Executive Spotlight: Aaron Diefanthaler, Chief Investment Officer & Treasurer of RLI Corp

Stewart: Welcome to another edition of the CIO Spotlight. My name's Stewart Foley, I'm your host. This is the InsuranceAUM.com podcast and we are joined by a very good friend, Aaron Diefenthaler of RLI. Aaron, welcome, man. How are you?

Aaron: Hey, Stewart. I'm great. How are you?

Stewart: Good, thanks. It's great to see you. Just back from the symposium a week or so ago-

Aaron: Great event.

Stewart: ... and thanks so much for being there and I want to get your thoughts on that. Fair warning to the audience, you and I have known each other for something on the order of 20 years, right?

Aaron: Correct.

Stewart: Only one of us is aging, which is lovely. That would be me.

Aaron: You're too kind.

Stewart: So start it off like we start them all. Hometown, first job, fun fact.

Aaron: Okay. So I currently reside in Peoria, Illinois and I grew up in the Peoria of Indiana, Fort Wayne. Fort Fun as it's most often referred to. But Fort Wayne is a great place to grow up and maintain my roots in my undergrad years at Indiana University and then have really been Chicago-centric or Illinois-centric since then.

Stewart: I have family in Fort Wayne.

Aaron: Oh, you do?

Stewart: Honest to Pete, like ancient relatives. But yeah, my Uncle Walter, great Uncle Walter was from Fort Wayne, so I heard a lot about Fort Wayne as a kid.

Aaron: Good.

Stewart: How about your first job?

Aaron: First job. It's hard to pick just one because I had a lot growing up. I mowed lawns, I babysat for kids in the neighborhood. I was the oldest cousin, so I was always babysitting for the extended family.

Stewart: And let's face it, you're trustworthy. You're a trustworthy guy. I mean, just looking; people who don't know what you look like, you look very trustworthy. I can see how the babysitter thing worked out for you.

Aaron: I appreciate that. Our family had a little family business office supply and office furniture business, I worked in the warehouse there. I worked at Sears. I worked at Baskin-Robbins. I poured concrete. I was a maintenance man for a home rental business.

Stewart: Oh, we share that. I was a maintenance person at a pool. It's not pretty what happens at a pool sometimes. What about the fun fact? You've got a lot of relationships with other CIOs. I'm open, this fun fact could go anywhere here.

Aaron: Oh, man. Well, you are correct to identify the insurance CIO universe as a fairly tight fraternity of folks, we get along great. We're very collegial. And I know a lot of fun facts about that group that probably many of those facts are not worth airing today. So we'll just leave it with, I've had many first jobs that have colored my career, which has been-

Stewart: I like it.

Aaron: ... centered on the insurance world for a long time.

Stewart: Well one of the things that's really, I mean probably our greatest asset, my greatest asset is the fact that the CIO community treats me very much as one of their own, undeservedly. But I appreciate the relationship very much. I started my career in a third-party business with a firm in Chicago that you and I both worked at. So we've had a long history together. You've worked in the asset management side of the business. You've been on the CIO side of the business for quite a while. And, we always kind of start out and want to pick your brain a little bit, and we talk about talking points, and your first one was making treasuries investible again. Can you talk about what you mean when you say that?

Aaron: Yeah, I think in insurance asset management, everyone gets the joke that income is very important to an insurance company because of its influence on operating earnings, which is, especially for public companies, that's a very comparable statistic across carriers. And for a long period of time, treasuries just were not investible because we were all looking for spread in order to maintain some level of book yield in the portfolio. So we were not the one part of the balance sheet that was responsible for eroding operating earnings. And I think today with the yield curve coming up and flattening, you have the ability to invest in treasuries, likely above where your average book yield sits today. So you're not in a position where you're eroding operating earnings. And I think it's our job from time to time to rebuild what I call ballast in the portfolio.

And I view treasuries and high-quality assets as ballast in the portfolio centered on the fact that we will have dislocations in the future. But I believe that historic correlations of risk assets, for example, public equities and duration, those correlations will come back into line based on what we've seen over time. And that correlation should move down the spectrum from where we are today. Currently, we have asset prices across the universe, risk assets, public equities, fixed income, all moving in the same direction down. And I think that correlation will come down and now is a time where you can build ballast in your portfolio and give yourself some flexibility to rotate toward risk assets. Simply rotate from treasuries to spread product if we get corporate credit moving wider in a more recessionary environment. And you can be agnostic right now where you're playing along the yield curve because it's so flat.

Stewart: And it's a great point, this idea, this concept of ballast. Really you're talking about, it's almost like a barbell, where you're talking about adding to a very liquid portion of your portfolio. And because you have added to less liquid portions of your portfolio over time as you've needed to reach for yield given the protracted low rate environment that we've seen for quite some time. Have I got that about right?

Aaron: Yeah, that's about right.

Stewart: So let's talk about, you and I are both recovering bond geeks and so let's talk duration. In school, I remember back at the University of Missouri, they're saying “Banks and insurance companies manage their assets versus their liabilities.” And what you come up with is that most PNC companies run significantly longer liabilities in the duration because typically the yield curves upwardly sloping. There was a very large insurance company who said publicly that they had shortened duration going into this increase in rates. You don't hear a whole lot of active duration coming out of an insurer. How do you think about duration and maybe just a little bit about RLI’s book, so that people get a handle on what the tail looks like?

Aaron: Sure. So RLI, we're a property-casualty insurer, and we're in the same range as most other PNC companies in terms of the duration of the liability structure, kind of in that three to four-year range. Certainly their longer tail liabilities in the casualty book and some shorter tail lines in our portfolio as well. So we don't think about it from a product-by-product standpoint. We think about it in total. And so we have a loss reserve structure on our balance sheet that reflects that.

But in terms of fixed income assets, which really I believe are the primary asset to support that reserve structure, we're over-allocated. And so some portion of our investment grade fixed income assets are pointed towards surplus because we have more fixed income than we have liabilities on our balance sheet. And so with that surplus-oriented fixed income portfolio, I view that as a longer-duration asset. So if I put it all together and fixed income that matches off directly with the reserve structure and those two are matched from a duration standpoint, I really view those surplus-oriented fixed income assets as taking on a longer duration profile. And that's how we get to a duration on the asset side of the balance sheet of about five years. Longer overall than if you were to just isolate on the duration of the liability.

Stewart: But on a dollar duration basis, it's even longer than that, right? Because you get more dollars thrown at it as well. When you and I were in the business, core bond meant investment grade only. And core bond has changed, the definitions of all these things have changed. So can you talk a little bit about how you view core bonds and how to add value there?

Aaron: Yeah, so I'll go back to my prior comment. I really view core bond as supporting the liability structure, primarily. It's there to pay claims. The fortunate position that the industry is in, really, is the fact that we constantly have flow coming our direction in the form of premium. And normally you don't have to call on a significant portion of a fixed income portfolio at any given moment. You certainly have certain situations that you tried to model for, a big cat event, for example, that would call on the portfolio. But in most instances, you're able to navigate around that, and therefore you're able to take some level of liquidity risk in that core strategy. And that can come in a couple of forms.

You could move down the credit spectrum a bit and do more of a core plus strategy with either five B exposure or higher, the higher end of high yield. For us, that's meant taking either structural risk, CLO structures for us top of the capital stack, or private placements have been part of that portfolio, Reg D privates. ABS structures, that may be a little less liquid. So you can do some things around the edges. I mean, I'll just offer the fact that insurance asset management, Stewart, you and I have talked about this before, it's an at-the-margin business, right?

Stewart: 100%.

Aaron: It's taking that next marginal dollar of operating cash flow and putting it to work in what you think at that moment in time is your best idea. And so you're steering the ship with these very marginal moves over time. In very few instances are you moving big slugs to the portfolio between sectors.

Stewart: So we talked a little bit about our symposium and you were the moderator of the alternatives panel. You've been in a lot of investment committee meetings and so have I. And while the core bond portfolio is the overwhelming swath of the thing, anything that's different gets a whole lot more attention and it seems to be a whole lot more interesting. So a lot of attention's paid to alternatives. One of the questions that you asked the panel was, is it worth it? So can you just talk a little bit about what in your mind is an alternative in insurance asset management space? And I just got back from the SS&C conference and someone had a slide up that showed allocations in the neighborhood of 4% of capital and that the trend line was between going to 5% to 8%, at least that was one person's opinion, is it worth it?

Aaron: I think that's an important question for folks in a seat like mine to ask. It takes a larger operational effort. Oftentimes you have less transparency into the structure itself for the underlying exposures themselves. We're all dealing with fairly efficient teams, that means low levels of headcount potentially. And so it does take extra effort to manage a portfolio like this. And when you're talking about an allocation in the 2% to 4% range, I think you do have to ask yourself that question. And oftentimes what shakes out is, do you have the right partner to help you?

Set aside the strategy for a moment and ask yourself, do you have the right partner to help you educate your investment committee, maintain transparency into what's going on in that portfolio or in that strategy at any given moment in time? Be prepared to help us, the CIO, communicate to other constituencies about that portion of the portfolio. So you kind of put all this in the mix and, no offense to our friends in the asset management community, but it is something that I hope is top-of-mind for them as they're presenting strategies to the insurance community. Because, we do have to wrestle with some of these other challenges, operational challenges, and we really need to lean on them to help us.

I think the definition of alternatives for insurance portfolios is pretty wide. It can mean anything from a strategy that's not in core bond to, it really has to be an LP structure or something that takes on significant liquidity risk and a lockup period or what have you. So if you ask different people, you're going to get different definitions, which to me says, should we be really talking about alts as a given sleeve and maybe break that down into what the underlying strategies really look like. And for us, that has meant strategies that have an income orientation, that have low correlations to the big slugs of exposure that all of us have – duration, and for us public equities. It certainly, almost always, I should say, takes on a component of liquidity risk. We talked about that already. So if you start to outline a framework like that, you can better navigate this very wide universe of alternatives. So I think the core questions for insurance CIOs are really centered. What are you trying to do with this?

Stewart: Yeah, and I mean we talked a little bit about this at the symposium as well, but the idea that how much liquidity does a P&T company really need? Do you guys, I don't know if you want to go there, but do you have any sort of contingency lines of credit, for example? An FHLB relationship or anything like that?

Aaron: We do, and we've had a relationship with the FHLB for a number of years now. That facility of course down at the operating company level where a liquidity event or a need for liquidity would come. So that's a great backstop for us. And I think more insurers are coming around on the idea of developing a relationship with that institution. It's regionalized, but all operate in a similar way. But there's still big elements of liquidity in the portfolio itself. You may not want to sell at a given price, but you certainly have the ability to sell.

Stewart: Yeah. So I'm going to get on my soapbox for a second because the next question here we've got is war on talent. Or war for talent, not on talent, for talent. Here's my soapbox speech to anybody who cares. The insurance industry's really a dynamic and interesting place to spend your career. My experience in teaching for a number of years is that a lot of students are A) completely unaware of insurance asset management in the insurance industry. B) don't understand insurance beyond the commercials that they see on TV or whatever, that those insurance companies outside of that, and RLI is certainly not that kind of an insurance company. And RLI is smaller, you're in the three and a half billion range or whatever it may be for your total AUM.

But here's my pitch. Aaron Diefenthaler is smart money and RLI is smart money. And for somebody who is interested in getting in the investment business in a meaningful way and doing interesting things in a variety of asset classes, and I definitely have an ax here, but I don't think any institutional sleeve of asset management is more complicated, or more challenging, than insurance asset management. And yet, what I've heard from students is that sometimes one of their criteria is how people are dealing with diversity, equity, and inclusion, or how industries deal with diversity. And that's one where both the investment business and the insurance business certainly has some wood to chop. So how do you see the war for talent shaping up in the insurance asset management business, data science? Everybody wants to go to work for big tech companies, but insurance was really the first big data user. I beat the drum for the insurance industry all the time and would love to hear your thoughts on the war for talent.

Aaron: Yeah, no, I think we certainly recognize that we need to cast a wider net to educate kids about our industry. There are certainly perceptions out there that we need to knock down about our industry. And I would characterize it as one that may be less complicated or challenging and more interesting, frankly, once you really peel the onion a bit on what insurance is, how it operates from a business perspective, not just from a consumer perspective. Because kids have one idea about insurance and that's the fact that they had to share in the cost of their auto premium when they turned 16 and that's it.

And so I think there are elements around data science, data, and analytics that we can draw on. Those majors are now well established at every institution out there and we can really draw on those foundations to bring talent into the industry. But I think the first step is really to educate kids all the way down at the high school level about our industry so that they're going into an undergraduate program knowing that this is an avenue that I can go down. And the industry is huge, right?

Stewart: Huge.

Aaron: There are huge companies in this industry. A lot of opportunities for kids to build a base around insurance right from the get-go. And, Stewart, you know as well as I, when you ask people, our peer group that have been around insurance for 20 or 25 years, every single one of us has the same story, which is “I kind of fell into this insurance industry from somewhere else. I had no intention of going into this industry when I was an undergraduate student.” And, I think you do have a handful of very good risk management schools with undergraduate programs throughout the country. And I think that's a great place to start. But I think we can really start to broaden the universe at the undergraduate level. Not only just around asset management within our industry, but industry as a whole is, really, a great place to build a career.

Stewart: Yeah, I mean there's a lot. I mean, it's a stable business, it's not going anywhere. It's very interesting. I'm amazed. I'm always interested in what insurance companies are underwriting and how they're underwriting it. It's very dynamic and I mean I think you know, we're in the process of putting together some curriculum around trying to put some fundamentals together around insurance asset management. So you're right, there are some great risk management schools out there, but still wood to chop as far as getting information out there on the insurance asset management side.

I always joke that in Moses's other arm was the rules of how to manage insurance asset management and the tablets have been passed down for generations with the following instructions, "Don't break these, we don't have another copy." So I think that's true. So one of the things that's somewhat unique about insurance asset management is the idea that your investment partners sometimes do more than just the investments. And often they have very robust capabilities to support your operational needs. So can you talk a little bit about that, whether it's strategic asset allocation or DFA models, or how are you using your partners beyond just strictly insurance?

Aaron: Yep. I think the industry of asset managers that serve us at a very core level have understood for a long time that teams within a given carrier are often small or efficient, as I put it before. And as I alluded to in our discussion around alts, we really want those partners to be an extension of our team. And often that comes in the form of operational support and the two things you've mentioned. Certainly, we're using outside managers to help us with strategic asset allocation work. And the foundation of that is a DFA model that models up the entirety of our balance sheet, both assets and liabilities. We take a view on a multi-year horizon and we use our capital bases really the center point of some of the answers there.

But we are altering our allocation to get a view on what an efficient frontier may look like for our business, and so that's an important way we lean on those partners. But I think it's broader than that. Asset managers sit in a very unique position where they see a lot of strategies that are all wrestling with the same challenges and problems, not just “Can I support the liability structure,” but “What other constraints, capital or otherwise am I dealing with? How do I continue to support operating earnings as we alluded to at the beginning of our call here?” And they can help bring some perspective to the table in an existing relationship that would be very difficult for me to gather on my own.

And so I just walked through a peer analysis with an asset manager yesterday. It's an exercise we go through every single year. And you certainly want to know where you sit in a given peer group, but you want to understand how things are evolving in other people's portfolios over time. And I think this particular asset manager had a very interesting perspective as to the whys around why things are evolving for this given group of peers or the industry at any given moment. So, I think absolutely you have to be ready to serve beyond just ‘buy this, sell this, rotate from this sector to that sector. Here's where relative value sits.’ I think you have to be prepared to do a lot more.

Stewart: So I moderate a panel at our symposium on climate, and I spoke on a panel recently on climate. The NAIC is putting out, and some states are taking them up on, this idea of reporting on climate exposure and so on and so forth. And the challenge, really, is the availability of data and any sort of agreement around what metrics we're going to measure. I mean, insurance companies have skin in the game certainly on climate change, because the extreme weather events create claims. We saw that in a big way in the tragic events in Florida with Hurricane Ian. How do you see climate playing out on the insurance side with, maybe not necessarily so much an answer as: what are some of the challenges?

Aaron: I would take the topic up a level to just talk about ESG broadly. Climate's certainly a component of that. I think the primary challenge is, you alluded to it, is that there are various opinions around these various frameworks on the same issuer. Some frameworks view large integrated oil and gas company as well capitalized and in the best position to meet a transition away from carbon-based fuels to something else. How long that takes, I don't know. Reasonable people can argue about that for a long time. But a given framework may view that issuer as in the best position to meet the coming transition. Another framework may say, this issuer is in this industry and today I view that negatively. So you have two different opinions on the same issuer. And so if you're trying to wrap your arms around what to do if you take an active stance, for example, I think it becomes very hard.

From my standpoint in insurance asset management, we have always taken this long-term view of putting new exposures in the portfolio at the issuer level and expectation that you're almost, in nearly every case, you're going to hold that bond, for example, to maturity. Or for given equity positions, you hold those positions for a long time. So we've always taken this view on sustainability at the outset of putting positions in the portfolio very seriously to the point where we want to make sure that we're protected not just for the next year and the next two coupon payments, but for the life of that position in the portfolio. So, sustainability is kind of central to what we do. And if ESG factors come into play on that question today, more so than they have in the past, we need to reflect that in our process.

Stewart: That's well put. That's a great perspective on that issue. You've got kids and I've got a daughter and I look out at the world and I've got a few years on you, but you've been around as well for a good long while. As you look out today, if you were starting your career, what advice would you give your 21-year-old self?

Aaron: Oh, man.

Stewart: See you thought you knew the questions, all the personal questions up front, the email you sent me, you already answered them. But this one, you weren't thinking it. I got to ask you a question you weren't expecting.

Aaron: Yep. So I would tell myself right out of plan, be willing to adjust the plan. Engage people that are more experienced with you about your plan. And I think it's important to have central elements of that plan to be fairly static and central elements of that plan to be fairly malleable. And so I think what I'm saying is have a stake in the ground, but adjust your approach accordingly based on new information. And that's kind of theoretical, but-

Stewart: It matters, right? It's just like going on a GPS. You set the destination but you drive along and you go, "Wow, that looks interesting. Maybe I want to take a little detour off of here or take a stop. But I've still got my long-term goals in mind." And I mean you mentioned it earlier, data science not that long ago wasn't that common. There are new opportunities and new avenues to pursue all the time. You have to be able to adjust. To be willing to adjust. Hang onto the goal, let go of the path.

So, I really appreciate you being on, man. It's great to catch up with you. You're very insightful, very thoughtful about the investment world and you're a good friend. I really appreciate all the leadership that you showed at our symposium and all the work that you did to make that a great event. So, thanks for taking the time, and thanks for being on.

Aaron: Appreciate it. Thanks, Stewart.

Stewart: You bet. Thanks for listening. If you have ideas for podcasts, please email me at podcastinsuranceaum.com. My name is Stewart Foley, and this is InsuranceAUM.com podcast.

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