How inverted yield curves and recessionary pressures are affecting investment decisions
Insurance Investor speaks to Tom Rogers, Chief Investment Officer at Farmers Insurance about the trends shaping investment decisions
Insurance Investor Editorposted on Friday, November 15, 2019
Insurance Investor: How do you envisage the current state of the U.S. and global economy, and what are some of the possible scenarios that we might see in the coming 12-18 months?
Tom Rogers: Globally, manufacturing is a bit off, and a lot of the PMIs are near or below 50, which is the threshold for whether we’re experiencing growth or declines.
The big question is whether this slowdown in manufacturing will reach over into the service sector. The answer to this is currently unknown, but will influence what happens in the next 12-18 months.
If it does, then we could be in a recession, employment will tail off a bit, and unemployment will rise. These effects will then be carried onto the consumer.
"The nightmare scenario that goes through my mind is the one with negative rates"
This could come with Federal Reserve easing, more so than they are doing now, in fact, probably more aggressively.
The nightmare scenario that goes through my mind is the one with negative rates, which is something that I hope doesn’t hit the U.S. But we cannot rule it out, either.
I don’t feel that this is the most likely scenario, but a recession is clearly a possibility.
Insurance Investor: Do you foresee that there will still be an appetite for being risk-on from the investment community or will there be more caution in any approach that is taken?
Tom: It is difficult to say, since there will be those who are willing to take risks and others who simply aren’t.
In the insurance asset management business, we try to keep the risks under control. It is really managing the risk profile that we have and any exposure we may have to possible events that could happen.
David: How will current yields in the fixed income market impact insurers’ investment portfolios?
Tom: With yields as low as they are, albeit not lower than in 2016, insurance company portfolios have higher unrealised capital gains in bonds and will experience faster prepayments in their mortgage portfolios.
Furthermore, reinvestment of the cashflow that runs off will have to be done at lower rates, which limits the potential for growth in investment income.
This won’t be contributing as strongly to the bottom line as perhaps people would have hoped for a year ago.
Insurance Investor: What impact will current yields have on the underwriting side of the business, and does this put pressure on the investment side of the business?
Tom: There is always pressure to produce more investment income, whether rates are high or low.
The lower contribution that can be expected in a lower rate environment from the investment income side is certainly going to put more pressure on the rest of the business to produce better results.
Within the insurance company, there are a few things we can do to address this. You could take on more risk on the investment side, which is a trend that we have seen over the past several years in this low interest rate environment.
It also does put pressure on the underwriting side of the business to perform better. That being said, being better in underwriting doesn’t necessarily mean higher prices.
"There is always pressure to produce more investment income, whether rates are high or low."
It can also mean reducing costs and using the data and technology available to get lower loss ratios out of the portfolios as well.
These are some of the methods that can be done and are being done within the insurance industry for the past several years.
The impetus and focus on the investment side is still going to be on managing risk.
The question that we have to discuss with our senior management is whether we want to allocate more of the capital to investment risk-taking when the rewards from this are relatively low; usually, the answer to this is “not really”.
Insurance Investor: Do you see insurers looking down the credit scale and at other forms of credit, such as private credit, in order to make up for shortfalls resulting from the current state of the fixed income market?
Tom: There is some trend in this direction. If you look at the corporate bond indexes, about half of the Corporate Master is in BBB. This is a much higher proportion than we have seen in previous cycles.
In some ways, you could say that any investor who has followed this as a benchmark is probably taking more credit risk than they were before.
They may not have known that was the direction they were headed towards, but they have found themselves there.
"Direct lending – what has been called bank loans – is also an area where you can get a good risk-reward trade off."
In the private credit space, there is room for doing this without taking more credit risk. But what you have to do here is to seek a liquidity premium, as opposed to a premium reward for getting the credit risk.
Private placements, which are traditionally dominated by life insurance companies, are one example of what you can do in the private credit space.
Direct lending – what has been called bank loans – is also an area where you can get a good risk-reward trade off. It tends to be lower in the credit spectrum than investment grade bonds, but very close to investment grade.
If it is done with good credit underwriting and effective covenants, it can provide a very good trade off between
the risk and reward.
Insurance Investor: Is there noise in the industry about specific asset classes that insurers are seriously looking at?
Tom: The trend in the past several years has been towards that private credit space. Infrastructure gets some attention, as well as the ESG space.
This is not so much to try and get excess returns, but rather to make sure that their portfolios are in good standing. There are various factors going on in this space that are affecting the industry right now.
Insurance Investor: As markets become more complex, what role is technology playing in data analysis, manager selection, and other areas of insurance portfolio management?
Tom: From a manager selection perspective, we haven’t found the killer model that will take all the data in the world to tell us what to do.
We try to exercise judgement when we are acting on our portfolios and deciding what the strategic asset allocation should be.
The trick here is to separate signal from noise. There is so much data out there that contains so much noise, making it hard to pick up on the extra signal that might be hidden within that noise.
"The trick here is to separate signal from noise."
We look at how asset managers are using data and the tools that they have, which can be something that differentiates one manager from another.
It is whether they are using the tools effectively and in creative ways to measure the risks in the portfolio to try and avoid piling unknown risks into the portfolio.
This is where the industry has become better. They don’t invest in stocks and bonds of companies who all happen to be exposed to the same risks.
The lessons have been learned here, and this is something that the industry is doing well now.
"We look at how asset managers are using data and the tools that they have."
Taking it to the next level, using satellite images to look at the parking lot in a mall to see how a real estate investment might do, or using the cell phone data to see the traffic around different stores, etc. is difficult.
There are only a few managers who are using these types of tools effectively, but many have not begun to do it at all, so this is an area that is starting to differentiate.
This excerpt was taken from the research report Insurance Asset Management, North America 2019. You can download the full report https://www.clearpathanalysis.com/reports/insurance-asset-management-north-america-2019.