Executive Spotlight – Christine Todd, CIO of Arch Capital Group

Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name’s Stewart Foley. I’ll be your host. I was born and raised in Missouri, and I saw an antique Mark Twain cigar box, and the slogan was, “Known to everyone, liked by all.” And that is very appropriate for our guest today. We are joined by Christine Todd, who’s the Chief Investment Officer of the Arch Capital Group. Christine, welcome. I’m thrilled to have you on.

Christine: Thank you, Stewart. It is my honor. I promise. I like your podcast very much, so I’m humbled to be a guest.

Stewart: I’m thrilled. And we got a chance to meet for the first time in person at Nathalie Rushe’s Rushe Capital event in Bermuda, where you were a rock star. You participated in every way, right? You were actively participating. And then during the musical bingo segment, we got a chance to see your lighter side. So it was really fantastic. And in all sincerity, you are very well known and you’re very well-liked, and I think it is consensus that you are really smart money. And so I can’t wait to hear what you think about markets and where we are today. But before we get going too far, we start out this one like we start them all. What’s the town that you grew up in, your first job, not the fancy first job, and then the final of the three is, what makes insurance asset management so dang cool?

Christine: Well, you could answer the last one better than anyone in the industry, but I’ll give it a shot. Town I grew up in, a small town outside of Boston, Massachusetts, and I raised my family in the neighboring town, which is a testament to how much I liked the area and appreciated my upbringing. First job, very frustrating. I was 15 years old and needed to be able to walk to the job, so I walked over to McDonald’s and Friendly’s, neither of which would hire me because I wasn’t 16. So then I walked down the street to what is called the Ship’s Way Motel, and you might’ve seen it driving over the Sagamore Bridge. It’s got a big sign beneath it. We used to call it the Shit’s Way Motel for obvious reasons, and they didn’t care how old I was, as long as I was willing to do the most disgusting cleanup of the rooms after the guests had all left. So I was very proud of my job. My grandfather said, “Oh my gosh, you walk all the way to work every day”? And I said, “Certainly not. It’s too far to walk. I run.” He loved that.

Stewart: That’s great. And what makes insurance asset management so cool for you?

Christine: The complexity is a big challenge. Delivering, maximizing and optimizing total return within the constraints, regulatory, liquidity, and honestly, some human risk aversion, is hard to navigate, but incredibly rewarding when you can deliver the results despite that complexity and restriction.

Stewart: That’s really well put. What does it take to be a good insurance CIO? What’s involved? Because you’re a damn good one. We have mutual friends that are also incredibly talented people. What do you think makes a successful CIO?

Christine: You have to understand underwriting. You have to be able to speak the language of actuaries. And you have to first and foremost approach the portfolio in service to the business. And in order to be effective in unlocking value and opportunity across the organization, you have to speak the language of insurance underwriters, executives, actuaries, analysts. And that was the hardest thing, the learning curve, for me. It’s not just about making good investment decisions, it’s about calibrating those investment decisions according to the underwriting cycle, the hard and soft market, and the liquidity and profitability of the organization.

Stewart: It’s funny, I moderated a panel for Chicago CFA’s Strategic Asset Allocation event for insurance. And I started off by asking the crowd, many of whom were CFA charter holders, to talk to me about the process of strategic asset allocation. And they threw out all of the things, all the capital market considerations that you would expect. And I looked at the panel who… Natalie Burkart from Allstate, Jill Phlegar from Nationwide, and Danielle Natonson from Cardinal. And I said, “Don’t you wish that was all…”

Christine: Star crowd.

Stewart: Yeah, it’s a good crowd. And I said, “Don’t you wish that was all you had to worry about?” Because I think that people who aren’t in this industry don’t understand that… I mean, the idea, and I’ve thought this for a long time, but it’s interesting that you brought it up, when you think about insurance terminology, rate online. Rate online is yield spread, I think. It’s the amount you’re getting paid to bear risk. Insurance entities are so interesting, because you’ve got one pile of capital, and you’ve got levered exposure to risk on both sides of the balance sheet. And you better be good at pricing that. And the concepts are the same, but the vocabulary is completely different, but the concepts are the same.

Christine: You just absolutely nailed it with that. Yes.

Stewart: And here’s the other thing that I think is interesting. When they talk to the CIO, they say, “I want you to maximize return per unit of risk.” That’s not what they’re telling the underwriter. Nobody’s telling the underwriter to maximize the top line. They’re saying, “Make good risk decisions.” Even though you and the chief underwriting officer are trying to do the same thing, you’re trying to maximize the return on the capital you’re putting at risk. So speaking of which, what risks do you think are mispriced today?

Christine: Risk in general is mispriced. The risk markets, especially in the U.S., have rallied beyond what we would’ve ever expected given the fundamentals. So you’ve got the Russell 2000, I think 40% is negative earnings. We are in an earnings recession in the S&P 500, it’s still up somewhere around 18%. You’ve got high yield spreads having come in over 100 basis points, inside of 400. And the yield curve is telling you the opposite. The yield curve is telling you that we’ve got a recession, if not a financial accident, on the horizon. And the consumer is just euphoric. Economists have shifted their expectations from a recession/hard landing to a soft landing/no landing. And to me, that’s a harbinger of the opposite to happen.

Piper Sandler back in February put out a piece where they clipped newspaper headlines back from… Going back to the ’70s, ’73, ’78, early ’80s, late ’80s, 2000s, right before the GFC, all of which were saying, “Soft landing approaches.” So we keep reminding ourselves of that when we see the jobs numbers, the housing numbers, and we keep reminding ourselves that fundamentally the structure of the economy doesn’t support this continued growth. It’s fake, largely because the consumer has excess savings, which are set to run out, although that finish line keeps moving forward. And then you’ve got the government spending, the Bidenomics, the CHIPS investment infrastructure, green economy, and that is not sustainable as compared to the structural change in the banking industry.

So the regional banks have, since March, permanently higher funding costs to the tune of 50 basis points. You’ve got regulators coming in, and the FDIC. So it’s all the regulators, SEC, FDS, you name it, are all over this, and we’re going to have a much more constrained capital environment for the banks, on top of the fact that they’re seeing more delinquencies in not only the commercial but also the household, the consumer book, less demand by the consumer and by the corporate sector, less supply of loans at higher cost. Just that in and of itself, on top of the fact that the Fed may or may not be done, but the Fed certainly is not in a mode of loosening policy and reducing interest rates given the jobs market.

So you’ve got high rates, sustained inflation, you’ve got a banking industry that’s being less generous with liquidity, and that’s structural. And you’ve got the private markets, lending markets stepping in. But Kipp deVeer from Ares made the statement on a podcast recently, you can’t finance the economy with 12% senior debt, which is what Ares and their peers are doing. So this is not sustainable. So I guess the short-winded answer to your question is, the euphoria and the expectation for a soft landing we believe are misplaced, and that the risk markets are very dangerous, particularly levered credit and U.S. equities.

Stewart: That’s really fascinating. So at the risk of making half of my clients mad, let me just walk down this path with you. Low loss experience, solid structures, 40 basis points of spread. That was, if memory serves, subprime mortgages in about 2006. And you look back and you go, “Well, I can get 40 basis points… I mean, look at this loss exposure, it’s been fantastic.” When I look at private credit today, I’ve heard it couched as defensive. I’ve heard it is super stable and so on. But the underwriting on a lot of that hasn’t been stress-tested, the non-bank lending market. Is that a concern for you? And a lot of those loans reside on insurance balance sheets. Are we on the same page with that concern, or are you looking at it differently?

Christine: It feels like the private lenders have more negotiating power. They need to lend less urgently than the borrowers need to borrow, and therefore the terms are very much slanted in the lenders’ favor, and they are more and more discerning about those to whom they’ll lend. And there’s a big difference between managers and their approach and their underwriting standards and the businesses to whom they’ll lend. That’s an important part of allocating capital to the private lending markets, is that manager selection, and really understanding what the terms and conditions are and the levers that they can pull when things don’t go right in their track record as to how they remediate when things go wrong.
Because you’re never going to have a 1.000 batting average. There’s going to be, in this market, times when you need to work things out. And there needs to be not one but three choices, three avenues to remediation. And that has to be underwritten going into the loan, rather than figure it out during a crisis. And a lot of these managers have the war wounds, have the track record, have the experience, have the playbook, that they can protect themselves going in and they can maneuver during the crises.

Stewart: Thank you, that’s really helpful. What’s the yield curve telling us right now? You touched on it a moment ago. I’ve been at this for a minute. When you see an inverted yield curve, someone stated the other day that the yield curve is as inverted as it’s been since 1980. I was in high school in 1980, but I remember the conditions. And it seems my fixed income geekness wants me to think that, when you’ve got this kind of inversion, you’re supposed to extend, because it means that there’s going to be lower rates due to economic weakness going forward. But that doesn’t seem to be what folks are doing today. So what’s your read on what the yield curve, just looking at it, what’s it telling you?

Christine: It’s telling us that there’s going to be a financial accident or recession. And for sure as we approach, as the data starts to confirm that more solidly, the front end will come down in expectation of the Fed needing to stimulate. I don’t have a lot of confidence that the curve will shift down in the 10-year type range. Point being, we have a big deficit problem, and we are showing no signs of restraint. And Fitch noted that in their recent downgrade, an erosion of governance, fiscal deterioration.
I think that was under-reported on. There is a governance problem in the United States that is going to cause a permanent change to our economy in the form of needing to maintain high levels of inflation, in order to defend against debt-to-GDP that gets to that 130 level when it’s not sustainable. So that supports higher rates.

Secondly, you’re seeing very clearly a diminishment of foreign demand for US treasuries, partly because other parts of the world, their yield curves are no longer negative. But also, I think countries are trying to de-risk concentration into the USD. And at the margin, it’s not material we’re still the fiat currency, et cetera, but over the long run, and markets are anticipating a long run, that may not be so true. That may be more permanent.

So I think that the terminal rate is higher than the market might be expecting. I think inflation is higher and stickier than the market might be expecting. And I think that over time the Fed is going to modify its language such that slowly 3% is the new 2%. And there were some tinges of that with some of the speakers coming out forcefully, not enough to rock the market, they’re very careful of course about that, but I think that will creep in. I don’t think that a 2% target is at all realistic.

Stewart: It’s interesting, and I know you were front and center in these markets in 2012, when Greek debt was like trading its $60 price. Right now, Greek tenure note is trading through U.S. Treasury tenure note. I’ve just looked at the levels, and I think it was seven basis points that the treasury is yielding, seven basis points more than the Greek tenure. So I think your point’s extremely well taken there. It always looks to me like we as a country or as a government don’t have the discipline required to address it. And it doesn’t seem like anybody caress until one of the wheels flies off the wagon, then we’re in there with bailing wire and Band-Aids and trying to figure it out, but as opposed to being more proactive in the front end.

Christine: And there are trends that we can’t fight, demographics. I mean, the whole world has a demographic outlook that’s going to tax the fewer young workers in favor of the greater population of older people. We’ve got the expense of climate change. I mean, Biden is spending recklessly on preventative measures, that may or may not be deployed according to schedule. But one thing that is for sure, is that we’re going to have to do remediation. When we have fires and storms, this is expensive and this is inflationary. And deglobalization is now a trajectory. That train has left the station. That is a tie that is not going to be reversed anytime soon. And it’s really surprising to see the power of the unions. Not so surprising in Europe and UK, but boy, that’s taking hold here in the U.S. And that’s a material expense to these businesses that have negotiated successfully with the unions or come to agreement with the unions. Whether it’s successful or not remains to be seen. But I saw where UPS workers are set to make $170,000 a year. This is a material lift in wage inflation.

Stewart: Absolutely. So, portfolio positioning. I’d like to start with your strategic asset allocation, and then if you can talk to us about how tactical fits in there as well, I’d love to just hear your views of how you take on that task. It’s art and science both.

Christine: Yes.

Stewart: You do it well. We’d love to know more.

Christine: Well, we try to be as quantitative as we possibly can. Arch is well known for its cycle management, and we apply that same philosophy of risk calibration according to opportunity in the investment portfolio. So while we do have a beacon, which is the strategic asset allocation, which gives you the sort of quantitative, modeled, optimized portfolio over the long term in terms of risk and return, we have other models which guide us in terms of the tactics of, A, overall risk allocation, and then B, how to supply that risk to the allocation. So, are you overweight or underweight risk, and how do you get there? Type thing.

The SAA exercise we went through about a year ago led us to two things. Decrease credit risk. So we went out of IG corporates into guvvies and increase, and this is the most important part, liquidity risk. So we reduced and indexed our equity exposure in the public markets, and reduced our high yield exposure in the public markets, all of which went to allocating to alternatives. And the alternatives we’ve mostly focused on credit strategies, opportunistic credit, but also moving into private equity. The portfolio is mature enough, so it’s cash flowing, and diverse enough so that the volatility is muted, that we can take some private equity J curve and volatility risk, finding really differentiated middle market managers as well as taking advantage of what we think is a really hard market in secondaries offerings in alternatives.

Stewart: I was going to ask you about secondaries. We’ve had some folks talking about secondaries market. And it seems to me that one of the things that you wrestle with as a CIO is, how much liquidity do I give? Because being over liquid has a cost, but being under liquid is catastrophic. And a highly functioning secondaries market helps you if you can come out of some of these exposures or allocations without getting your face ripped off. What’s your view there?

Christine: We don’t have a desire in this market to manage the portfolio by reducing exposure through secondary sales. We do have some discussions going where some of our holdings could get credit in terms of contributions to fund investments. Those are very early stage. We don’t really want to lock in losses of portfolios that we think have good potential returns, even if we want to reduce our exposure to a certain risk. And the funds that have disappointed us are going to be equally disappointing to the buyer, and it’s going to be reflected in the price. So there is this notion that we’re mostly stuck with what we have, and that changing the allocation of the portfolio is more going to come from our new commitments rather than managing and finding liquidity in the existing portfolio.

And we are really significantly ramping up our commitments on the alternative side, based on the guidance of the SAA, based on where we see relative value, and based on the profitability and surplus of Arch. So to your point about liquidity being something that can really take an insurance company down, it’s an intolerable risk, we have more flexibility because of the cash flows and the surplus at arch, and we are very rigorously analyzing stress scenarios, coincident with the investment portfolio and the underwriting results, such that we’re feeling very well cushioned from any severe situation. We do it on a 1 in 200 scenario, if not greater, but that’s sort of our base case. So that’s pretty extreme.

Now, a 1 in 200 event seems to be happening every three years, so I get that statistics aren’t perfect, and there’s a quarterly process that we go through with the CFOs of our different entities to review the expected cash flows from a bottom-up basis of our alternatives portfolio. We’re not worried about the liquidity on the other side. You may get a bid-ask, but you’re going to be able to get out of your names. But that would be considering a pickup in calls and a reduction in distributions, if the LBO markets don’t open up and capital is deployed because the opportunities are great. This is very in the weeds and very rigorously modeled, what that liquidity risk might be, which gives us confidence to go in there.

And where we’re funding the increased allocation to alts is out of those buckets that I mentioned, high yield, common equity, not only did we reduce our exposure to equities, we went all U.S. and we went all S&P index. So we just think that these are efficient markets where it’s harder to add value and while you need exposure and a balanced portfolio, it’s better to capture value in the private markets where it’s significantly less efficient, and the upside is significantly greater.

Now, in the liquid portfolio, we’re not extremely underweight risk, we’re underweight risk shading it on the conservative side. And that trade-off is really overweighting very significantly securitized credit. And this would be mostly high grade securitized CLOs, though we do hire outside managers who have specific expertise in CMBS and really taking apart every deal and understanding every property, so that we can get double-digit, high-teen type results, even in investment grade. And then some private bridge loan strategies in the commercial real estate side, which is filling the void of where the regional banks have left and just the quality of borrower has gone up, the rate has gone up, the terms have improved. I mean, there’s a lot of money to be made in the commercial real estate market selectively.

Stewart: I’m just sitting here soaking it in. I love it. And the question reads, challenges, opportunities, solutions of managing a portfolio within an insurance company. But if you weren’t familiar with the industry at all, what would you tell somebody that you just met on the street? What’s a complication… And if it was one of your well-regarded colleagues, what would you tell them was the biggest challenge today?

Christine: I would probably commiserate with them on a couple of fronts. On the onshore entities, we might commiserate about taxes. And it’s less of a problem, ironically, when the markets are rallying, and more of a problem when the markets have sold off because taking capital losses can trigger in the U.S. a very unfavorable BEAT tax, which affects retroactively not only your income tax, but also your surplus. So we manage to a very strict loss budget in the onshore portfolios. That said, there is recognition across the organization that active management can add more value than tax costs. So we built a model to understand the breakeven of that math, that if the sale of this particular security at a loss going into another security with this potential improvement to return exceeds the tax cost within a certain range, we should feel free to go ahead and make those transactions, even if it exceeds our lost budget.

Stewart: And there’s a lot of communication required between the treasury, tax, CFOs, just in order to make sure there are no surprises there. And that sort of friction along the way is a headwind to flexibility and delivering the best total return possible. But that’s the reality, and you just have to create channels of communication and agree on processes, data-driven systematic processes that can sort of pave the way for these decisions to be made quickly and easily.

The regulatory limits as it pertains to the alternative investing onshore, that also is difficult to maneuver. We have found a structural way to create diversification, smooth cash flows, smooth volatility, in the alternatives portfolio for the different entities within Arch on the onshore portfolios. And that is viewed favorably from a regulatory perspective. That said, you do need to go through the regulatory process of approval, and being innovative means that there’s an education element to that and a process element to that that makes it… Again, there’s some frictional costs and headwinds to that, but once you break through, it just feels so good and you think, “Oh my gosh, this gives us a real advantage in order to exploit opportunities in that market and be really efficient there.”

And as you know, it’s not just that you’ve got insurance, reinsurance, and mortgage insurance. You have many different entities within those entities who all have their individual guidelines and regulatory oversight, et cetera. So there’s a lot of technology support that’s needed in managing these portfolios too. And then offshore, the biggest breakthrough we had was recently, with Lloyd’s being less restrictive about their guidelines and limitations, and allowing the syndicate portfolios and the funds at Lloyd’s to be looked at holistically from a risk perspective, such that you can use a bigger risk budget and your FAL assets if you manage the syndicates more conservatively, which is their objective anyway. So we created a lot of flexibility in our Lloyd’s assets, by commingling them from an overall risk perspective and redrafting the guidelines, such that we can create flexibility in the FAL we didn’t formally have by having less flexibility in the syndicates.

Stewart: Wow. I love it. I’ve learned so much. I can’t believe it. It’s been such a great podcast, and thanks for being on. I’ve got a closing question for you. You can take your pick, you can take either or both, and you being a gamer will, I’m sure, take both, but no pressure. First question, what’s the best piece of advice you’ve ever gotten? And the second one is, who would you most like to have lunch with alive or dead?

Christine: Best piece of advice is, when you’ve made a mistake at a full sprint, after you’ve processed it and understand your options from remediation, quickly but not hastily run to your boss’s office and disclose the error and your view of the options that are available to remediate and problem-solve together. No surprises is the mantra. And the person I would like to have lunch with is Roger Federer. I think that his endurance, tenacity, integrity, humor, intellect, his ability to win under high pressure and unexpected circumstances makes him an athlete who brings fundamental skill that an investor would benefit from, especially an investor in the insurance market where there are so many moorings to navigate out at sea.

Stewart: Wow. Great answers. You’ve come a long way from the Shit’s Way Motel, I’m telling you. A long way for sure.

Christine: I’m not wanting to clean toilets any more!

Stewart: That’s right. No, I understand. I had a job at the same… I was in the same situation, not exactly, but I can relate. So I can’t thank you enough for being on. We’ve been joined today by Christine Todd, the Chief Investment Officer of the Arch Capital Group Limited. Christine, thanks for being on.

Christine: It’s my honor, Stewart. Thank you.

Stewart: If you like us, please rate us, review us, wherever you get your podcast content, whether that’s Apple Podcasts, Spotify, Google Play, Amazon, wherever it may be. My name’s Stewart Foley, and this is the InsuranceAUM.com podcast.

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