Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name’s Stewart Foley, I’ll be your host, and I’m joined today by Tim Antonelli, insurance strategist and portfolio manager, and managing director at Wellington. How are you, Tim? What’s going on, man? Welcome back.
Tim: Stew, I’m great. It’s always a pleasure to be on with you.
Stewart: You are a regular, man. This is great. So the title of your paper that we are publishing is ‘2023 Insurance Outlook, Resolve to Solve With a Restock Toolkit’. So when we look back at 2022, I mean, my point of reference here is when I was hosting the New York CFA round table this year versus last year. A year ago, everybody was like, “Where am I going to get yield? Yields are so low. Oh my goodness.” And this year, completely different story. So much has happened in 2022. Before we go into a 2023 outlook, can you kind of recap 2022 for our audience?
Tim: Yeah, I mean, I think your point about yield is a huge one, which will play into what we’re thinking about, moving forward. But if you remember, it feels like a decade ago, but only a few short months ago heading into the new year, there was cautious optimism about the world getting over COVID, and potentially, economic prosperity on the back end of that. And even avoiding a looming recession that the summit considered on the table in 2021. And then the Russia/Ukraine conflicts kind of really kicked things off in a meaningful way. And in addition to the obvious larger issues that came out of that conflict, it certainly fueled the fire on things like inflation, a trend towards de-globalization, more increased probability of a recession, and just a general sense of economic uncertainty that we really hadn’t seen over the last decade or so.
And as we head into the new year, I think a lot of those same elements are still going to be at play. And you’re going to start to see, and we saw it the other day with the Bank of Japan raising their rate target, you’re going to start to see central banks beginning to have a lot of stop-and-starts as they attempt to balance lowering inflation with avoiding an all-out recession. And so in my mind, more uncertainty should be our base cases as we move ahead. And the things that worked in 2021 and earlier may not work going forward in 2023 and beyond. And I think what we’re here to do is just give our insurance clients some actionable items that can help as they try to tackle the new capital market regime we find ourselves entering.
Stewart: It’s really interesting. The Fed does not appear to be ready, willing, and able to come to the rescue as they have in the past. They’ve got a balance sheet that’s chock full of very low yielding mortgages. It feels different right now, and they’ve hit the brakes. It seems like oftentimes, I mean, when you get the yield curve inverted, strange things happen after that. There’s a lot of uncertainty out there, and I’ve done some podcasts with a number of CIOs. There seems to be a tailwind toward public markets that you can get north of 6%, buying straight down the fairway fixed income. So, interesting environment for sure. And I like the idea that we need to consider this a very different environment. One of the things that you point out in your paper is embracing a solutions-oriented mindset. Can you kind of expand on that and talk about what you mean there?
Tim: Yeah, so I mean, I think it plays into larger themes of, as we say, not setting it and forgetting it. I think this is an environment that’s going to be much more ripe to be more dynamic with how you’re allocating, both to add exposure and also when to reduce exposure. I think this general lack of consensus in the market is going to lead to more volatility, more dislocation, more uncertainty, and then in my mind, that creates more opportunities. So when we say embrace the solutions mindset, we mean a couple of different things. First and foremost, I think it’s revisiting your existing investment policy statement and just making sure, are you permitting all the appropriate asset classes or is it a dated policy statement where it’s not reflecting the truths of today? And whether that’s different flavors of securitized, or defining a specific role for structural allocations to alternatives or liquids, or making sure that your benchmark relative performance includes things like triple B at the level that you’re seeing today, which is substantially higher than it was 10 years ago.
So, it’s almost like you want to just take a look in the mirror and identify your current opportunity set and then think maybe more purposefully about how you can maximize your potential there. And then the other element that feeds into that is streamlining your governance and approvals process. So think back to March of 2020 when there was that huge selloff in the US high yield market on the heels of COVID. And then as soon as the Fed stepped in to backstop companies for that time, relative value play disappeared, what felt like overnight. I think we’re going to start to see a lot of those extreme valuation relative value plays that will be compelling for insurance companies to be able to add. The problem is if you need to get an idea through your investment committee, through your board, and then implement it; it can be very challenging to do it before the market takes away the chance.
So, having a solution where you have a PM who either has the ability to allocate outside of just a core universe and maybe include some plus sectors, or you create a solution that has a maximizing income across a multi-asset construct, or you have a multi-strategy solution that’s used to fight inflation or target a total return, you’re giving more tools to the portfolio manager to be able to allocate across diverging circumstance. And I think that’s been huge. The last thing I’d say, which plays into your earlier comment about the elevated yields in the public credit environment, it seems like yesterday we’re all talking about book yield erosion and how you were just, the market yields were considerably less and you had to fight that.
Well, now the reverse is true. And so what we’re seeing is a desire in partnering with our clients to say, okay, what’s the amount of portfolio turnover and the losses that we’d have to take, and what would be the payback period reinvesting at these higher yields? And how can we get money to work in a challenging environment when it comes to unrealized losses? And so again, having this solutions mindset of identifying the problem and being creative with how you address it, I think should be top of mind for our clients moving into the new year.
Stewart: And when you’re talking about that process of looking at redeployment, are you looking at it through a lens of evaluating weak credits for example, and saying, “Hey, if we’ve got a recessionary headwind here, yeah, I know maybe I’m taking some losses,” but the credit cycle has been so benign for so long, folks tend to kind of forget the things can get kind of ugly there. So is that part of the consideration as well?
Tim: Yeah, so it definitely factors in because just applying the reinvestment rates at the benchmark level doesn’t really do insurance companies any good when you want to be a long-term holder. So obviously everything is predicated on fundamental credit research. But I would say one of the interesting items that makes this next market regime different from the ones we’ve seen in the past has been we’re having this increased probability of a recession and these elevated inflation levels at a time when corporate balance sheets are still very strong. They are benefiting a lot from COVID-era policy, and some of the backstopping we just mentioned, the consumer balance sheet remains relatively strong as well.
And so I think you’re able, particularly in the more defensive parts of the fixed income market, to find stories where you hope that they’re going to be able to weather the storm more than some other more volatile sectors. And you’re able to capture maybe not the most spread-filled stuff in the market, or the most frothy stuff rather, maybe a notch down, a little bit less yield, but you’re still able to capture a lot of the yield elevation with hopefully less of the future risk.
Stewart: Yeah, I mean, it’s a great point. We had Aaron Diefenthaler on at RLI, and he made the point that I can buy two-year treasuries and raise my book yield. And to your point, the speed at which things have changed requires a more responsive ability to move more quickly. It makes all the sense. So in your paper, you mentioned approaching illiquid allocations through a more nuanced lens. Can you expand on that just a little bit, please?
Tim: Yeah, so I think you and I have chatted about this before, the dominant trend across the industry, which quite frankly has been an excellent trade, has been to just continue to allocate to liquids and earn a spread premium to public market equivalence. And I think it’s been great and is now, in my mind, a structural part of reserve backing fixed income, at least the investment grade private placement part of the market. And if you’re a life insurer, I think you can just basically say “If our net of fee yield in the private market is greater than the public market yield, we’re going to continue to ramp up our glide path of private placements.” I think given their lack of liquidity needs, or immediate liquidity needs rather, that might continue to be their formula. But as I think about this from the perspective of a non-life insurer with less certain liquidity needs and certainly less duration overall versus some life insurers, I can’t help but notice that about 20% of US health and P&C insurers have about 20% of their bond portfolios in private placements.
So if that trend is going to continue, I do think you need to be more in the weeds about what that spread premium is. And so we’ve done some work with our private credit team at Wellington to look back at what the yield premiums were over time. And if you think about A or better in triple B rated private placements relative to similarly rated public corporates, the median spread, excess spread for the private markets is 35 basis points. So that’s pretty good, but it can diverge substantially. And if you look at 2018, there was almost a negligible amount of spread premium there. And then 2021, it was substantially higher, closer to 75 basis points. (Source: Please refer to Wellington Management’s 2023 Insurance Outlook here)
So again, being able to say, okay, we’re going to dial up or dial down our exposure and what our glide path is based on what that spread levels are at a point in time, I think will become a much more detailed decision than it was in an era of low interest rates where the public markets weren’t all that attractive. And doing that within the context of both regulatory oversight, which is now focused more and more on liquids, but also rating agency thresholds and constraints, when you think about some of the liquidity tests, I think will become a greater focus in the year ahead, particularly if you believe that interest rates are likely to stay elevated for the foreseeable future.
Stewart: Yeah, I mean, I think one aspect of insurance company portfolios that often gets overlooked is the equity component. So property and casualty carriers often have a fairly significant allocation to equities. And in your paper you mentioned a pivot from growth to value. Can you talk about what’s behind that idea there?
Tim: Sure. And just first and foremost, we’re talking in a multi-asset context like the outlook we published on InsuranceAUM every quarter, I would say investing in the public fixed income market at 5.5%, 6% yields when real-world equity market expectations are 7% over a cycle is a no-brainer in my mind. But as you mentioned, using equity exposure to grow surplus is something that non-life insurers have been doing forever. And so as you enter this new market, and we saw the run on growth equities over the last decade, basically driving the whole US equity picture in a substantial way, you’re starting to notice that there could be a reversal of that trend. And what we pointed out via some research from our investment strategy team was when we looked at the trailing tenure performance of growth versus value, and they compared it to the next 10 years for each period, whatever performed better in the previous 10 underperformed in the following 10. There is a long history of mean reversion when it comes to that performance variance. (Source: Please refer to Wellington Management’s 2023 Insurance Outlook here)
And so number one, we’ve seen that from a historical perspective, but number two, based on, again, this forward-looking view of what the market’s going to look like, I think that value’s poised to do very well. If something like the allocation to more defensive sectors, as we mentioned on credit holds true in the equity market, de-globalization and increased regulation on the US tech sector should definitely play into growth equity valuation. And then also just the ability to generate dividend income in the value space is substantially higher than in the growth space. And I think that that provides another compelling data point.
And so in my view, being able to monetize some of the growth equity gains that you made over the last decade and then reallocate to dividend paying value equities could be a really good play. And the last thing I’d say is, doing a look back at dividend payers, growers, non-dividend payers for the MSCI equity, the volatility associated with dividend payers and growers is about two-thirds that of non-dividend payers. So if you’re thinking about it from a P&L management perspective, it could also be pretty compelling when you’re considering drawdowns as it relates to your surplus.
Stewart: At the beginning of that answer, you mentioned the yields in public fixed income. Insurers, prior to 2022, were giving liquidity in a variety of ways in the face of a protracted low interest rate environment. Do you see a tailwind, do you see insurers reliquifying portfolios at this point, given the better yields that are available? I mean, it feels that way to me and I’ve talked to a number of CIOs, it seems that’s there. Are you seeing that as well?
Tim: Yeah, so definitely. Certainly, there’s some relative value trades you can do on the margin. If you have alternative exposure, and I do expect this to be a large theme going forward, secondary market sales for things like private equity, which we’ve seen some larger insurers do over the last year, but also things like private credit could be approaches that insurers take to just kind of level off some of their private exposure relative to the rest of their invested assets, particularly in down markets. So I do think that there is an element of insurers who are getting more questions from regulatory bodies and rating agencies, but also more of a desire to get compelling public market returns in a way that they didn’t have the option to do before.
So one interesting thing about that potential is that the unwinding of some of those legacy exposures could actually provide compelling buying opportunities for insurers who are looking to either initiate an allocation of private credit or private equity, or to increase relative to what their overall assets would be. So typically a private credit private placement mandate is constructed largely through new issuance. Maybe that could be expedited if you’re able to supplement that with an active secondary market. And I think we’re going to start to see that story play out a lot more.
Stewart: One of the things that resonates with me a little bit is we hear a lot of talk about inflation and this and that, and there’s been a lot of risk that previously resided on bank balance sheets that now resides on insurance company balance sheets, in the form of leverage loans and other asset classes. The performance of that asset class has been fantastic, right? And, are you concerned at all about that asset class in particular in the face of recessionary headwinds?
Tim: Yeah, I can tell you that for our insurance clients where we manage exposure, there is a strong preference to go up in quality where possible there. And, I think eliminating some of the tail risk that comes with the recession is certainly important. That being said, if you think about the structure of those companies and what they’ve done with the ability to refine, push out all their borrowing costs, the maturity wall with high yield bank loans is closer to a 2024, 2025 event. So given that they have pretty good borrower covenants, at least with some of the legacy loans, and you’re able to get diversification across sectors and issuers, I don’t think it’s all that big of a worry, at least at this point. But I do think it’s something to be mindful of, particularly if you’re holding a passive exposure. I think something where you’re active and you’re skewing to the double B, single B space, it’s a little bit less of a concern.
An interesting thing for me will be to see how that market’s going to evolve moving forward when I think companies are going to want to start to use leverage loans in the bank loan construct a little bit more than traditional high yield if interest rates stay as high as they do, because you’re able to structure the deal in a way that may be less than what a market yield on a high yield bond would be if they went to market through that avenue.
Stewart: One of the things that Wellington has done a great job of is climate impact. You’ve done a lot of research, you’re working with some academic institutions. Can you talk a little bit about what you refer to in your paper as ESG integration 2.0? It seems as though the regulators are, it seems as though there’s information requests coming. I think there’s challenges, and I’ve been told that there’s challenges with getting the data on certain asset classes. How should insurers be thinking about ESG integration 2.0?
Tim: Sure. And so using these outlook themes, it is certainly a topic we’ve covered over the last few years. A surprise to no one. In my mind, the conversation continues to shift from a look back where it started as something of “How were we positioned, what should we be excluding,” to an evaluation of the current positioning, and “What is our weighted average carbon intensity or what sectors are we in today that are the most exposed?” And oftentimes those type of requests are directly from regulatory bodies or shareholders. And what we say by ESG 2.0 is to decouple from the assessment of your standing today and think more about forward-looking metrics.
Now ESG can mean a lot of things to a lot of people. And so there isn’t a prescriptive oversight of you need to be investing this way, or you should be investing this way instead. It’s, okay, what’s the best available data? And depending on how that aligns with your corporate philosophy, it could be anything from something you integrate within your IPS to something you’re purely using as a scenario analysis or stress test tool. And so ESG 2.0 really features two main things. The first is this idea of science-based targets. And so science-based targets is an initiative that seeks to understand the company’s plant, not only emission profile today, but also commitments and trajectory moving forward to see if they’re Paris-aligned in the decades to come. And about 50% of the acqui has a science-based target either implemented or pending. And within the fixed income universe, it’s about a third. So it’s a lot less within fixed income, but it can give you a really good indication of what types of industries are covered, what names are covered.
We’ve seen some insurers, particularly those in Europe who have started to say “All else equal, if there’s a relative value decision, we want the name that has a science-based target in our portfolio, we want to avoid the ones that don’t.” We haven’t seen any overly prescriptive guidance around only buying those, but it’s an interesting if/then statement that I think you might see a lot more. The other forward-looking metric is this thing called implied temperature rise, which uses something like a science-based target and that it considers the current emission profile of a company. It’s for future-looking targets. It then says what the temperature of the world would be if every company had that profile. And so it gives you a sense if it’s Paris-aligned to one and a half or two degrees or not.
And by using those types of assumptions in things like strategic asset allocation, which we’ll be publishing a paper about in the coming month or so, I think you’re able to at least get a sense of what the relative value trades are in things like your high yield portfolio or your EM exposure relative to DM or IG credit. And so again, it’s about moving the conversation from your positioning today and having a forward-looking view on what that might be like in the future.
And just the last thing I’d say to your point about the data inconsistencies, in my experience, the regulators that are the most active or the rating agencies that are the most active in this space are really looking at this as a best efforts basis at this point. I think they’re going along from a fact-finding perspective as much as the insurers are. And so I think if you make a best efforts basis, even with simplifying assumptions for things like securitized or your municipals exposure, I think that still puts you in a small group of insurers who would be the furthest along when it comes to ESG integration. And that’s really our 2.0 theme that we think is going to show up in a big way this next year.
Stewart: I love that. And so this is going to be a little bit of an out-of-field question, but if when we look out into 2023, what risk do you think is mispriced or that the market is not taking into account as you look forward here?
Tim: Yeah, so for me, it keeps coming down to elevated interest rates in inflation. And I think what we’ve seen, and honestly, the can continuously gets kicked, but the market continues to price in some element of not just reducing the amount of hikes, but also beginning cuts in 2023. And in my mind, I think the Fed would be quite comfortable with leaving it at an elevated level to make sure that the inflation story is playing out as they wish. I don’t think that they’re going to flip into easing mode just when the inflation picture fully turns. I think they’re going to want to just make sure that the story’s playing out over a longer period of time, and I don’t believe the market’s pricing that in enough. Certainly, there’s all sorts of other tail risks from how well you expect the opening of China in Q1 to be as it relates to COVID, or even some additional items that could come out of the Russia/Ukraine conflict. But for me, it’s this idea that we’ll see rate reductions next year. I’m not sold on that.
Stewart: I think that’s a great point. Listen, man, thanks for being on. I mean, for full disclosure, you’re a frequent guest on our podcast. We’re friends. And I just want to point out to you, do you know that you have more letters after your name than that’s in your name? I just counted it up, right? CFA, CAIA, FRM, SCR.
Tim: I’ve promised myself that that does it. That is all the alphabet I can handle.
Stewart: I love it. You’re an astounding resource. You always have great insights and I appreciate you being on.
Tim: Stew, thank you so much, and it’s been a real pleasure to be part of the podcast a handful of times now, and what you built at InsuranceAUM is such an awesome resource. So kudos to you and the team and excited to see how much it grows in the future.
Stewart: Thank you very much. I appreciate it. Tim Antonelli, managing director, insurance strategist, and portfolio manager at Wellington Management. Thanks for listening. Please follow us on Apple Podcast, Spotify, Google Play, Amazon, or wherever you get your podcast. Please rate us and review us. We appreciate it. Thanks for listening. My name’s Stewart Foley, and this is the InsuranceAUM.com podcast.