Alton Cogert, CFA, CPA, CAIA, CGMAPresident & CEO

March 21st, 2013

Insurer Investment Forum XIII

Investing for Insurers:Review and Preview

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The #1 Investment Challenge in Over 30 Years:“Low Rates for Longer”

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U.S. Financial Repression

Source: Federal Reserve, J.P. Morgan Asset Management3

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Where We Are Today

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• Book Yields Continue Downward Path• Insurers Grappling with Risk• Insurers Grappling with Product Pricing• Insurers Grappling with ERM

“A further unpleasant reality adds to the industry’s dim prospects: Insurance earnings are now benefiting from “legacy” bond portfolio that deliver much higher yields than will be available when funds are reinvested during the next few years - and perhaps for many years beyond that.

Today’s bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over.”

- Berkshire Hathaway Shareholders’ Letter, March, 2013

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Improving Investment Income - It Takes Planning

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Improved Investment Income - It is possible...

3.50

3.65

3.80

3.95

4.10

4.25

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Unchanged Market interest RatesPo

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Improved Unchanged

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Key Long-Term Asset Class Return Assumptions

6Source:JP Morgan 2013 Long-Term Capital Market Return Assumptions

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Key Long-Term Asset Class Risk Assumptions

7Source:JP Morgan 2013 Long-Term Capital Market Return Assumptions

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Risk/Return/Correlation Expectations vs. Aggregate Investment Grade Bond

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What Does “Low Rates for Longer” Mean?

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• How Long?

NOV, 2009 “Federal Reserve Chairman Ben Bernanke said interest rates will remain low for an extended period as the U.S. economy still faces considerable challenges.”

FEB, 2010 “Chairman Ben Bernanke told Congress on Wednesday a weak job market and tame inflation warrant low interest rates for an extended period.”

JAN, 2012, “The Federal Reserve anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

FEB 2013 - “It plans to hold short-term interest rates near zero even longer, at least until the unemployment rate falls below 6.5 percent.”

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What Does “Low Rates for Longer” Mean?

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Until Unemployment Rate Hits 6.5%, which will be...It would take an average job-growth rate of 250,000 each of the next 13 months to arrive at a 6.5% unemployment rate.

But if increases were just 125,000, the average trend rate for the last 30 years, it would take 96 months — or eight full years — before unemployment got to 6.5%.

(This isn’t just job additions, mind you, but net job creation; that’s why simply jumping from 125,000 to 250,000 cuts the time down so dramatically.)

So bond bulls and dollar bears take heart. It looks like Helicopter Ben will be hovering for some time to come.

- http://blogs.wsj.com/marketbeat/2013/01/04/when-the-unemployment-rate-hit-6-5-calculate-it/

Here’s the Atlanta Fed’s calculator to help answer this question:

http://www.frbatlanta.org/chcs/calculator/

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What Does “Low Rates for Longer” Mean?

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Comparison with Japan - 15 Years and counting?

10 year JGB: Jan, 1990 to March, 2013

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How About ‘Black Swans’ - Very Low Probability/Very High Impact?

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Inflation - according to the ‘experts

Keynesians -

- Demand/pull - increased economic activity

- Cost push - supply side disruptions

- Built-in inflation - wage/price spiral

Monetarists -

- Quantity Theory of Money

- Long run inflation =

Money supply growth rate

+ Rate of change in Velocity of Money

- Growth rate in Real Output

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How About ‘Black Swans’ - Very Low Probability/Very High Impact?

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The Fed says, “Take More Risk”...Should You?

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What is Your Risk Appetite?

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Positive Result

Negative Result

Good Quality Process Expected Bad Luck

Bad Quality Process Good Luck Expected

Over the long run, Process determines Results.

Thus, Process becomes more important than Results.

The Fed says, “Take More Risk”...Should You?

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What about Luck versus Skill?

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TextTexthttp://insurercio.com/content/how-much-ones-success-or-failure-skill-or-luck

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What about Luck versus Skill?

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Paradox of Skill:

Standard deviation of skill decreases as expertise increases, which means

Luck has more to do with results

And that means

Difficult to rely upon historical performance

More important to rely upon process

Counter-intuitively, process is more important than results

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From the London Business School...

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• Decisions Are More Important Than Results• Results don’t necessarily reflect a high-quality process• Ultimate criteria for good decision making is tied to:• What are we trying to achieve with this decision?

(Criteria)• What can we feasibly do? (Alternatives)• What do we have to watch out for? (Consequences)

• It’s not enough to measure leaders on results; How they are achieved is equally important.

• Implement a good process; Manage risks

- http://bsr.london.edu/lbs-article/407/index.html

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Could we make understanding risk any more complicated?

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8 Steps to Answering: “Should You Take More Risk?”

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• Step 1 - What do you mean by ‘risk’?• Probability of Not Meeting a Goal• Not VaR• What Goal? • Return on Surplus, • Net Income• Spread Over Liability• PV Enterprise Value• Drawdown

• Step 2 - Quantify Risk• Single, multi periods, 1 yr. 5 yr.?

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8 Steps to Answering: “Should You Take More Risk?”

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• Step 3• How do different asset mixes impact risk metric

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8 Steps to Answering: “Should You Take More Risk?”

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• Step 4 - Implementation Issues• Strategic or Tactical

Strategic Tactical

Entry

Execution

Exit

Board OK Parameters Set for Entry

Slowly, Over Time Active Management

Board Decision Parameters Set for Exit

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8 Steps to Answering: “Should You Take More Risk?”

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• Step 5 - Consider Game Theory Impact

Risk Assets Rise Risk Assets Fall

Increase Risk

Maintain Risk

Decrease Risk

Bad Good

Opportunity Cost/Gain

Opportunity Gain/Cost

Good Bad

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8 Steps to Answering: “Should You Take More Risk?”

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• Step 6• Know your Board/Senior Management Team

• Step 7• Make a Decision - Even if it is to make no decision

• Step 8 • Monitor the Impact of the Decision• Stewardship Report

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What has SAA seen so far?

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Goldman Sachs Insurance CIO Survey - July, 2012

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Insurers expecting to increase risk: 26%

Insurers expecting to decrease risk: 14%

Asset Class% Who Expect

to Increase Allocation

High Yield 36

IG Corporates 35

Real Estate 34

Emerging Market Debt 31

Private Equity 27

Bank Loans 25

Mezzanine Debt 23

Asset Class% Who Expect to

Decrease Allocation

Cash/Short Term 39

European Financial Credit 24

http://www.goldmansachs.com/s/GMeT_othermailings_attachments/6347837329351787503251.pdf

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Asset Classes - a Layer Cake of Choices

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The Basics• Make certain all IG asset classes are included (public/

private)• Diversified equity allocation• High yield/growing dividend slant

Tex The Next Layer• Lower investment grade mandates for

munis (where applicable)• Below investment grade in various

guises t

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• The Next/Next Layer• Non-equity exposures• More illiquid asset classes• What your manager may suggest, based upon their

proven expertise

•Tex The Next/Next/Next Layer• More complex strategies using

derivatives explicitly or implicitly t

Asset Classes - a Layer Cake of Choices

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The Risk Trap

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• Always ask, “Who is on the other side of the trade? And why?”• Too easy to see well groomed, credentialed person in a suit as

authority figure.• It could still be snake oil.• If presenter is too confident, walk out of the room. • Investment management is a humbling activity.

• Ask more questions - the “dumber” the better until...• You fully understand ALL aspects of the asset class• Remember:• There is NEVER a dumb question, especially in a Committee

or Board setting.

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The Risk Trap

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• Other Questions:• Will this play in Oldwick?• Ask for ideas from your peers, independent third parties, etc.

• There is no way you are expected to know it all.

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The #1 Investment Challenge in Over 30 Years

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The #1 Investment Challenge in Over 30 Years

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• Low rates for longer gives us the opportunity to• Reassess our asset allocation

• Shed the blinders of ‘we’ve always done it this way’• Reassess the relationship between investments and reserves• Reassess the relationship between investments and product

pricing• Take a deep breath, step back and review the overall

investment process• Be better prepared for meeting future challenges• Improve profitability over what it might have been• Get a ‘leg up’ over competitors - succeed where others may fail• Develop a process for constantly improving your company

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The #1 Investment Challenge in Over 30 Years

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Thank You

More updates at:

LinkedIn: www.linkedin.com/in/acogert

Twitter: www.twitter.com/saa123

www.insurercio.com

www.saai.com

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