Stewart: Changes in the regulatory environment for insurance companies have massive implications. We are here to talk about the most recent changes with Tim Antonelli of Wellington Management. Tim, welcome.
Tim: Stew, thanks so much for having me. It feels just like yesterday, we were talking before.
Stewart: Here’s a nice thing. It’s great to have you back. You are a clear expert in this, and I’m going to take a minute to read your bio and your intro for those folks who may not know you. You and I are friends, but for everybody else. So, Tim is Wellington Insurance’s multi-asset strategist, responsible for identifying and sharing and acting upon major business trends affecting insurers globally, and their investments across all asset classes, which is a high bar. He synthesizes information on capital management, regulatory changes, and increasingly ESG and climate implications that drive insurers’ investment behaviors and decisions. Tim has regular interactions with various insurance industry regulatory bodies, rating agencies, and industry trade organizations, and also collaborates with the Woodwell Climate Research Center, an independent climate science think tank and Wellington’s climate research team to develop actionable climate insights for insurance clients.
Your background’s impressive, you know this stuff, and we’re thrilled to have you on. How are you? How are things, man? I read your paper. It’s amazing. I can’t wait to talk about it. How’re you doing?
Tim: Yeah, no, I’m doing well. I think this year, like all the years that I can recall in recent history, has provided an interesting change from what we all expected heading into the year. So, it’s obviously the market implications of not only the geopolitical mess that we see ourselves in, but also the fact that at least for the first time in my career, inflation is a real thing that we’re discussing with clients and interest rates actually increasing is something that we’re seeing happen. So, it provides a unique backdrop relative to the last decade, decade and a half, for insurers to tackle. So, we’re having no shortage of conversations around that. Quite frankly, a lot of it centers on strategic asset allocation, which as you know, has many different levers that you can work in an optimization. One of those is certainly capital consumption. So, we wanted to get this piece out there to just make folks aware of not only what the changes are, but also how that could impact their investment decisions in a day to day basis.
Stewart: Your paper is available on your site. It’s on our site. We’ll make it available on this podcast as well so that everyone can see your paper. It’s not hugely long, but it is very informative. I want to talk about, I have an ax to grind and I’m going to say some stuff that you can’t say at Wellington. You ready? Because, my compliance department is speaking at the moment. Regulators’ job at the first order of business is that the check that you get from an insurance company to cover a loss clears the bank and you get your money, right?
Stewart: Banking regulation’s the same. You put your money in the bank, you go down there and you say, I want my money out. And they go, okay, here it is. FDIC they go, no-no, and if the bank’s making a lot of money, or the insurance companies making a lot of money, or they’re making no money, not the regulator’s concern, right?
Stewart: They’re not worried about making money. They’re worried about protecting the consumer, which is I think the nucleus of a lot of regulation.
Stewart: So in the day, what we is the big risk to insurance companies? That they’re going to lose their principle through default of an investment that they’ve made, what at the time was likely some investment grade bond, right?
Tim: Right. Yep.
Stewart: Now, then, that was at that point the largest risk to an insurer. I would argue that today, that is not the largest risk to an insurer. The largest risk to the insurer is that they can’t earn enough on their invested assets to earn a reasonable profit.
Stewart: And that the regulation is well behind. I would argue risk regulating insurers, particularly life insurers, out of business.
Stewart: You’ve seen some of these major block sales move from one to the other. Now, this regulatory change certainly addresses some of that. But as you point out in the first sentence or two of your paper, these things tend to move at a glacial pace.
Tim: That’s right.
Stewart: Can you talk about the changes that are currently taking place with this most recent regulatory change?
Tim: Yeah, sure. So, I think it’s been the better part of a decade in terms of when they proposed getting more granular on the risk charges for fixed income to when they were actually implemented. So, they were being reported unofficially at the end of 2020, but effective at this previous year end and now implemented. What they set out to do was basically move from this six rating tier and EIC model that looked at something like AAA down to single A as a single rating cohort, to 20 ratings that reflect individual rating notches, which I think makes a ton of sense because the default or downgrade experience of an A rated bond is extremely different from a AAA rated bond.
I think what they saw was (and also it’s indicative of the credit market broadly), was that insurance companies were taking as much single A minus risk on as possible because, on a capital adjusted basis, you were being charged the same as a non-government AAA. So I think they set out to make the risk charges more indicative of the rating, certainly, but also to recognize that the legacy grouping of those ratings did not make much sense at all. So, they updated those risk charges and they originally based it on life insurers. But then, for the first time ever, they also created separate risk charges for non-life groups. So, health and PNC shared the same risk charges forever, and now they operate on different matrices as well, which again, I think makes a lot of sense.
Stewart: So in effect, if I understand this correctly, RBC charges were in six buckets before, and they kind of grouped the letter ratings from NRSROs into kind of buckets.
Tim: That’s right.
Stewart: So a single A minus and a AAA of the same capital charge, and what this new regulatory framework does is it graduates those capital charges in line with the changes in those letter ratings. Is that at about 10,000 feet?
Tim: That’s exactly right.
Stewart: Is that fair?
Tim: That’s exactly right. What it ended up doing was, certainly on a relative basis, the risk charge for a single A went up to where it was before for the reasons we just discussed, but, it did create some opportunities in particular with the high quality high yields part of the market for life insurers of things actually improving on a relative basis from where they were before, because of the fact that they were all grouped together. I do want to point out that is life only because PNC and health saw their relative charges go up. But, as we discuss in the paper and I’m sure we’ll touch on today, what drives the ship in terms of the bottom line capital implications from investments are very different between life and non-life insurers. So, it’s been mostly a life focused issue to date.
Stewart: And so, the market implications, if I’m just a plain straight up markets guy and I’m applying supply and demand, it just tells me that I’m a seller of A minus credit and I’m a buyer of high grade high yield because the step from the last tier of IG to the first tier of high yield was substantial, and now that step is smoother, right? It’s less severe, that step.
Stewart: So, here’s an insurance AUM journal term that’s never been used before. On a yield per unit of capital charge, that relationship looks better and creates a market opportunity. Is that fair?
Tim: Yep. That’s spot on. To be honest, I think you’ll start to see that play out with the redeployment of cash as bonds roll off. We didn’t see. I wouldn’t expect to see it, just given the elevated risk capital positioning of US insurers post-crisis being on relatively strong footing. I would expect to see redeployment on the margin to that high yield from single A credit. I think what we have seen, and it’s also reflective of recent trends broadly, has been the demand for securitized and increasing that as a more meaningful percentage of your overall core bond allocation, because, unlike the credit markets, there’s still a substantial portion of that universe that has a AA or AAA rating attached to it. We’ll touch on how that could evolve over time as well, but for the time being, municipals and securitized assets also look really good.
Stewart: This is a tangential topic, but for those people who may not be steeped in the fixed income T, an AA structured security, an AA corporate bond, and an AA muni bond: tax adjusted yields, they’re not the same across those asset classes, or through those big silos, you can’t compare across. Right?
Tim: Correct. Yep. The securitized piece in particular, and it depends on the part of the market, but generally speaking, you can expect to get a complexity yield premium versus corporate credit because of the amount of underlying due diligence that needs to happen at the position level for those assets.
Stewart: And so, in your paper, you point out… A lot of times, investment people like me, I always think about RBC as strictly in investment terms, but that’s not true. Obviously insurance companies write insurance and there’s a risk component there. The ratio of total RBC risk is quite different. Life insurance to PNC or health.
Stewart: Can you talk a little bit about that? I was struck by that difference.
Tim: Sure. Yeah. To be honest, I’m always surprised at how few people actually talk about what I call that rule of thumb, where people are talking about the function that they do in the business. So they think about maybe they’re managing to a risk capital figure based solely on invested assets. But, when you think about it in the context of your total positioning, the rule of thumb I use is about two thirds of a life insurance total risk adjusted capital is driven by the investment portfolio, which is substantial. So, as I mentioned earlier, this change for a life insurer, it moves the needle. Ultimately, I think there’ll be a lot more active management because of it on that end.
If you switch over to PNC or health, that ratio is flipped. So, their risk based capital, and correctly so given the volatility of their businesses, is driven by the underwriting. Only about a third is from their invested assets. So while the punchline for a lot of folks that are non-life CIOs was, “Oh, wow, our bond risk charges are going to increase across the board. How do I think about that from the portfolio?” I’m always cautioning folks to say, okay, don’t think about it in isolation though, because they could double, and it’s not going to really deteriorate your capital position relative to your underwriting.
Stewart: One of the things that’s been, and I want to stay on topic here, but I’m curious as well. When you look at these various asset classes and you see there has been a trend toward private asset classes, has there been a regulatory change that impacts private assets in particular?
Tim: Yeah. So if anything what’s happened so far has made private assets even more attractive because, and this is not just a US phenomenon, if you think about solvency too, if you think about Bermuda BSCR, you’re seeing basically the same risk charges applied, regardless if it’s a public bond or a private bond, and the same with a lot of rating agency, capital calculations as well. So, when you thought about those investments in capital adjusted terms, they looked attractive first public equivalent across the board. The most recent change, and I think it’s the early days of the NAIC saying, okay, maybe we need to be spending more time on this, is the requirement for an insurer at time of purchase and then every year end to basically submit to the NAIC a private credit rating justification from the rating agency that says, here’s how we got to this rating.
I think as an industry, they’re becoming more aware of issuers who are rating shopping, and then working with a rating provider that’s going to give the most favorable treatment. I would note that the NAIC said that they don’t expect to enforce anything on the back of this at this point, but it does open the door to future policing or changes around private markets at some point.
Stewart: You mention the increase in yield. In relative terms, bond yields have moved dramatically with interest rates. You and I both know, maybe everybody else doesn’t know, insurance companies don’t just blow out of an asset class and land at another one. It’s an incremental, right?
Stewart: So they can ride up this yield curve and they can invest in there. The question is, and from my perspective, does that slow the flow to private assets versus public assets? Does that change the risk return profile between those two buckets, even though there’s been changes that make private assets more palatable to hold?
Tim: Yeah. Stew, that is such an incredibly timely question because we were literally, including this morning, debating that very topic with our colleagues on email, because an insurer in Asia had actually made us aware that they would be reducing their flows to private credit in the face of rising rates. It had us talking about if this is something that’s going to be a trend, or if this is a one-off. I think there’s a couple different items in play here. So, I’m going to couch that by saying that there’s deferring views. The first thing I’d say is a large part of the private market is floating rate. So, that actually can be very attractive in the face of rising rates as the coupons grow.
The other element is that we’ve seen it become such a meaningful portion of the US insurance balance sheet. So, life insurance in particular have nearly 40% of their fixed income portfolio in private credit or private placements. So, it’s now almost to coin flip with where they’re making these allocation decisions. To the case against continued increases, number one, the amount of complexity for doing a private deal. Obviously the liquidity that comes along with that versus the public market. If the public market yields get very compelling, there’s just a lot less lifting to do there. I think having some sort of structural liquidity build into your total assets probably makes sense, especially if yields are compressing versus the public market.
The other element is obviously the case of the liabilities, right? So as we see interest rates go up and you’re a life insurer, you are going to have to be aware of liquidity needs as policy holders either lapses or surrender or policy to go somewhere else. Being in the private market heavily doesn’t afford you those opportunities. So, I do think that the relative value gets a lot less obvious than it maybe was over the last 10 years. But I think if you are a long duration insurer, it’s a structural part of your SAA now and will continue to be, unless there becomes some sort of risk capital adjustment on top of it.
Stewart: Let me ask some big convoluted question that only I could come up with. So, when I was a professor full time, we taught a case about a company that was holding a lot of cash, no debt. They were lagging their competitors from an ROE perspective. The case centers around restructuring that balance sheet and taking out some of that liquidity; the concept was that they were over liquid, which is an interesting concept, but if there’s a liquidity premium for private assets, that is the mirror image of that fact is that there is a cost to liquidity, right?
Tim: Right. Yep.
Stewart: So PNC companies, for example, often have liquidity options outside of selling investments. For example, they may have an FHLB arrangement where they can borrow against their RESI mortgage holdings, right?
Stewart: I think that a lot of PNC companies—I would argue that a lot of PNC companies are over liquid.
Stewart: And that’s costing them money. Can you talk a little bit about that?
Tim: Yeah. Well, I think you’ve seen, to a much lesser extent I think over the last five years when you’ve seen their share of private placements go upwards of 10% to 15%, you’ve started to see, that was a trade I don’t think a lot of folks thought that a non-life insurer would make, even as recent as a decade ago. So, I think as yields have ground lower and you’re not getting much of a material return from your traditional core fixed, and you have choppiness in the equity markets, even though it’s been a great run, you have seen them being willing to take on more liquid assets as a result.
Again, from a risk capital perspective, they’re agnostic to if it’s public or private, so you don’t have to worry about all that. As we mentioned before, you can have more investment risk as a non-life insurer, traditionally speaking. I think you’ve also seen them become players in real assets as well, in real estate or at least liquid versions of that market. So, we’ve seen a lot of discussions with non-life insurers trying to get into REITs or global property type approaches. But I do think they are more mindful of their liquidity position. I think more, because rating agencies and how they’re thinking about stressed cash flows in some of their work.
Stewart: Okay. So, while I’m on my soapbox, Tim, core bonds perform miserably with inflation. The bond market hates inflation.
Stewart: We both know that the nominal treasury curve is artificially low. The fed wants it that way. Real rates are negative, blah, blah. We know that. So, a much better hedge for inflation is equity, right?
Stewart: But the RBC charge and property and casualty carriers (and which is my background). I’m not a life person. I’m a PNC person. But at the end of the day, when you write a long tail line of business, like workers comp, medical inflation is even higher than kind of core inflation. So you’ve got a lot of exposure to inflation on a really long tail line of liabilities, and core bonds aren’t a good hedge there. So, equities are a better hedge for inflation, yet the RBC charges are massive on equity. Is there a solution there? Do you see that changing? What I’m trying to get into is, kind of what’s the future looking like here?
Tim: Sure. So I would also say, in addition to medical inflation, social inflation, which is outside of traditional CPI as well is embedded in there. So they’re being hit on all fronts. And again, as we touched on earlier, this isn’t something that folks have had to think about in terms of how to evolve your portfolio for the last three decades. So it’s a relatively new thing. Traditional inflation hedges, obviously the premier one would be commodity exposure. We just talked about the traditional equity capital charge, depending on which we’re regime you’re in, you could be holding commodities at a 50% capital charge. Some rating agencies have it even higher. So, having that type of exposure in the market value volatility for your income statement and balance sheet that goes along with it is not appealing for most insurers.
So what we’ve seen on the margin to tackle inflation, and then I’ll speak to how I think the industry could evolve. We’ve looked to help clients think about assets that have a positive beta to inflation potentially, but also to rising rates and have negative, empirical duration. So, as part of our 2022 themes, we suggested things like, again, REITs because of their inflation hedge that’s embedded there, and also, and this speaks to where the future of capital could go. If you think about REITs under Hong Kong RBC, for instance, that’s a 22% charge versus 40% for other equity. So, there are regulatory capital charge incentives there. Convertible bonds or another asset class that you can get this equity upside participation, potential inflation hedge that goes along with it, the bond floor to dampen volatility, and it’s risk charged, unless it’s a mandatory convertible as a fixed income asset.
So in my mind, that continues to be a best idea. We’ve seen a lot of take up in an asset class that quite frankly has been forgotten by the broad insurance industry over the last two decades. Then finally, which I think plays into the earlier theme we mentioned the relative value attractiveness of a high quality high yield, the bank loan market. So again, floating rate nature of those investments, BB, single B exposure looks good on a capital adjusted basis. We’ve seen those things become looked at more frequently because of the risk capital consumption relative to traditional equities. But, to your point on traditional equity, there was a proposal with the NAIC maybe three years ago, where if an insurer had basically a ring fenced allocation equities that they viewed as an infinite duration asset, and we’re going to be holding it for inflation protection or to hedge their longest liabilities where investments did not exist out to those tenors.
Some of the largest life players have been doing that and continue to do that today. There was a request to have a significant capital charge reduction for those types of assets, with certain constraints in place. It did pass, which I was a little bit surprised about because it had some of the larger players backing it fully, but we have seen it pass in other parts of the world. So again, solvency too, long term equity holdings, there’s given constraints around how you manage those, but if you prove that they’re strategic in nature, low turnover, you’re not actively trading, you can have a capital charge that’s roughly half of what equities would be. I think that makes a ton of sense for the US to consider because it’s more reflective of what insurers are doing today. I think that the traditional risk charges for those asset classes could be a little bit outdated to your point earlier.
Stewart: Yeah. I think that, look no further than the big, big life blocks that have been sold these big transactions. It’s basically getting out of the regulatory regime and allowing… insurance companies, back on my soapbox again. I think insurance companies are viewed as dumb money by other institutional investors. That makes me so angry because you and I both know that to run money for an insurance company, it’s like having your shoelaces tied together, and yet you have to cross the finish line at the same time as everybody else, because you’ve got all these other regulatory constraints. Insurance companies don’t hold massive IG bond portfolios because they think it’s a wonderful investment. They hold it because they’re forced there by a regulatory regime that is making it difficult for them in the current market environment. I think that’s my opinion. Certainly, I’m not trying to put that on line.
Tim: Yep. We’ve talked about this before, but if you just think about the naming conventions that are embedded within the statutory accounting system, they’re certainly not reflecting the investible asset universe that exists today.
Tim: Just calling all corporate type bonds industrial bonds. It’s a very dated term that comes from years gone by that isn’t reflective of the diversity of assets. I recognize they’ve made some sub components, but I think there’s some work to do there. I think the biggest thing I would love to see, when I think about what could be coming up the road, I would love to see a reevaluation of the scheduled BA or other invested asset framework so that you’re getting a capital charge that’s closer to what the underlying investment’s doing from an economic perspective, because a catch all 20% or 30% charge depending on your business, if you’re in something that’s low volatility or you’re using as a diversifier against your portfolio, it’s going to discourage those types of investments because you risk charging them as a fund.
I know that the NAIC had tabled that 10 years ago, and I think the new working group they started that’s solely focused on risk based capital and investments, I think that’s one of the things they’ll take a look at in the next coming years. In the nearer term, they are asking the industry for feedback on how to consider risk charging ABS and CLOs. So, they’ve reached out asking, what should they do in terms of, should they do a different modeling framework? Should they do it the same way that they do it with CMBS and RMBS today on the non-agency side? So, I think you’ll see another set of risk charges there. To be honest, I think that makes a lot of sense because-
Tim: … they’ve acknowledged that using corporate default matrices to calibrate non corporate fixed income, obviously it’s not the perfect approach. So, I’m hoping that as they start going through in more detail and more granular fashion, that it’ll start to pay off for insurers down the road.
Stewart: I hope that someone alerts them to the fact that there’s urgency. Not like urgency like decades, urgency like now.
Stewart: So one of the things that I just missed earlier, and it’s near and dear to my heart, because I was a municipal treasurer. How many people have that on their resume? I was the treasurer of the city of Columbia from the ripe old age of 27 to 30. We were a standalone AA. We owned all the utilities and everything, except for the gas company. Wonderful, wonderful place, Columbia, Missouri, University of Missouri’s home, great spot. Munis are very, very credit stable, right?
Stewart: You can’t easily change the capital structure. The city of Dallas is not going to lever up and take over Fort Worth. In your paper, you mentioned this anomaly or this change in the RBC that makes the very high grade high yield market attractive, and that it can also make the municipal market attractive and you can pair those together. Can you talk a little bit about that strategy of being able to do pairing those together?
Tim: Sure. Yeah. I think the barbelling idea is a great way to play he capital trade off here. I think to your point on the stability around municipal bonds, it’s great because the default history is lower than similarly rated corporates. You have greater certainty as a borrower, or as a lender rather, about the underlying fundamentals of municipality because of how focused they are. So it’s a really good place from that perspective. Again, if you’re thinking about making an allocation or investing a segment of your balance sheet and it looking for the average credit rating combined, taking on some BB or single B exposure, and then dampening the overall rating volatility by adding a part of the fixed income market that has a substantial amount of issuance at the AAA or AA level, it’s a great way to get a net rating of something like single A or BBB with a pretty compelling yield, because you do find pockets of opportunity in the taxable municipal space in particular that look really good. We haven’t even got into the tax situation in the US right now, but potentially if the corporate tax rate goes back up, you could see renewed interest in increasing tax exempt municipals, which makes that trade off you just talked about even more compelling.
Stewart: I’ve had a great time with this discussion and I really appreciate you being on. We always ask the signature question about what would you tell your 21 year old self, but you’ve already been on and you’ve already been asked that question. So I can’t ask that one again. Jenna goes, “What are you going to ask him?” And I go, “I’m not telling you.” So, here’s the thing. I have a former student. His name is Anthony, and he was working at an insurance company’s investment team, a large insurer with a large team with multi-asset classes. He was in there in their training program basically. He had options about what asset classes he could pursue. He had been out of school for a couple of years. So if you’re sitting in an asset management firm or in the internal investment department of an insurance company and I said, “Hey, what direction do you think is an interesting avenue to go with your career given the landscape today?” What would you tell somebody who’s early on in their career in the asset management business, whether or it’s on the buy side or the sell side?
Tim: So I think, from my perspective, the alternatives part of the asset management universe is certainly the most compelling when you think about long term prospects, and it’s for a couple different reasons. Number one, when you’re starting out, I think it’s great to find an area that has less of a structure, less of a blueprint for how you should do things. I think the alternative space in particular has the most blank canvas for somebody that’s just starting out, both in terms of the types of assets that you can invest in, but also the outcomes from those assets. I think feeding off that last thing, a second piece of this that is hugely important, good from a social perspective, or to help in the climate transition or climate risk and opportunities generally. I think for the younger generation, there’s a lot more of a cause-focused feel to what they want to do from a work perspective. I think that area in particular is very ripe with opportunities.
Stewart: That is great advice, and I appreciate it. Tim Antonelli, multi-asset strategist on the insurance team. You do so much more. You are really a tremendous resource in this business than I really appreciate you being on.
Tim: Stew, thanks for having me. I love what you’ve built and it’s always a pleasure.
Stewart: Thank you. Thank you very much. Thanks for listening. If you have ideas, please give us a ring at email@example.com. My name is Stewart Foley, and this is the Insurance AUM Journal podcast.