Stewart: What is going on, on Schedule BA assets? This is the Insurance AUM Journal podcast. My name is Stewart Foley and I'll be your host. We are very fortunate to be joined by Danielle Natonson, managing director of Cardinal Investment Advisors. Welcome Danielle.
Danielle: Thank you, Stewart, it's nice to be here.
Stewart: We're happy to have you. Big news flash, for those people who are living under a rock for the last 20 years, who is Cardinal Investment Advisors?
Danielle: We are an institutional investment advisor with a practice specialty or expertise in serving the insurance industry. Today, we're at about 270 billion in assets under advisory with about fifty-three insurance clients. And that ranges from property, casualty, to health insurers all across the US.
Stewart: There's a lot going on, insurance companies, big news flash, everybody needs more yield and people are searching for other ways to get it. Those assets sometimes end up on Schedule BA. The question first out of the box is, what's Schedule BA?
Danielle: Sure. I don't want to call it a catch all, but it's an area of the insurance company's balance sheet where you're required to file basically anything that isn't done in a separately managed account, isn't an individual security, is essentially an LP or an LLC type structure. This could be high yield bank loans that are done in a commingled structure. It could be non-US investments in equity, international equities, where it's cheaper to access the asset class through a commingled fund than it would be in the mutual fund for those that are fee sensitive. But often we found it's your private equity investments, it's maybe private real estate. Anything that falls under that alternative bucket also falls into Schedule BA.
Danielle: And lately the conversation has been less about private equity, private equity being one of the bigger components we think that has wound up on BA, it's been private credit. We've had clients for several years where we've spoken to them about accessing the credit markets in a private structure and often the pushback has been is now the time? Where we are in the credit cycle, is this is the time to allocate to those private sectors? And the reality is it's an all weather asset class, much like public high yield or public investment grade credit, it's an asset class that's just sort of been underrepresented.
Stewart: There's a lot of fund flow going there now and not just now, but it continues. I always say, I learn more on these deals than anybody else because I get to ask really smart people questions that I don't know the answer to. Here's another one: constraints of Schedule BA assets. This is an area that not a lot of people are well versed in so help me out please.
Danielle: Sure. I think one of the more important things to note before you talk about how it's constrained is what it means to put an asset on Schedule BA. It is the highest capital charge usually that you'll have on your schedules. By comparison, an investment grade bond has basis points of capital charges, equities have a 15% capital charge, Schedule BA assets wind up with a 20% charge which is fairly high. If you're going to invest in an asset class and put it on Schedule BA, you really have to have the return potential or return profile that makes that capital charge worthwhile. I would say, ten, fifteen years ago, Schedule BA was constrained in that many insurance companies maybe didn't have enough capital to really fill out that bucket or they weren't willing to do so or they had other investments that were more strategic in nature that fell on Schedule BA.
Danielle: Now, the issue is probably not capital. What we've seen in the industry is that capitalization levels are actually pretty high, very healthy and Schedule BA assets themselves if you take a look at the AM Best database and look at the industry segments over time, whether it's PNC mutual, PNC total health, the allocations to that Schedule BA, the size of those investments has grown pretty significantly as a percentage of the invested asset. It's not just us who have been talking to our clients about how to utilize assets on Schedule BA, the industry is clearly moving in the very same direction.
Stewart: I've asked some guests in the past, tell me what you think about fund flows to private versus public credit. And I've had a lot of people say they expect the fund flow to private credit to continue to grow. Can you talk a little bit about emergence of private credit, otherwise known as direct lending? Can you just talk about the progression if you will and where you see it today?
Danielle: Yeah. And even direct lending, it's a single confirmation of an asset class, but it can represent middle market, lower middle market, upper market. Where it almost resembles something that's very similar to senior secured, syndicated debt, public market debt. On the one hand, those direct lending asset classes can carry the kind of unlevered yield that is attractive. That's probably two to 300 basis points over public market yields. And then as you move up the spectrum, whether it is to levered products, getting a little bit more yield because you've got leverage on the strategy or you're going down in the market capitalization size so you're going to increase the spread again. Maybe it's a difference of four to 500 basis points. There's definitely an advantage there, but I think what it unique is the data that we have and that's being more accurately spoken about today is both the default levels and the recoveries that are associated with private credit versus public markets.
Danielle: You tend to have lower default rates, you've got better recoveries. And when you combine all those components, both the higher yield along with those better credit metrics and actually lower leverage oftentimes, we see lower leverage in private deals than we would see in the public market, all of that adds up to an advantage. And it's the realization that the banking model of providing credit to middle market companies, it doesn't exist. The teams that would have made those deals are no longer at the banks. They're all at private asset management companies and providing that much needed liquidity. And with the knowledge that there's a maturity profile that needs to be funded over time. And there's, on the side of the private equity sponsorship, there's more and more deals being done there too and debt will eventually become a part of those companies' capital structure.
Stewart: All right. You've convinced me, I want to go out and search for a manager and implement a private credit strategy in like 120 seconds, how do I do that?
Danielle: The public market databases are obviously a great source for getting that information. Nowadays, Prequin is a pretty good source, but having been in that market, the private markets for a very long time, you get to be very familiar with the names. And so first and foremost, I think the decision really has to be where you want to play in that segment. Do you want lower middle market? Do you want true middle market? Do you want something that maybe is a little bit bigger? Start focusing on the type of return profile you want and then sort of look to the mandates that would fit that. And there's plenty of them. Most of the ones that we would meet with or speak to are certainly put in manager searches or those that are going to have multiple credit cycle experience.
Danielle: There are many that have popped up in the last several years, we like to see something with a little bit more underwriting expertise and horizon to it. There's plenty of them out there, Prequin being a very good source of information for that. The next decision would be do you want to access this through a closed end fund? There are some evergreen funds that have begun to crop up. They're not without their challenges, but the structure is probably the second set of decisions that you'd have to make when moving into private credit.
Stewart: That kind of segues me right into the next, by the way, neither one of us have a relationship with Prequin one way or the other, so just I want to get that out there. Wall Street is nothing if not creative, so has anybody put together anything that's insurance friendly in terms of the structures of these deals?
Danielle: Absolutely. We've certainly seen these types of structures before, but I think this is the first time that the underlying assets are actually very well suited to the type of structures that they're creating. Rather than keeping it in the LP, which again, sits on Schedule BA and carries a very high capital charge, they're able to separate them into something that looks more like a note and sits on a different part of the balance sheet and can be rated by an NRSRO. Those are much more capital friendly. And then there would be a sleeve that could be held as an equity and literally sit as a form of equity on the balance sheet and carry again, an advantageous charge of 15%.
Danielle: Now, the reason I think these make a lot more sense than say several years ago, we saw the hedge fund industry trying to do the same thing. Package up a long short strategy, or maybe credit sensitive type strategy and package it into a note so it was more capital efficient and friendly to the insurance investors, but those didn't make a ton of sense. Whereas this does, these are amortizing assets, they are loans. They paid down, they will eventually go away. They will mature or they will be paid down early. And you may benefit from some prepayment fees that go with that. There have been efforts, not all insurance managers, but many of them are definitely taking this route. And as you said, creating these insurance friendly structures to make it a little bit more accessible.
Stewart: I'm a CIO some place, I'm trying to look at what goes on my Schedule BA. How do you look at ways to test for efficacy or efficiency or whatever you want to call it on what do I put on my BA?
Danielle: Well first we take a look at the state regulations. We talked about this a little bit earlier when we discussed, what are some of the constraints that go with BA and again, 15 years ago, it was probably gee, that's a high capital charge. I don't know that I want that on Schedule BA because that's really going to affect my RBC rating, risk based capital, or maybe CAR, the best capital adequacy rating or ratio. Nowadays it's more the constraints that are put in place depending on your state of domicile. Some states are very restrictive, say 10% of total admitted assets is the limitation so that could be fairly small or large, depending on the size of the insurer. Other states are far more lax in terms of the limitations that you put there. Often what we'll do is try to look at first, what is the return potential?
Danielle: Definitely something that's going to have an above average, certainly above your investment grade fixed income return to make it worthwhile to put on Schedule BA. But what we wind up doing is on an asset allocation basis is testing the limits of a lower bound of a CAR. As you put more assets on your Schedule BA they carry a much higher capital charge, you run the risk of eroding your RBC or your BCAR scores, generally not by enough to make a huge difference, but it's still a component. And certainly the way that AM Best have changed the way that they calculate their VaR levels at these higher VaR levels, you have a much higher capital charge to these assets. One way we walk into it is to do it from an RBC or BCAR threshold, asset allocation decision making level. That's the first step.
Danielle: And then the next would be to again, take a look at what the return profile is going to be. Maybe you want to take a little bit more risk. Maybe you want to add a levered strategy to amp up the returns of the yields in particular that you be getting from these private credit vehicles and then comparing that to anything else that you might be putting on Schedule BA. Again, whether it's private equity or any other equity like strategy and weigh the ups and downs of that.
Stewart: This is, pardon my ignorance on this, how transparent is the BCAR score model? In other words, how closely can you monitor that or model it for your clients? Because it's a huge deal. And the other thing that's interesting is, and is the RBC methodology as different than the Paccar methodology by a lot so one seems to be more transparent than the other one, but how are you making those determinations?
Danielle: Sure. It does need to be done through dynamic financial modeling. And we need to have the various capital charges at each one of the VaR levels and they do increase from low to high. Generally, what we do is start with our current client base. They provide us with the BCAR work papers. We can then use that as a proxy for making forecasts as to what those capital charges will be in the future. In many cases, if it's a manager that we already see at another client, we can use those capital charges as a proxy for the go forward charges that we would expect for a new investor. But here's what's interesting and you, you bring up an excellent point, for us, even from client to client, we see that there is discrepancies in the capital charges for the very same investment strategy, the same manager, the same fund, all of it and they're different from one client to the next.
Danielle: Some of it's definitely going to be based on the relationship that an insurance company has with their AM Best analyst and walking them through the risks of the underlying assets that are in these Schedule BA assets. And sometimes we've been involved in those discussions. We've learned quite a bit. Other times we just provide as much detail as we can, client goes ahead and has those discussions with AM Best without us. But we can pretty much back into, from a calculation standpoint, they're pretty clear on the methodology. It's the moving parts of whether a different charge is seen at a different level that could make a big difference between the BCAR charges.
Stewart: This is me getting on my soapbox and if you want to pass on this question be my guest: Regulation. Regulation at the end of the day is designed to protect a policyholder. You crash your car, Geico writes you a check, the check clears. Regulator's done their job. Whether Geico's profitable, not profitable, doesn't matter at the end of the day. What's the big risk the regulator's trying to guard against? Well, default risk. You've got capital charges that favor fixed income assets and so I'm going to create a capital charge structure that's based on the likelihood of default. That's what I'm going to go with. Now, rates fall, now they've bounced back, but the ten year note at 175 or whatever it is today, bounced off of fifty-six basis points or something like that. The question is, is that default risk the risk to the policy holder? Or is it the insurance company's inability to earn an adequate rate of return given the regulatory regime in place? Go.
Danielle: That's a lot to unpack. We would agree. Obviously regulations are meant to be in place to protect the policy holders and to ensure that there is solvency, that there's the ability to pay in the event of whatever accident or even in catastrophe. That does seem very far removed though from how assets get treated on an insurance company's balance sheet. And to that point, we can take, as we've talked about here with private credit, which yes, default risk is of course a big risk, but there's a lot of other assets that show up on that Schedule BA that are not at all commensurate to the type of risk you'd be taking in a debt instrument than say private equity. You could have a venture capital fund alongside a senior secured private credit fund, they both carry the same exact charge, but the true underlying risk of the assets are very different. They're literally on the other end of the spectrum.
Danielle: Our hope is that through our engagement with groups like ISA and other industry groups, that regulatory piece catches up to the investment world. You mentioned earlier that Wall Street is nothing but innovative and certainly they are and certainly there's good reasons for it in some cases. What we need though, is for the regulators, whether it's AM Best, the NAIC, to also embrace that and do a little bit more digging as it relates to those types of investment strategies because they're certainly not uniform and they're not accurately capturing the risk that really sits on an insurance company's balance sheet.
Stewart: And I think in fairness, you look at a Schedule BA and you go, "Oh, they're Jolly Roger 3 Fund. What the hell is that?" Well, I got to go out and buy an expensive subscription and whatever to figure it out where it's not always obvious when you look at the BA what the hell it is. You've got to know more than a little to figure out what those risks really are. I'm not saying the regulator has an easy job at all, but I think your point's very well taken.
Stewart: Okay, so you convinced me on these private assets and now I've gone out and done a wicked cool manager search with you and now we've hired a manager and I've allocated my assets to the point of maxing out my BA. Now what? You talked a little bit about how the national regulator or rating agency is not necessarily treated in the same manner as things are at the state level. Even something as simple as ETF look through gets a different treatment. I bang my head on my BA limit, now what?
Danielle: We do have some clients that have reached that point. There are some that will freely decide to non admit an asset. Essentially treat it as though it carries a 100% capital charge. It doesn't show up on your balance sheet as an admitted asset. Like I said, if the capital levels are high enough, they're willing to do that. It's not always a popular decision, I will say that. Very few of our clients take that route. The next step would be making the decision. And again, whether it's an asset allocation decision to maximize the return on the assets that would show up on Schedule BA or to just reallocate. Maybe that international fund that you've carried in a commingled fund, that's saving you five basis points or 10 basis points in fees doesn't belong on Schedule BA. Can you move it into a mutual fund?
Danielle: We've got many of our insurance companies simply are not willing to take the currency translation issues and put it in a separate account and that makes a ton of sense. But when it comes to the trade off between a mutual fund option and the commingled fund option, maybe that's a slam dunk. Until you realize that those commingled funds may have huge embedded gains. The majority of our client base is taxable so that's yet another wrinkle that needs to be considered. And maybe it's through again, through active cash deployment to relieve that pressure on Schedule BA. Begin funneling new assets into maybe a mutual fund type structure, but keeping your asset allocation in line. Or you just begin to favor other asset classes.
Danielle: We've had some luck with reallocating from commingled funds into separately managed accounts if the company is large enough. For example, a private credit mandate, if you don't have, I would go with upwards of fifty to a $100 million, and again, that's going to be very dependent on the type of strategy that you're employing, you can't touch a separately managed account. That's something that maybe has to reside within the Schedule BA as a commingled fund. And then again, it's cash flows, making changes on the fly as rebalancing occurs. That's really the only way to relieve that BA upper limit pressure.
Stewart: Insurance company, underwriting operation, the CEO is not going to the chief underwriting officer going, "Maximize premium," because that's insane. You're supposed to take risk, insurance companies get paid to take risk when they underwrite and they get paid to take risk when they invest. It's both of those operations are levered off the same piece of capital. The underwriting side of the balance sheet, you take risk when you're getting paid for it, ie., a hard market and you're supposed to be real cautious in a soft market. But on the investment side, the rate online, the equivalent is yield spread. I'm not getting paid a lot to take risk and yet, everybody seems to be taking on more and more. And oh, by the way, you can't just go back to core bonds and stick your head in the sand. How are you viewing risk premia today and where money's going?
Danielle: The risk of being in core fixed income is probably the greatest today than I've ever seen it. There's no denying that and everyone is having the very same discussion. Is really a default risk as great as either an inflation pressure or a rising interest rate regime on your core fixed? Are those equal risks or is one greater than the other? And certainly the broad exposure to investment grade fixed income feels like a significant risk amongst insurers.
Stewart: Well, here's the other one, if you think about duration, you go, "Well, I got cash inflows and cash outflows." Yeah, that's true. But when interest rates move, those present values go in opposite directions and inflation is a big risk, a big cost that's very difficult to effectively hedge for an insurance company in particular. It's interesting. It's a tough problem. You're allocating assets and helping clients allocate assets in a really complicated puzzle. And that's what it is. It's a puzzle of how do I put these pieces together the best to get the client to perform in their maximum way, given all the myriad of constraints that they face?
Danielle: Right. But some of those investment constraints today are maybe not as significant as they would have been again, ten, fifteen years ago. There's so much more capital on the balance sheets of the insurance industry as a whole. Maybe the answer is increasing those risk assets makes more sense because your fixed income portfolio, while it will not do well in a rising rate environment on a short term basis, mark to market, you will eventually reinvest those cash flows into a higher rate, which is ideally a better deal for insurance companies. You will earn more off of that reinvestment rate. Now inflation is a slightly different story. It has the potential to significantly erode returns. Unanticipated inflation is really where we spend more of our time focusing. And there are very few asset classes that do a great job of protecting against unanticipated inflation.
Danielle: With that said, capital being what it is amongst the insurance industry, having a greater allocation maybe to risk assets, even at a time where it doesn't feel necessarily appropriate to do so. But if you're looking at, in a way immunizing your reserves, that's what your fixed income portfolio is there for and your surplus can be utilized in those higher risk areas. If we saw sustained inflation, some of the feedback we hear from our clients too, is that wouldn't be the worst of all worlds because they may be able to take that inflation pressure and pass it through as higher rates. Depending on whether it's a health insurance company or a PNC company, of course that may flow through differently. That's another real life side of the risks that insurance companies take in both the way that they treat the underwriting, as well as the investment strategy.
Stewart: This is the ask me anything part of the program that you weren't aware of, Danielle. Ready? Here we go. This is going to be a lightning round. It's the Thursday before a long weekend, you look at your email, you have no unread messages, you have a three day weekend in front of you. What is on the agenda?
Danielle: If I can access a mountain, I'd like to go skiing.
Stewart: All right. Skiing, that's the key. All right, cool. And in Chicago, of course you can go to Wilmot, but other than that, it's an airplane. Okay, so here we are, it's graduation day from your undergraduate institution. Now, regardless of the festivities, the evening before, you look bright eyed and bushy tailed in your mortarboard and gown. And there you are, you've waited patiently through umpteen million people in front of you whose names you can't recall or don't really care and you're standing there and you've walked up the steps and now they read your name and the crowd goes crazy. You walk across the stage, you shake the president of the college's hand, they hand you your diploma, quick photo op, down the stairs you go elated and you meet yourself today. What do you tell your 21 year old self?
Danielle: Oh wow. That's actually a very funny lead in, or question, I should say. I actually started my career with an insurance company. I was in the Treasury Department, I did the investment accounting. I ran the short term portfolio way back in the day when you could buy all the Chrysler and Ford that you liked and John Deere and go to bed at night and wake up and it was all fine the next day.
Stewart: Everything was fine.
Danielle: Everything was fine.
Stewart: Good old days.
Danielle: Of course. Of course we did have a spike in rates during that time period without aging myself too much and I made the decision many years ago that, did I really want to work for an insurance company? Maybe I wanted to experience some more interesting things, broaden the horizon. And I did and I'm very glad that I did, but it's very funny because I've said this many times in my life. I started my career working for an insurance company and I left it and now I work for many insurance companies. And I'm so thankful that I had that early opportunity and I do tell so many young graduates that you may think the insurance industry is some sleepy, possibly boring industry, who wants to work in that? It's not exciting. But it is if you have the right group. Always changing, very challenging, great places to work, you can have a lot of job security for those who are looking for it and what a great start.
Stewart: Amen. Good advice. I love this industry too and it's been good to me and I think it's been good to you as well. And so very happy to be able to give back a little bit. Thank you very much for being on. Great discussion.
Danielle: Thank you , Stewart. It's always a pleasure to see you and thanks for all the time you gave to me and to Cardinal today.
Stewart: Of course, my pleasure. You can find us on all the major podcast platforms. If you like us, please do and tell your friends. If you have ideas for podcasts, please email us at firstname.lastname@example.org. My name is Stewart Foley and this is the Insurance AUM Journal podcast.