Stewart: This is The Insurance AUM Journal Podcast. We are standing with you at the corner of insurance and asset management. My name is Stewart Foley. And today, Joe Eppers is in the house, CIO of Selective Insurance. Welcome, Joe.
Joe: Thanks, Stewart. It's great to be here and it's great to be in the house, and presumably on the hot seat.
Stewart: Oh, I love it, man. Today, we have a guest that doesn't talk to a whole lot of people, doesn't do a lot of interviews, so we're very glad to have you on, Joe and we appreciate Rich Coffman for getting us together.
Joe: Yeah. Well, it's great to be here. I've been pretty shy over the years, but look, I really enjoy your periodical. Of course, I have a lot of respect for Rich, and so I thought I would join.
Stewart: That's good stuff. We appreciate that. So what is the toughest part about being in a CIO's chair today for an insurance company?
Joe: Yeah. You start with a hard question. So I think everything is really tough right now because when I look at the investment landscape, and the low yields, and what that's doing to ROEs across our industry, it's challenging. Our job is to try and be creative and find ways to mitigate some of that lower yield, and do it in thoughtful ways where we're not opening ourselves up to risk that we don't want to take. So I think it's probably the most challenging period in my career in the insurance space. We're trying to be careful. We're trying to tread lightly and do what we can.
Stewart: So with the markets today, and I look at this, I see the same thing you do, right? Is there anywhere that you see what I would refer to as measurable value?
Joe: I think it depends on how you define value, what you're measuring value relative to. So when we think about value, we think about it relative to traditional core fixed income, which is probably like many insurers. That's our primary asset class where most of our assets are. So there are some things that are attractive relative to traditional core fixed income. In particular, as I think about three ways in which we can add income or take on risk, one is through duration, the other is credit, and the third lever is liquidity.
Joe: I think that's the area that we're the most keen to exploit over the course of time, which we've been doing for the last couple of years or so, but continuing that theme of taking more liquidity risk because the public markets are just so tight in terms of credit spreads and yields that you're not getting paid that much or compensated for duration or credit risk.
Joe: So where we can take liquidity risk in areas of the market, like corporates or commercial mortgage loans, or even in alternatives, those are the areas that we're looking to exploit.
Stewart: In that answer, you said traditional fixed income, right? So you and I have been in this business long enough to know that wasn't that many years ago that an investment grade core bond portfolio was the predominant asset class, an overwhelming majority asset class and largely driven by regulation, capital charges of those assets, the entire regulatory regime, that's really focused on default risk, right? That's really the core of it.
Stewart: If that regulatory regime were different or how big of a shift, do you think there is... Or is there a shift away from traditional core bonds? I know we've seen it. What's the regulatory environments impact on that decision?
Joe: I think it certainly weighs in the calculus of determining how much risk you want to take and where you want to take it. It's certainly something we're aware of. As a P&C insurance company, we do look at capital. We do look at the regulatory environment and regime. We care about RBC, but we try not to let it get too much in the way of how we make decisions. A perfect example is, as I said earlier about taking liquidity risk, that its not really factored into the regulatory regime other than in alternatives.
Joe: So if I can own a private credit or a private investment grade placement bond at a similar duration as a public bond, and pick up 50 basis points in additional yield or spread, that's really attractive whether you're thinking about it from a regulatory framework or just from a pure economic standpoint.
Joe: And that private bond is actually even more attractive on a fundamental basis if you consider that you're getting covenants, you're getting structure in many cases, and you're getting compensated for that illiquidity risk. So I think most insurance companies are starting to think differently and look at their portfolio differently, not so much because of what's going on with the regulatory side, but more about the opportunity set.
Joe: I also believe that liquidity is something that we as an industry have probably overvalued for quite some time. If you need liquidity as an insurance company, you probably have a bigger problem. And when you do need liquidity, it's typically not there. So as an example, last year at this time, if one needed liquidity to de-risk their portfolio or to meet operating needs, you were going to pay a heavy price for that.
Joe: So I think people are starting to come around to the conclusion of, "Hey, I can take more liquidity risk, whether that's in privates or in alternatives or other areas of the market, and get paid appropriately for that illiquidity risk." As a result, I don't need to own as much traditional, down the fairway, core fixed income, which is typically high-grade corporates, high-grade municipals, and cards and autos within structure product.
Stewart: It's a really good point. I think when you start talking about risk mitigation and when you do see market dislocations, it's like, do those traditional ways of looking at risk mitigation work, right? Or does it desert you at the time you need it most? It's interesting, we're talking about duration risk, credit risk, and liquidity risk, but there's of course a whole myriad of other ways of looking at risk. Is there anything that you think is particularly mispriced one way or the other?
Joe: It feels like everything is mispriced, just given where risk-free rates are at. So if you discount any cashflow based on today's risk-free rates, everything feels quite expensive as a result. Over the next couple of years, I think we're going to be in this low return, low risk-free environment. And that's primarily a result of the Fed's efforts and fiscal deficits. I think if I had to look out over the next year or two, I'm not too worried about risk, but where I get more concerned is beyond the next couple or three years, and trying to figure out how does this environment that we're in come to an end or evolve, and trying to understand how the Fed extricates themselves.
Joe: We saw in 2018, the Fed really struggled with that. And we saw what happened to risk markets. I fear that we may have a similar problem in the next few years when the Fed begins talking about tapering or tightening, and their messaging begins to change. So I worry more about that period of time.
Stewart: You make a really good point that in 2018, at the end of it, even though the Fed telegraphed their move repeatedly. It sure didn't help the market from getting the shakes after the actual event.
Joe: That's right. It's like a vicious cycle, right? The Fed eases, and everybody puts risk on. The Fed begins to signal tightening, so people get nervous. The Fed begins tightening, and then people begin to take risk off, which causes problems in the economy. The Fed then has to either pause or re-stimulate. I feel like the Fed is in a corner, and it’s going to be really hard to get out of it longer term.
Stewart: So when you see a backup in a ten-year note like we've seen, a pretty aggressive backup, particularly in relative terms in particular when you go from 80 basis points back to a 150 basis points or whatever it was. Is that a head fake in your mind or do you think rates trend higher from here or are we going back where we were in terms of the lows?
Joe: I wish I knew.
Stewart: Me too. I'd stopped doing podcasts and just trade the 10-year note futures. It'd be perfect.
Joe: In all seriousness, I really don't have a strong view either way. I read the arguments on both sides of the coming wave of inflation and as a result, higher interest rates. Then I read the other argument, which is around these secular forces that have been at work for the last 30 years to keep interest rates low. And I think both sides make strong arguments. So I don't know. Honestly, though, I'm cheering for higher rates. I think we need that as an industry. Whether it's the insurance industry or the pension world, higher interest rates, as long as they get there in a slow and gradual way, are going to be good for us, but I have no idea what the future's going to look like for the direction or level of rates.
Stewart: There's been some pretty big transactions recently where folks are selling their life blocks to PE firms or acquisition firms because they have a broader set of more arrows in their investment quiver, if you will. Does that continue in your mind? Does that sort of transaction where these folks can get permanent capital, do you think you're going to see more of that? Or do you think that mitigates, if rates start to rise And what a bond geek... Like me, a bond geek, thinks rates going up is not good. Right? But in this environment, we need it. So what do you think there?
Joe: Well, I think it depends partly on the supply. Companies who are unloading their pensions to these insurance companies, who are buying them, are they going to continue to do that? I think that trend will continue. I think companies want that liability off their balance sheet. And as they become more well-funded, that will continue to be a good option for those companies who want to remove that. I think on the other side, in terms of insurance companies who are in this space and acquiring these large blocks, I do think that will continue. I think these business models have been created to create transactions in the market. And we've seen them in our seat, and we're a property casualty company. We've seen deals in the market, and we've participated in them as well that were structured for these life and annuity companies, that you wouldn't have seen five, 10 years ago.
Joe: So there's a lot of creativity amongst these companies to create flow, to create product, to meet that duration tenor, and to meet that spread need to capture that business, and be able to price it. So I think it's going to continue.
Stewart: That's interesting that you're seeing those deals. So you mentioned earlier going down on liquidity, what do you see as the future for public versus private markets given where fund flows have been going not today, but for a little bit here? How do you see those two markets going forward?
Joe: I think at least in our market, in the insurance space, I think you're going to continue to see a push to privates. I think that's really driven by where public yields and spreads are. I think as long as those continue to stay low, that's going to naturally drive our industry to want to take more liquidity risk.
Joe: I think today with re-investment rates at a one handle or sub two on high-grade corporates, people are going to continue to be incented to take liquidity risk in different areas of the market. So it really depends on where the public markets go, but if the public markets continue to stay low, then I think that the drive to privates is going to continue pretty aggressively.
Stewart: We hadn't talked about this, but we had a conversation with Nick Martowski last week, and it was really focused on the use of equities by insurance companies. What's your view of equities in a property and casualty setting?
Joe: There's certainly a place for them in asset allocation. We have a small allocation of public equities. We have a bigger allocation to private equity. And just in terms of how we think about public equities as an example today, I think even though the markets are trading at 20-22 times forward earnings, which feels really rich here, there are areas of the market that I think have value. So whether it's value stocks, and those have done really well lately, but the under-performance of value stocks over the last 20 years has been significant, so there's probably more room to go there. And the starting valuation is just a lot lower than growth stocks in general.
Joe: Then dividend stocks. I'm a big fan of dividend stocks. We started buying dividend stocks last year at this time, and we were getting 4% plus yields at the time. Today, you're getting 3% plus yields. I can't really replicate that anywhere in core fixed income. So buying that dividend, and having the upside option of that as an equity, I think is very attractive for us and for others who like income and also like the upside.
Stewart: So let's turn back the clock to last year. Pretty tumultuous. Obviously, COVID driven a lot of it, but not solely. What were your takeaways from last year?
Joe: As I think back on the lessons and experience of last year, obviously it was very unique in my career and probably most careers. You think about the '08 crisis and that tended to unfold over a longer period of time. I think the thing that I am really proud of from last year is just how my team and how our managers responded to the events. While it was quite a stressful environment, what made it in hindsight feel better, and the outcome in terms of the actions we took, was the strong governance we had going in working with our management investment committee. Beginning in late February and through into the summer having multiple meetings per week to talk about the portfolio, and what was troubling, and to talk about opportunities and where we could take risk.
Joe: Also, our relationship with our internal partners within Enterprise Risk, and really doing a lot of modeling on the portfolio to understand how the portfolio was reacting and whether we could take more risk. That allowed us to eventually take more risk coming out of that period, which set us up well for the second half of the year and into this year.
Joe: So I think as stressful as that period was, as I look back on it, I'm quite pleased and very proud of how we as a team and as a company handled it. We didn't sell anything, and where we could, and where it made sense, we decided to add risk, and I think ultimately that made for a much better outcome as I sit here and look back today.
Stewart: Yeah, it's really interesting. The risk management and governance protocols really come into play at that point, right? That's when you need to make sure your seatbelt was on. Can you expand a little bit on how you model the investment portfolio? Is that done internally? Is that external combination? How are you accomplishing that risk modeling?
Joe: We look at the risk in the portfolio under a number of different models and methodologies. But I would say that if you talk to our enterprise risk folks, they have their model, which is an economic scenario generator, that's more of a stochastic analysis in terms of how they look at and proxy the portfolio. Then internally on the investment team, we have our 3rd party model, which allows us to drill down on where the risk is in the portfolio, whether it's duration, credit, sector, or issuer. All those things allow us to have a pretty wide lens across the portfolio, which kept us well-informed of what was going on during that period.
Joe: It also allowed us to have better and broader conversations with our outside managers on the risks they were taking and the risks that were in the portfolio. Obvious sectors that were more tied to COVID risk, whether it's debt tied to leisure and hospitality or energy, or CMBS, or other areas of the portfolio that were more impacted by COVID. Those tools really allowed us to stay informed on what was going on in the portfolio, and make sure our portfolio could withstand it.
Stewart: And you bring up a good point. People in the industry know, but people outside the industry don't always know that managing money for an insurance company involves managing a very substantial investment portfolio inside the belly of an operating entity.
Stewart: Right. You're not making decisions in a vacuum. If you take a capital hit, that can impact the ability of the entity to write business. Right? So it adds, not one layer of complexity, but many, which is why I think that insurance asset management is underrated for its complexity.
Joe: I couldn't agree more. I think in fact, one of the things that came out of a lot of the work we did last year in understanding our risk profile is with the drop in rates that we've seen, and I think you're going to see this across the industry, is that risk in company portfolios is elevated more than it's ever been. And that's primarily because with interest rates being as low as they are, we as an industry are not getting the benefit of duration that we once did in times of stress.
Joe: I haven't heard many of my peers or any other industry participants talking about this. You tend to see this in VAR, or in scenario analysis. I really haven't heard anyone talking about that, but I have to believe that's going to be a topic of conversation this year as people think about their asset allocation and think about their risk positioning and the outcome of having lower interest rates and what that means to people's ability to put more risk on.
Stewart: Okay, good. This is my final question, and it's my favorite. So here it is. It is your graduation day of undergraduate school. You are looking good. Despite the festivities that may have occurred the night before, you're looking bright eyed and bushy tailed in your robe, and your cap and gown, there you are. You're in there and you're waiting patiently, and the way that this usually goes is you have to walk up the stairs and then they hold you, and then they announce your name and the crowd goes crazy.
Stewart: You walk over to the university president and he or she reaches out their hand, shakes your hand, hands you your diploma, you get a nice little picture, right? You walk off and your raise your hands or you go, walk down the stairs and you run into Joe Eppers today. Right? What do you tell your 21-year-old self?
Joe: First of all, that's a really hard question because I'm not sure what I would tell my 22-year-old self except that it's going to be okay. I remember this coming out of college and I'm hearing this from some of my kids who are in college that there's a lot of anxiety and concern about what am I going to do? What am I here for? What's my career? You just can't have all the answers when you're 22 years old. You can't plan your life and your career absent graduating and becoming a doctor or a lawyer or certain lines of profession. I think generally speaking, most of us don't know what the future holds and what we're going to be happy doing down the road.
Joe: If you'd have told me 30 years ago, when I graduated college, that I'd be where I'm at today, there's no way I would've been able to see a path to get me there. So you just can't predict the future. I think as a result, what I would tell myself is learn as much as you can, take chances, network and build relationships, and put yourself in a position so that as opportunities come along, because they always do, as do challenges along the way. It's going to make you more prepared for finding that ultimate place that you are going to be the happiest in terms of a career.
Joe: So that's what I would tell myself. And interestingly, I just heard my wife giving similar advice to my son last night on the phone, who's away at college. So I think that would resonate with me at that age.
Stewart: That's good advice. Really, really good advice. Joe, thanks for being on. Joe Eppers, CIO of Selective Insurance. Joe, thanks for joining us.
Joe: Thanks. It's great to be here. Appreciate your time, Stew.
Stewart: Absolutely. If you have ideas for podcasts, we want to hear them. So please email us at email@example.com. If you like us, please tell your friends. You can follow us on all the major platforms. My name is Stewart Foley, and this is The Insurance AUM Journal Podcast.