several clients have sold bonds at losses to offset the tax liability from gains in the equity or convertible portfolios. This is a tax-efficient way to take advantage of higher interest rates.

For our risk pool clients, the decision process is a bit different. Risk pools do not carry investment grade bonds at amortized cost, rather the change in market value is marked through surplus. Also, they do not pay taxes. The decision to execute a trade to realize losses in the bond portfolio hinges much more on the pay-back period and preference of the board.

For all clients, there is also an element of adding some risk to the bond portfolio for the pay-back period to be attractive. If we sell a bond at a loss to buy a bond with the exact same risks (credit risk, call risk and duration), the pay-back period is roughly equal to the remaining maturity of the bond we are selling. This usually limits the attractiveness of the trade. However, if an investor considers selling a bond and adding some risk, the pay-back period tends to shorten. The risk clients seem most comfortable adding in this environment is duration risk, to keep these higher yields in their portfolio for longer.

Some clients are in a position where they have to sell bonds at a loss to raise cash for claims or expenses. If there have been meaningful realized losses already, the appetite for more losses to generate future investment income may be diminished. Ultimately, it is prudent to revisit the decision to sell bonds at a loss to increase income periodically. Over time, the tolerance for losses or the acceptable pay-back period may change. There are plenty of bonds issued in much lower rate environments that will remain in an unrealized loss position for years to come, so insurance companies and risk pools should have opportunities to consider this trade into the future.

*Outlooks and recommendations are subject to change should market conditions warrant.

Source: Strategic Asset Alliance, AAM. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.