Session 13 PD, Investment Strategies and Issues Impacting ... · Session 13 PD, Investment...

Session 13 PD, Investment Strategies and Issues Impacting Small and Large Companies

Moderator: Mark W. Whitford, FSA, CERA, MAAA

Presenters:

Mike Dziadus, CFA Mark W. Whitford, FSA, CERA, MAAA

Current Investment Themes

Presented to

Society of Actuaries

May 4th, 2015

Presented by

www.cia-llc.com

Saint Louis231 South Bemiston Ave., Suite 200

Clayton, Missouri 63105 (314) 726 9911

Orlando13506 Summerport Village Parkway #406

Windermere, Florida 34786(321) 939 1372

Chicago150 North Wacker Drive, Suite 2660

Chicago, Illinois 60606(312) 212 4000

1150504-MSC Society of Actuaries Life and Annuity Symposium.ppt

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2 Yr. Treasury

10 Yr Treasury

30 Yr Treasury

KEY INTEREST RATES OVER TIME

Since 1993, interest rates have followed a downward trend. How low can rates get? 0%? Who knows?

Source: Cardinal Investment Advisors analysis, U.S. Treasury


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10 Yr Treasury

AAA

AA

A

BBB

10 YEAR RATES WITH CREDIT SPREAD

Owning Corporates helps pick up some yield; however, a portfolio of 30 yr. BBB bonds isn’t prudent. How can insurance companies meet obligations in this low yielding environment?

Source: Cardinal Investment Advisors analysis, US Treasury, Barclays Live


ASSET CLASSES GETTING LOOKS

Clearwater Analytics surveyed over 400 finance and accounting professionals to understand which asset classes insurers are evaluating to provide yield. 17% of the respondents were life insurers. The response below indicates which asset

classes the respondents are currently considering for their portfolios.

Source: Cardinal Investment Advisors analysis, Clearwater Analytics 2014 Insurance Benchmark Survey Results, Jan. 20, 2015

Cor

pora

tes

Gov

ernm

ents

Mon

ey M

arke

t

Mun

icip

als

Forw

ards

MB

S

Shor

t Bon

ds

Com

min

gled

Fun

ds

Futu

res

Pref

erre

d St

ocks

Wor

king

Cap

ital F

inan

ce N

otes

Com

mon

Sto

ck

Lim

ited

Part

ners

hips

Mut

ual F

unds

Mor

tgag

e Lo

ans

Swap

s

REI

TS

Opt

ions

Hig

h Yi

eld

Ban

k Lo

ans

0%

1%

2%

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4%

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10%

DerivativeLegal Structure

Asset Class


HIGH YIELD BANK LOANS

High Yield Bank Loans offer floating rate income in securities that are senior to bonds in the capital structure.

Advantages+ Senior debt leads to generally high recovery rates

in the event of default

+ Floating rates structure reduces interest rate risk

+ Separate accounts receive fixed income RBC treatment

Disadvantages- Below investment grade credit quality

- Presence of LIBOR floors can limit floating characteristics

- Labor intensive accounting in separate account structures.

Source: Cardinal Investment Advisors analysis, eVestment Alliance

Representative Bank Loan Managers*• Babson Capital Management• BlackRock• Credit Suisse Asset Management• Crescent Capital Group, LP• Eaton Vance Management• Franklin Resources, Inc.• Invesco, Ltd.• OFI Global Asset Management• Pyramis Global Advisors• Symphony Asset Management• Voya Investment Management

* Based on Size.


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2,000

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*

Def

ault

Rat

e (%

)

Yiel

d S

prea

ds (b

ps.)

Yield Spreads vs. Default Rates

Spread

Default Rate

CREDIT SPREADS AND DEFAULT RATES

High Yield Bank Loans offer attractive spreads. Default rates have generally remained low.

Source: Cardinal Investment Advisors analysis, CSFB, Shenkman, Eaton Vance

* Estimate for 2014 year end data.


REAL ESTATE FUNDS

Investors can access REITs through both public and private vehicles. Public REITs are more liquid, whereas private REITs have a lower correlation to equity markets.

Advantages+ Pays a higher yield than many other “equity”

investments

+ Low interest rate environment has allowed restructuring and reduced leverage

+ Real Assets can provide diversification to a portfolio of stocks and bonds

Disadvantages- Private REITs can be illiquid

- Public REITs behave similar to the equity markets

- Individual investments typically employ leverage

- Real Estate recovery has led to large inflows into REITS in recent years


Representative Public REIT Managers*• BlackRock• Brookfield Investment Management, Inc.• Cohen & Steers Capital Management, Inc.• Deutsche Asset & Wealth Management• Dimensional Fund Advisors LP• Heitman Real Estate Securities• Principal Real Estate Investors• Pyramis Global Advisors• T. Rowe Price Group, Inc.• Vanguard

Representative Private Real Estate Managers*• AEW• ASB Capital Management, LLC• BlackRock• Deutsche Asset & Wealth Management• Franklin Resources, Inc.• Heitman Real Estate Securities• J.P. Morgan Investment Management, Inc.• Principal Real Estate Investors• Standard Life Investments• TIAA-CREF Asset Management, LLC.

* Based on Size.


DIFFERENT INVESTMENT STYLES OF COMMERCIAL REAL ESTATE

REITs are most common in the more conservative styles of commercial real estate investing.

Source: Cardinal Investment Advisors analysis, NCREIF

Pote

ntia

l Ret

urn

Risk

Security of Income Growth of Income & Value

Opportunistic(<2% yield)

Core Plus(5-7% yield)

Core(5-6% yield)

Low Leverage(< 30%)

High Leverage(>70%)

• Leveraged multi-tenant property

• Lease out risk• Development

projects• Joint venture activity• More active buy/sell

• Distressed sellers globally

• Private partnerships• Recovery capital• Emerging property

sectors• New company

formation• Real estate private

equity

• Substantially leased, stable, single or multi-tenant property

• Quality of income• Low lease

rollover• Long-term

leases• Longer holding periods

Value-Added(2-4% yield)

• Property repositioning strategies

• Re-development projects

• Change of lease profile

• Sector specific• Specialty properties

(medical, assisted care)

REITs


MASTER LIMITED PARTNERSHIPS (MLPs)

Master Limited Partnerships (MLPs) are companies structured as limited partnerships with ownership units that can trade on public exchanges. The majority of MLPs are formed to own and operate natural resource assets.

Advantages+ Large portion of total return is investment income

+ Investment in real asset can diversify stock and bond portfolios

+ A portion of income distributions are treated as depreciation, creating a tax deferral mechanism

+ For accounting purposes, securities are treated as stocks instead of partnerships

Disadvantages- Tax deferral is not as beneficial for institutions

- K-1s can make accounting cumbersome

- Fund investments do not receive tax deferral treatment

- Potential to be reclassified as a C-Corp


Representative MLP Managers*• Advisory Research, Inc.• Center Coast Capital• ClearBridge Investments, LLC• Cushing Asset Management, L.P.• Goldman Sachs Asset Management• Harvest Fund Advisors, LLC• Miller/Howard Investments, Inc.• Neuberger Berman• OFI Global Asset Management• Salient Partners, L.P.• Tortoise Capital Advisors, LLC

* Based on Size.


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Oil

Pric

e

Inde

x V

alue

MLP Return Components vs. Oil Prices

Total Return

Price Return

Oil Price (WTI)

MLP ASSET GROWTH

The amount of income generated from MLPs has grown drastically in the past five years.

Source: Cardinal Investment Advisors analysis, Alerian


BC Gov't/Credit

BC Long Gov't Credit

Municipals

Mortgage Loans

Private Placement

Trade Finance

Preferred Stock

High Yield Bonds

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1.00%

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7.00%

0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0

Yiel

d (%

)

Duration (Years)

Yield vs. Duration

OTHER YIELD BASED ASSET CLASSES

Insurers have shown interest in virtually all yield-based asset classes that are structured to work within the regulatory environment.

Source: Cardinal Investment Advisors, Barclays Live, Federated, Bank of America/ML

Primary Risk (Other than Interest Rates)• Municipals – Less liquidity than Core Bonds• Mortgage Loans – Illiquid• Private Placements – Illiquid• Preferred Stock – Concentration in Financials• Trade Finance – Illiquid, Credit Quality• High Yield Bonds – Credit Quality

For Internal Use Only / Not for Distribution to the Public

Mark W. Whitford, FSA, CERA, MAAA

[email protected]

www.ftinstitutional.com/iam


Matching the Right Investment

Strategy with the Right

Company

Mark W. Whitford, FSA, CERA, MAAA

Senior Portfolio Investment Strategist

Franklin Templeton Companies, LLC

May 2015


Insurance Industry Analysis


Highlights

• Life and Annuity companies have over US$3.7 trillion in general account assets

– Not easy to find a “diamond in the rough strategy”

• Sometimes it is possible (Build America Bonds)

• Concentrated

– 90% of the assets come from less than 5% of the companies

• Long-tailed liabilities

– Some lines (LTC) have durations over 30 years

• On average, 10% of a company’s invested assets are capital and surplus

– Limits the amount of investment risk a company can take

Life and Annuity Industry

3

Data above based on SNL data as of 12/31/14. SNL Financial collects, standardizes and disseminates all types of relevant corporate, financial, market and M&A data for a variety of

industries including insurances. SOURCE: SNL FINANCIAL LC. CONTAINS COPYRIGHTED AND TRADE SECRET MATERIAL DISTRIBUTED UNDER LICENSE FROM SNL. FOR RECIPIENT'S

INTERNAL USE ONLY.


Challenges and Issues

• Asset Liability Management (ALM)

• Hitting yields similar to rate used in pricing

• Adding alternative asset classes, including equities

• Enterprise Risk Management (ERM)

• Own Risk & Solvency Assessment (ORSA)

Life and Annuity Industry

4



INTERNAL USE ONLY.


Highlights • Surplus increased $24 billion in 2014

– Average RBC ratio increased from 967% to 975%

• Liabilities-to-Surplus ratio, decreased to its lowest level in the past five years

– Net Premiums increased 14.97% – Biggest jump in premiums was from annuities

• Asset Allocation

– Increase allocation to mortgage loans, equities, high-yield securities and schedule BA assets

– Average maturity increased 0.2 years

• Net Yield on Invested Assets was 4.83% in 2014 (4.92% in 2012, & 5.24% in 2010)

• Percent of total revenue coming from net investment income decreased 1.5% (23.7%–22.2%)

• Return-on-Surplus ratio, on average, decreased 0.5% (12.1%–11.6%)

Life and Annuity Industry Changes from 2013

5



INTERNAL USE ONLY.


Highlights • As companies grow they tend to increase their allocations to mortgage loans, derivatives

and other invested assets at the expense of bonds, cash and short-term investments.

– On average, the smallest companies will have over 85% of their assets in bonds, cash and short-term investments and less than 15% in mortgage loans, derivatives and other invested assets

– For the largest companies, the 15% jumps to over 25% at the expense of bonds, cash and short-term investments

• In terms of fixed income, as companies grow they tend to allocate by:

– Increasing allocation to industrial bonds and decreasing allocation to U.S. Gov’t issues

– Increasing allocation to lower rated issues

– Increasing the bond portfolio duration

• As a percent of surplus, allocations to riskier assets (mortgage loans, high yield bonds) increase as companies grow

• Approximately 20% of revenue comes from investment income

Life and Annuity Industry 2014 Analysis

6



INTERNAL USE ONLY.


• As a company grows, it tends to:

– Increase the amount invested in mortgage loans, derivatives and other invested

assets

– Decrease the amount invested in cash and short-term securities

Life and Annuity Industry Invested Assets

7


industries including insurances.

Asset Allocation as % of Investable Assets

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

< $0.1 Billion $0.1–$1 Billion

$1–$5 Billion $5–$10 Billion $10–$20 Billion

> $20 Billion

Other Invested Assets

Derivatives

Contract Loans

Real Estate

Mortgage Loans

Preferred Stock

Equity

Bonds

Cash & Short Term


• The amount, as a percent of surplus, invested in riskier asset classes increases as

a company grows

– Mortgage loans and high yield make up a majority of the riskier assets

Life and Annuity Industry Capital and Surplus

8



Investment Leverage and RBC Ratio

0%

50%

100%

150%

200%

250%

300%

<$0.1 Billion $0.1–$1 Billion $1–$5 Billion $5–$10 Billion $10–$20 Billion >$20 Billion

Derivatives

Other

High Yield

Mortgages

Real Estate

Equities

RBC Ratio

1,341% 892% 898% 889% 768% 1,057%


• As a company grows, it tends to:

– See an increase in the amount of RBC coming from C-0 and asset risks

– Decrease amount coming from business risk and insurance risk

Life and Annuity Industry RBC Ratio

9



Estimated RBC by Factor

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

<$0.1 Billion $0.1–$1 Billion

$1–$5 Billion $5–$10 Billion

$10–$20 Billion

>$20 Billion

C-4b Business Risk Health

C-4a Business Risk Life

C-3a Interest Rate Risk

C-2 Insurance Risk

C-1o Other Asset Risk

C-1cs Common Stock

C-0 Subsidiaries


• As a company grows, it tends to see an increase in investment income, as a

percent of invested assets

Life and Annuity Industry Investment Income

10



Investment Income as a % of Invested Assets

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

<$0.1 Billion $0.1–$1 Billion $1–$5 Billion $5–$10 Billion $10–$20 Billion >$20 Billion

2014

2013

2012

2010


• Increased allocation to mortgage loans (21%) in the past five years

• Increased allocation to “other invested assets” (45%) in the past five years

• Increased allocation to equities (10%) in the past year, 5% increase prior

four years

• Even with the above increase in investment risk, net yields are down 50bps

over the same time period

These are Interesting Times

11

• Doubled allocation to high yield securities (2.5%-5% of the bond portfolio) in past five years

• Increased allocation to equities (43%) in the past five years

• Allocation to “other invested assets” increased (60%) in the past five years

• OAD increased 0.3 years in the past five years

• Percent of Capital & Surplus invested in risky assets has increased over 10% in the same time period

• Average Gross Bond Yield is down over 100bps over the past five years

1

LIFE & ANNUITY INDUSTRY

2

HEALTH INDUSTRY

3

P&C INDUSTRY

Insurance companies have been increasing their risk tolerance over the past few years



INTERNAL USE ONLY.


• U.S. economy is starting to pick up

• U.S. governments current debt is over $18 trillion and growing

• U.S. Social Security disability fund may run out of money in 2016

• Highway fund estimated to run out of money in 2015

• Potential for rapid inflation

Where are Rates Going? Up? Down?

12

• GDP has not consistently grown above 2% for a long time

• Labor slack

• Low inflation

• Some expecting an inverted yield curve before year-end

• Another recession – Deflation

• QE in Europe just started – estimated at $1 Trillion, over $100B moved out of Europe in 4Q14

• Near record spread between the 10yr U.S. treasury bond and 10yr German Bund

• 9 European countries currently have negative 2 year bond yields

• Nestle recently issued a 2yr bond at a negative 2bps yield

• Baby Boomers working longer and saving more

• Stronger U.S. dollar – some estimate Euro/Dollar will be at parity soon

1

CASE FOR RATES GOING UP

2

CASE FOR RATES STAYING AROUND WHERE THEY ARE TODAY

3

CASE FOR RATES GOING DOWN

Source: Franklin Templeton


Case for Rates Going Up

13

As of April 7, 2015

Source: USDebtClock.org


Case for Rates Going Up

14

CBO’s February 2013 Report

The Budget and Economic Outlook: Fiscal Years 2013 to 2014

Source: USA.gov


Case for Rates Staying Close to Where They are Today

15

Source: Federal Reserve as of 9/30/13.

0%

10%

20%

30%

40%

50%

60%

$0

$400

$800

$1,200

$1,600

$2,000

1Q90

1Q93

1Q96

1Q99

1Q02

1Q05

1Q08

1Q11

Total Liquid Assets Liquid Assets/Short-Term Liabilities

3Q13



16

Source: Bloomberg

Japan’s GDP, Unemployment & Inflation Trends



17

For illustrative and discussion purposes only. Source: BEA; Hokenson & Company; “Global Population Developments and Implications for Investments”; BLS. As of June 30, 2013.

Estimates for July 2013 – December 2016.

0%

3%

6%

9%

12%

15%

57 61 65 69 73 77 81 85 89 93 97 01 05 09 13 17 21 25

0.00%

0.75%

1.50%

2.25%

3.00%

3.75%

Labor Force (right scale) GDP (left scale) 10Y Treasury Rate (left scale)

Labor Force Forecast GDP Forecast



18

Source: USA.gov

Median usual weekly earnings of full-time wage and salary with ethnicity, and sex,

4th quarter averages, not seasonally adjusted

TOTAL

Age, Race, and Hispanic or Latino Ethnicity Number of Workers in

(Thousands)

Median

Weekly Earnings

TOTAL

16 YEARS AND OVER 107,368 $799

16 to 24 years 9,755 493

16 tom 19 years 1,150 387

20 to 24 years 8,605 505

25 YEARS AND OVER 97,613 847

25 to 54 years 75,993 827

25 to 34 years 26,188 743

35 to 44 years 24,559 882

45 to 54 years 25,245 903

55 YEARS AND OVER 21,620 915

55 to 64 years 17,882 922

65 years and over 3,738 869



19



INTERNAL USE ONLY.

Total Assets ($) 2014 2013 2012 2011 2010

Life Industry 6.26 Trillion 6.00 Trillion 5.64 Trillion 5.37 Trillion 5.20 Trillion

P&C Industry 1.78 Trillion 1.74 Trillion 1.65 Trillion 1.59 Trillion 1.55 Trillion

Health Industry 0.31 Trillion 0.30 Trillion 0.27 Trillion 0.18 Trillion 0.23 Trillion

U.S. Retirement Assets 23.0 Trillion 19.9 Trillion 18.2 Trillion 18.2 Trillion

Total 31.04 Trillion 27.46 Trillion 25.34 Trillion 25.18 Trillion


Case for Rates Going Down

20

Source: Bloomberg


Case for Rates Going Down

21

Source: Bloomberg.


Why Diversify? Because Winners Rotate

22

1.Source: © 2015 Morningstar, Credit Suisse, Barclays, Citigroup, Payden & Rygel. See www.franklintempletondatasources.com for additional provider information. Floating-rate loans as

represented by the Credit Suisse Leveraged Loan Index; short term government bonds as represented by the Barclays U.S. Government 1–2 Year Index; high–yield bonds as

represented by the Credit Suisse High Yield Index; global bonds as represented by the Citigroup World Government Bond Index; Treasury inflation-protected securities (TIPS) as

represented by Barclays U.S. TIPS Index; mortgage–backed securities as represented by the Barclays U.S. Mortgage Backed Securities Index; investment–grade corporate bonds as

represented by the Barclays U.S. Corporate Investment Grade Index; Municipals as represented by the Barclays Municipal Bond Index; 10-Year U.S. Treasury Bonds as represented by

the Payden & Rygel 10-Year U.S. Treasury Note Index. Indexes are unmanaged, and one cannot invest directly in an index. Past performance does not guarantee future results.

Annual Total Returns of Key Fixed Income Sectors 1991–20151

Worst

Best

Worst

Best


Appendix


Mark Whitford is a senior insurance investment strategist at Franklin Templeton Institutional. Mr. Whitford is in charge of providing asset liability and integrated risk management advisory services to insurance company clients. He is responsible for life and health and property and casualty insurers, as well as reinsurer's portfolios managed by our clients throughout the U.S. and Bermuda. His focus is to effectively provide advisory services that results in maintenance and growth of assets under management with our client. Mr. Whitford is also responsible for assisting the marketing team with strategies for attracting new clients. He works closely with the investment group to implement investment policy within client portfolios. Mr. Whitford will also represent the firm at regular client board and investment committee meetings, investment strategy, and performance results. He will continuously monitor regulatory and tax issues that may affect the performance of our client's portfolios.

Mr. Whitford has been employed by Franklin Templeton since 2013. He has been in various Actuarial roles since 1995.

Prior to joining Franklin Templeton, Mr. Whitford worked for Brookfield Investment Management in a similar capacity. He spent the first 13 years of his Actuarial career on the liability side of the balance sheet and the past seven years focused mainly on the asset side.

Mr. Whitford earned his B.S. in Actuarial Science from the University of Connecticut. He is a Fellow of the Society of Actuaries, a member of the American Academy of Actuaries and holds the designation of Chartered Enterprise Risk Analyst.

Management Profile Insurance Asset Management

24

MARK W. WHITFORD, FSA / CERA / MAAA

Senior Insurance

Investment Risk Strategist

Franklin Templeton Institutional

Franklin Templeton Institutional, LLC

New York, United States


© 2014 Franklin Templeton Investments. All rights reserved.

This document has been prepared for circulation to persons reasonably believed to be within one of the professional or qualified investor

exemptions contained in the applicable regulations of their jurisdiction or to whom this document may otherwise lawfully be

communicated to give preliminary information about the investment advisory services described herein. It is a confidential communication

to, and solely for the use of, such persons and is not intended for public or financial advisor distribution.

The description in this document of our investment management services and other matters is general in nature. The information

contained in this document is subject to updating, completion, modification and amendment. It should not be assumed that the approach

described will necessarily be followed in a particular case. Such matters will also be subject to any specific arrangements with a particular

client. Various account minimums or other eligibility qualifications apply depending on the investment strategy. This material is not an

offer to buy or sell securities or an offer of investment advisory services and is not intended to be, nor should it be used as, investment

advice; it may not be copied or distributed without the prior written consent of Franklin Templeton Investments. Opinions expressed are

current opinions as of the date appearing in the material only.

It is the responsibility of every person receiving a copy of this document to satisfy him- or herself as to the full observance of laws of any

relevant country, including obtaining any government or other consent that may be required or observing any other formality that needs to

be observed in that country. None of the services or other matters described here should be taken as an offer or a solicitation of those

services or other matters in any jurisdiction where such an offer or solicitation is not permitted under applicable legislation.

Important Disclosures

25

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