Stewart: Welcome to another edition of the Insurance AUM Journal Podcast. My name is Stewart Foley, and I’m standing with you at the corner of insurance and asset management with Bill Cox, Senior Managing Director, Global Head of Corporate, Financial and Government Ratings, and Peter Giacone, Managing Director, Global Head of Insurance Ratings at KBRA. Welcome, gentlemen.
Bill: Thank you, Stewart.
Peter: Great to be here today. Thanks for having us.
Stewart: It’s great to have you guys on. I’m very excited about this podcast in particular. As a rating agency, you bring a completely new perspective, and my introduction to KBRA came from your CEO, who’s a friend of mine, Jim Nadler. We’re both from small towns in Missouri. We used to work together at a firm 10 years ago or so, and that’s when I learned about KBRA. But if you would, just for the benefit of our listeners, Bill, would you give us kind of a backdrop of KBRA and your niches and your capabilities?
Bill: Sure, Stewart. KBRA was founded in 2010, so just 10 short years ago. We’ve quickly grown to become a global rating agency, and we’re certified by regulators in the US, Europe, and lots of other places. We’ve rated over 40,000 transactions, 2,800 entities, and over two and a quarter trillion dollars in debt in almost every asset class. That is what makes us somewhat unique in terms of rating agencies that were founded anytime recently in that our early investors and founders and CEO Jim Nadler decided they were going to build a full service rating agency rather than specialize in a specific asset class or region.
Bill: And that has certainly served us very well. We are active and growing in the insurance sector, providing insurance companies with ratings for themselves. And also for many insurance companies, we’re actually providing a lot of ratings for the investments going into their balance sheet reserves. And I’m sure we’ll talk more about that later. But one other thing about what makes us different. We were founded in the shadow of the financial crisis, and Jim and others were determined that we would serve markets better than the way the legacy rating agencies had.
Bill: In particular, we were going to focus on serving issuers and investors with greater transparency. Our reports are lengthy and available for free, more credit by credit round up analytical rigor, rather than rigid approaches using mechanical black box methodologies, which we skew. And most important, more senior and experienced analysts like Peter, who’ve seen and worked in and around the industries they cover and have been through plenty of prior credit cycles.
Bill: As has happened in this past year, KBRA was quite measured, quite balanced, and managed the portfolio of credit ratings with a steady hand as we and others worked through the impact of the pandemic.
Peter: Yeah, and maybe I’ll just add to that. On the insurance side, our founder often says we punch above our weight. In the insurance sector, we cover the entire waterfront and that includes both life, P&C companies, reinsures, pretty heavy presence in Bermuda. Again, all of our ratings are published ratings, are well over a hundred, and they’re out there on our website for all to see. And from a methodology perspective, just to echo what Bill was saying, is our approach does not use a capital model.
Peter: It is more fundamental financial analysis and a very heavy focus on management. We’re going to be talking about management later on today in terms of how it drives a lot of our views on companies and on the debt that we rate. Great to be here today and look forward to chatting with you some more.
Stewart: It’s fantastic. Thank you so much. The title of the podcast is Putting COVID in the Rear View Mirror, something that I assure you I am very ready to do. Outlook for the insurance industry. Before we get there, what if we started off with an overview of where credit markets have been, where you think they’re headed into 2021. Bill, I’d love to get your thoughts on what you and your colleagues are seeing. Any particular themes that are common to multiple asset classes, for example.
Bill: Indeed, Steward. And like you, I’m certainly looking forward to this New Year’s Eve like no other that I can recall. There are indeed some broad themes that have emerged this year and probably knowing what we know today will continue into at least the first half of 2021. All of which presume a slow gradual recovery to some semblance of economic normalcy, which we don’t see coming until late ’21 at the earliest. Some common themes.
Bill: First, we see transportation and travel related credits and some commercial real estate credits remaining under pressure for some time. So think airports, airlines, aircraft securitizations, hotels, office and retail complexes. The reasons for this pressure are obvious and the sectors have experienced the most significant credit migration in our portfolio so far and likely will remain under some pressure, and many of those have negative outlook still.
Bill: We see some state and local governments who entered the crisis on weaker footing, getting even more deeply imbalanced as a result of the crisis, yet others who showed more discipline and balance before the crisis have actually demonstrated remarkable resiliency. So think big States like Texas and Wisconsin, who’ve done very well despite some pain and pressure. Unlike other examples, like New York, New Jersey, Illinois.
Bill: In the financial institution space, banks having been reigned in by the post-financial crisis regulation entered the pandemic generally with stronger reserves and stronger assets in their books and have fared very well, with a few exceptions of perhaps a regional banks that were focused on energy or on real estate in a local market. Most banks have fared very well through this crisis. There is not a banking crisis this time, and we expect that to continue as banks have raised a lot of capital this year to bolster their lending capabilities in the future.
Bill: And then a real fascinating development is that the pandemic has done nothing to slow down the growth in the private markets. And this is probably something of great interest to many of your listeners. Private equity and private direct lending funds have amassed enormous stores of dry powder, have presumably absorbed the impact of pandemic weakened assets more resiliently than banks would have been able to, and thus, have distributed losses with no equivalent crisis to speak out so far.
Bill: And again, relevant to your audience, we see amongst many insurance companies some really creative ways to increase exposure to these private markets. For example, insurance company lenders have sought ratings from us in their bid to displace or collaborate with banks to provide liquidity facilities or subscription lines and other types of lending to private debt and private equity funds. In other words, insurance companies have become increasing seekers of ways to participate in fund finance, having already been very active as LP investors in that booming and growing sector.
Stewart: It’s interesting. There was just an article published yesterday on fund financing. It’s very topical. Peter, you are the global head of insurance ratings. If we can do a quick rundown of the major insurance sectors of how the industry has been affected so far, would you share that with us? That’s a pretty tall order, but we’d appreciate your view.
Peter: Sure. No, and I’ll try to keep it to a high level because we could spend a lot of time on any individual one of these for quite some time. But from a very high level, I’m actually going to just divide my comments to sort of let’s focus a little bit just on the asset side of the balance sheet. And I think this applies to whether it’s P&C, life, or insurance. I think the entire industry saw the volatility in the market. I mean, that was sort of the headline event at the start of the crisis.
Peter: Tremendous changes in values of assets across various sectors and very large unrealized loss positions being recorded by many of the major players across the industry regardless of which sector they’re in. What we’ve seen is the vast majority of that has reversed out. That was sort of a timing thing. We’ve gotten to the point where most of the companies we’ve seen, both the ones we cover as well as some of the others that we don’t, have recovered most of those values.
Peter: So the asset side of the balance sheet has recovered, with one very important point to note is that we are in a low interest rate environment and it looks like that is going to continue for a while. And I’ll come back to that again. That has some real implications particularly for the life sector. Turn to the liability side of things. Very quickly on the P&C side, we actually just put a piece out yesterday regarding the hurricane season. The storm season just ended, November 30th on Monday, and it was the busiest season on record.
Peter: We went well into the Greek alphabet in terms of naming conventions. We actually ran out of names on the official list. Had to go into the Greek alphabet. That’s never happened before. Storms have happened earlier in the year than they’ve ever happened in previously. One of the things that we noted in our report was that what’s different this year relative to some of the prior years is not necessarily the severity, but the frequency. That’s a new paradigm, both in terms of how companies manage that risk, how they look at it, and how it hits their balance sheets.
Peter: Very important consideration, and we’ll come back to that a little bit later on. On the man-made cat front, we have business interruption, right? That’s a big deal. All of the shutdown orders across the nation have created a flood of claims. At the moment, it appears most of the legal battles are going the insurer’s way, but a lot of that still remains to play out. It’s a big unknown right now, and it’s something that we need to keep an eye on.
Peter: If you look in jurisdictions outside the US, in fact, there was a court case in the UK that’s being appealed where those claims actually were honored, because the policy language was not quite clear regarding exclusions for pandemic risk. And then there’s other man-made cats. We’ve made this point in some of our other research articles. Some of the civil disorder and unrest that occurred over the summer gratefully did not result in major claims, but it’s something to keep an eye on.
Peter: It’s a new dynamic in the market, and it’s something that could create sort of physical damage to facilities and something that insurance companies could be on the hook for. It’s not all bad news. There are some positives there too. From a liability perspective on the P&C sector, general liability claims are down. People aren’t going out. There’s no slips and falls that you would normally see. That activity has dropped.
Peter: And, of course, it’s been pretty well publicized that auto claims are way down as well because miles driven was quite a bit lower as people stayed home because of the stay-at-home orders. Switching to the life side, I think, again, asset side is going to be important in terms of interest rates and a lot of challenges for the life sector for those that are in spread intensive businesses. Those who are big VA riders and fixed annuity riders are really going to have their hands full as we sort of stay in this low interest rate environment probably for the foreseeable future.
Peter: One of the big things that the life industry was very concerned about at the start of the pandemic was potential impact on mortality. And as what we found is that over the course of the year, that risk, although there were some very big concerns about it early on, what’s happened or what’s transpired since that time is that has not been a major impact. And part of the reason is because a lot of the mortality experience and a lot of the mortality that has occurred has been in areas where it’s under-insured.
Peter: There’s not heavy life insurance penetration in the segments of the population, which saw, sadly, some of the highest death rates associated with coronavirus. This is something the industry will continue to keep an eye on. We’re going to keep an eye on it. But the mortality impact probably can be fairly muted across the sector with a couple of exceptions perhaps. And then finally, looking in the reinsurance side of things, came into the year with a very strong capital position. Clearly we’re in a hard market.
Peter: We saw that with the July 1 renewals. We would expect the Jan 1 renewals are going to see a continuation of that trend of increased pricing across many of the effected lines. And we’re actually even starting to see the retro market opening up again. And that disappeared previously, given the strong capital positions and reinsurance keeping that risk on their balance sheet. There is now a demand for them to reshape their books, and so demand for retro seems to be opening up again and creating a new sector or a renewed interest in that risk mitigation strategy.
Stewart: It’s interesting when you look at the industry, right? Jim Nadler and I are both from Missouri small towns. Forgive me when I start this question. The old saying goes, “There’s no educational value in the second kick from a mule.” The question is, how do you think these insurance sectors are going to adapt in a post-COVID world?
Peter: I think you’re going to see a lot of evolution. I think what you’re going to see is that the COVID experience and the pandemic is accelerating trends that were already going on in the industry for quite some time. On the P&C front, clearly new focus on contract wording. Those pandemic expires exclusions, as I mentioned earlier, very, very important. There’s going to be continuing discussions around that, so you’re going to see a very refreshed and renewed focus on that.
Peter: I think also as often happens in these types of situations, as companies are going to revisit their distribution, they’re going to revisit their business partners. When the chips are down, when you go through volatile times, that’s when you find out who your friends are and who’s a good business partner or maybe someone is not such a good business partner or is not fitting into your strategy as well as you might have thought. You’re going to see some reshuffling of that I think across the sector in terms of how companies distributed their products.
Peter: I think on the life side, you’re going to see an increased demand for reinsurance. We’ve already seen the life reinsurance business sort of picking up. A lot of new startups in sort of the alternative markets. We’ve certainly seen that in Bermuda. A lot of money, a lot of capital flowing to the life reinsurance business. And we think that trend is going to continue, because life insurance companies are going to need to shape their portfolios and need to take some of that risk off their balance sheet in order to make room for new business.
Peter: You’re also going to see some pricing and underwriting adjustments. You’ve seen some press as well. Cost of insurance adjustments that were sort of unheard of historically have now started to become a bit more common. Some of those older contracts that are not economic. Given the, again, protracted low interest rate environment that most companies never built into their pricing models, this forced companies to reevaluate and put forward some cost of insurance inquiries as they’re reverberating through the industry and are going to cause consumers to take a fresh look at how they evaluate that.
Peter: And then finally, on the reinsurance side, again, beyond pricing, that same contract wording in terms and conditions. On the reinsurance side, it’s more about the terms and conditions of that treaty that you have with the cedents. I think you should be prepared for a little more direct risk transfer. Fascinating, last week I believe it was Alphabet, and a lot of folks might have seen this, actually a cap bond into the market to mitigate the risk of earthquake in California, because they have a lot of offices out there.
Peter: And rather than buying earthquake insurance, just went out and did a cap on on their own. Fascinating, right? Is that a good thing or a bad thing? I think it’s a great thing for the market because it shows how risk mitigation is working its way all the way through the value chain, all the way through the food chain. Companies are starting to get comfortable with accessing those markets directly. That creates some tremendous opportunities. There was an old saying, “The educated consumer is our best customer.”
Peter: Well, that is very true in insurance to the extent that the customers and the users of insurance are educated about what risk transfer is really all about. I think that creates some real opportunities for everyone in the industry. We’re optimistic. I think there’s some challenges for the industry, but I also think they’re well-positioned to take advantage and move forward and evolve the way they approach risk mitigation going forward.
Stewart: Yeah. The Alphabet cap on example is really an interesting transaction. For both of you, do you see the potential for rating actions in the near or mid-term from these COVID-19 impacts?
Peter: Yeah, certainly on the insurance side for our rated universe, not seeing much. As bill alluded to, we’ve tried to keep a very steady hand. Our ratings are forward-looking. They are developed in the context of achieving stability in the sense that within a certain reasonable range of outcomes, those ratings should hold up. And we found that that has been the case. We were on the phone back in March and April with every single one of our clients to find out how the volatility in asset value changes were affecting their balance sheet.
Peter: We were in constant contact and monitoring all that. And then as we kind of rode the wave and asset values returned and we got comfortable, we put a few things on watch and most of those things have all resolved. I think as we sit here today, I think there are some challenges for the industry, as we mentioned, low interest rates and a few of the other things on the liability side, but I would see the likelihood of mass changes or mass ratings changes are being fairly unlikely absent some other major event occurring.
Peter: And hopefully the event we’ve just lived through or living through now is enough for a while. Maybe we’ll be good to build some capital and move forward and write some profitable business.
Bill: In the broader array of asset classes, we continue to believe that the most pain is likely to be felt in transportation, travel, leisure, and related sectors. In fact, of the negative outlooks that we have on all of the credits in our portfolio of ratings, those sectors account for probably 85 to 90% of the negative outlooks. Most other sectors are holding up pretty well for now.
Stewart: I appreciate that insight. It’s difficult to get that insight very many places, right? Bill, you can’t read the financial press for very long and also, frankly, pieces that have been posted on our site without a reference to ESG. It’s a big issue for insurance companies. Can you share how KBRA is addressing this issue in its ratings process?
Bill: Yeah, that’s a great question, and we can’t get through a day without being asked this question. We agree that it’s very, very front of mind for investors, for issuers, and even regulators now if you look at some testimony that was in Congress just yesterday. Here’s our approach. First, we do not believe that it is our responsibility or rating agency’s role to be developing ESG scores, these subjective rubrics that assign weights and values to various ESG considerations.
Bill: We do not see them as being correlated to credit, and we see the ones that have been developed being somewhat of a disservice to fixed income debt investors. Because at the end of the rubric, it typically says, “Oh, and none of these factors impacted credit.” We do believe and we understand the role of those subjective values-based rubrics for selection, for investment selection, for reasons that go beyond and in some ways might be more important than credit for some investors.
Bill: What we do do as part of our credit rating process as it relates to ESG is we focus on two steps. The first step is that we look for clear, tangible, direct impact issues. Examples of that might be a utility that has transitioned costs because it needs to reduce its carbon emissions, or a city that might have large amount of exposure to tax paying properties that are in harm’s way in certain sea level rise scenarios. These are specific. They’re direct. They’re often quantifiable. Our analysis has always incorporated those issues.
Bill: And what we are doing differently now to be helpful to investors is that we’re consolidating those kinds of issues into one section of our report so that they’re easy to find. Direct, impactful, somewhat immediate ways that a credit or an issuer is impacted by either ESG issues. Governance has obviously always been an important aspect of our rating of corporate financial or governmental entities management itself has always played an out-sized role in our methodologies, because we believe management decisions influence all other aspects of a credit ratings factors.
Bill: In a second step that we are increasingly performing in our credit analysis is finding ways for analysts to capture some broader ESG issues that may not be immediately impactful, but certainly are strategically important to corporate financial or governmental credit. What do we mean by this? We mean examples of things like it’s not our place to decide what level of diversity a board may have, and we’re not going to score it, but we are certainly interested in understanding from management what constituent pressures they are facing with regard to that issue or any other issues like it.
Bill: And constituents may mean employees. It may mean customers. It may mean regulators or any other party that could exert pressure on a company. And our desire is to understand whether or not the management of an organization is aware of the pressures on E, S or G topics, is planning for them and/or is addressing them in ways that may reveal both risks and/or opportunities, because there are certainly many times where ESG scoring rubrics leave out some positive things that are E, S or G related that are not otherwise covered.
Bill: For example, you’re likely to see more conversations reported in our reports about climate issues that might not have immediate impact, but certainly we’re expecting management teams of all sorts of organizations to be aware of how constituent climate pressures may be impacting an organization. Are they measuring their carbon footprint? If not, why not? Why do they feel that they will escape those pressures? And if they are, are they establishing goals for themselves and/or expecting goals from third parties like regulators that they need to address?
Bill: In summary, in that step two, our focus is through a lens of management analysis and our belief that management of ESG issues is essentially a management issue. And we intend to raise the bar on exploration of these topics with management teams.
Peter: And just to bring it home on the insurance side in applying that framework, that paradigm of how do you incorporate ESG into your credit rating process. I think for insurance companies on the direct side, some fairly obvious things that we’ve been doing all along. Climate change.
Peter: Okay, well, any insurance company that has exposure to catastrophes, as I was talking about earlier, clearly climate change is front and center of their analysis around where the next storm is going to hit and will the frequency and severity of storms increase over time and how do we manage it, how we manage our reinsurance around that, and all the issues. On the insurance side, this is not new. It’s just maybe some new packaging around it in what we call it, but it’s issues we’ve been focused on for a long time.
Peter: But on the management side, and that’s such a big part of the way KBRA rates insurance companies, is looking at management and we spend a lot of time with management teams trying to understand their strategy, their operations, their risk management. This folds in beautifully with the way we’ve been doing our ratings all along from day one, which is this is yet another aspect of the way you run your business. Talk to me about how your constituents are focused on this, how are you evolving and changing.
Peter: If you’re selling in a retail environment, these issues are going to be huge on E, S or G. All of those are going to come to bear on your key constituents. How are you going to modify and change your strategy? Are you going to adopt and start using more technology in order to address these things? It’s just a host of issues.
Peter: Those conversations are incredibly helpful because, again, they’re held within the context of the way management runs their business and what it ultimately mean in terms of how that translates into the financial health of the company, which ultimately obviously is the credit rating that we assign to the various entities that we rate.
Stewart: Guys, we have covered a lot of ground, and this has been a really great podcast. I’ve learned a lot on here. Any final thoughts for investors as you see them continue to navigate the choppy waters into 2021? Any kind of final thoughts there?
Peter: I’ll just say that I think one of the trends we’ve noticed and we’ve referred to this a little bit earlier on when we’re talking about reinsurance is the whole insurance link security space. One of the things we saw, which I found was fascinating, is the fact that in ILS space, and this may be of interest again to your listeners who are a lot on the investment side, the lack of correlation between that dip that we saw at the start of the pandemic and all of the securities, even treasuries, everything was really taking a hit. ILS securities rode through that storm.
Peter: Very, very, pardon the pun, rode through that storm quite well. It reinforced the fact that you have a very uncorrelated set of risks here. I think the market noticed that. I think when everything else was going in one direction, these ILS securities were staying relatively stable. And I think that was sort of a lesson for investors in terms of diversification.
Peter: And I think what that means is we’re going to see more capital flowing into that market potentially going forward, because there’s going to be more investor interest across a wide range of investor classes as they try to find those uncorrelated asset returns that can fit in very nicely with the rest of their fully diversified portfolio.
Stewart: Bill, Peter, thanks for being on today. It was great to have you both.
Bill: Thank you, Stewart. It was great to be here.
Peter: Thanks for having us. Have a great day.
Stewart: Bill Cox, Senior Managing Director, Global Head of Corporate, Financial and Government Ratings, and Peter Giacone, Managing Director, Global Head of Insurance Ratings from KBRA. Thanks for being on. A couple of housekeeping items. Insurance AUM Journal has announced a joint venture with CAMRADATA in the UK to bring asset manager evaluation, search, and selection tools to insurers. There’s more information coming on that. If you like us, please follow us, share our posts, tell your friends, all of that stuff helps our efforts.
Stewart: And if you have ideas for podcasts, please email us at email@example.com. Thanks for listening. I’m Stewart Foley, and this is The Insurance AUM journal Podcast.