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

March 21st, 2013

Insurer Investment Forum XIII

Investing for Insurers:Review and Preview

2

The #1 Investment Challenge in Over 30 Years:The #1 Investment Challenge in Over 30 Years:

““Low Rates for Longer”Low Rates for Longer”

3

U.S. Financial Repression

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

4

Where We Are Today

• Book Yields Continue Downward PathBook Yields Continue Downward Path

• Insurers Grappling with RiskInsurers Grappling with Risk

• Insurers Grappling with Product PricingInsurers Grappling with Product Pricing

• Insurers Grappling with ERMInsurers 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

5

Improving Investment Income - It Takes Planning

Improved Investment Income - It is possible...Improved Investment Income - It is possible...

6

Key Long-Term Asset Class Return Assumptions

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

7

Key Long-Term Asset Class Risk Assumptions

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

8

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

9

What Does “Low Rates for Longer” Mean?

• How Long?How Long?

NOV, 2009NOV, 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.”

10

What Does “Low Rates for Longer” Mean?

Until Unemployment Rate Hits 6.5%, which will be...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/

11

What Does “Low Rates for Longer” Mean?

Comparison with Japan - 15 Years and counting?Comparison with Japan - 15 Years and counting?

10 year JGB: Jan, 1990 to March, 201310 year JGB: Jan, 1990 to March, 2013

12

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

Inflation - according to the ‘expertsInflation - according to the ‘experts

Keynesians -Keynesians -

- Demand/pull - increased economic - Demand/pull - increased economic activityactivity

- Cost push - supply side disruptions- Cost push - supply side disruptions

- Built-in inflation - wage/price spiral- Built-in inflation - wage/price spiral

Monetarists -Monetarists -

- Quantity Theory of Money- Quantity Theory of Money

- Long run inflation = - Long run inflation =

Money supply growth rateMoney supply growth rate

+ Rate of change in Velocity of Money+ Rate of change in Velocity of Money

- Growth rate in Real Output- Growth rate in Real Output

13

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

14

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

What is Your Risk Appetite?What is Your Risk Appetite?

15

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?

16

QuickTime™ and aApple Intermediate Codec decompressor

are needed to see this picture.

What about Luck versus Skill?

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

17

What about Luck versus Skill?

Paradox of Skill:Paradox of Skill:

Standard deviation of skill decreases as expertise increases, Standard deviation of skill decreases as expertise increases, which meanswhich means

Luck has more to do with resultsLuck has more to do with results

And that meansAnd that means

Difficult to rely upon historical performanceDifficult to rely upon historical performance

More important to rely upon processMore important to rely upon process

Counter-intuitively, process is more important than resultsCounter-intuitively, process is more important than results

18

From the London Business School...

• Decisions Are More Important Than ResultsDecisions Are More Important Than Results

• Results don’t necessarily reflect a high-quality Results don’t necessarily reflect a high-quality processprocess

• Ultimate criteria for good decision making is tied to:Ultimate criteria for good decision making is tied to:

• What are we trying to achieve with this decision? What are we trying to achieve with this decision? (Criteria)(Criteria)

• What can we feasibly do? (Alternatives)What can we feasibly do? (Alternatives)

• What do we have to watch out for? What do we have to watch out for? (Consequences)(Consequences)

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

• Implement a good process; Manage risksImplement a good process; Manage risks

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

19

Could we make understanding risk any more complicated?

TextTextTextTextTextTextText

20

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

TextTextTextTextTextTextText

• Step 1 - What do you mean by ‘risk’?Step 1 - What do you mean by ‘risk’?

• Probability of Not Meeting a GoalProbability of Not Meeting a Goal

• Not VaRNot VaR

• What Goal? What Goal?

• Return on Surplus, Return on Surplus,

• Net IncomeNet Income

• Spread Over LiabilitySpread Over Liability

• PV Enterprise ValuePV Enterprise Value

• DrawdownDrawdown

• Step 2 - Quantify RiskStep 2 - Quantify Risk

• Single, multi periods, 1 yr. 5 yr.?Single, multi periods, 1 yr. 5 yr.?

21

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

TextTextTextTextTextTextText

• Step 3Step 3

• How do different asset mixes impact risk metricHow do different asset mixes impact risk metric

22

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

TextTextTextTextTextTextText

• Step 4 - Implementation IssuesStep 4 - Implementation Issues

• Strategic or TacticalStrategic or Tactical

Strategic Tactical

Entry Board OKParameters Set for

Entry

Execution Slowly, Over Time Active Management

Exit Board DecisionParameters Set for

Exit

23

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

TextTextTextTextTextTextText

• Step 5 - Consider Game Theory ImpactStep 5 - Consider Game Theory Impact

Risk Assets Rise Risk Assets Fall

Increase Risk Bad Good

Maintain RiskOpportunity Cost/Gain

Opportunity Gain/Cost

Decrease Risk Good Bad

24

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

TextTextTextTextTextTextText

• Step 6Step 6

• Know your Board/Senior Management TeamKnow your Board/Senior Management Team

• Step 7Step 7

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

• Step 8 Step 8

• Monitor the Impact of the DecisionMonitor the Impact of the Decision

• Stewardship ReportStewardship Report

25

What has SAA seen so far?

TextTextTextTextTextTextText

26

Goldman Sachs Insurance CIO Survey - July, 2012

TextTextTextTextTextTextText

Insurers expecting to increase risk: 26%Insurers expecting to increase risk: 26%

Insurers expecting to decrease risk: 14%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

27

Asset Classes - a Layer Cake of Choices

TextTextTextTextTextTextText

The BasicsThe Basics

• Make certain all IG asset classes are included Make certain all IG asset classes are included (public/private)(public/private)

• Diversified equity allocationDiversified equity allocation

• High yield/growing dividend slantHigh yield/growing dividend slant

Tex The Next Layer The Next Layer• Lower investment grade mandates Lower investment grade mandates

for munis (where applicable)for munis (where applicable)

• Below investment grade in various Below investment grade in various guises guises t

28

TextTextTextTextTextTextText

• The Next/Next LayerThe Next/Next Layer

• Non-equity exposuresNon-equity exposures

• More illiquid asset classesMore illiquid asset classes

• What your manager may suggest, based upon their What your manager may suggest, based upon their proven expertiseproven expertise

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

derivatives explicitly or derivatives explicitly or implicitly implicitly t

Asset Classes - a Layer Cake of Choices

29

The Risk Trap

TextTextTextTextTextTextText

• Always ask, “Who is on the other side of the trade? And Always ask, “Who is on the other side of the trade? And why?”why?”

• Too easy to see well groomed, credentialed person in a Too easy to see well groomed, credentialed person in a suit as authority figure.suit as authority figure.

• It could still be snake oil.It could still be snake oil.

• If presenter is too confident, If presenter is too confident, walk out of the room.walk out of the room.

• Investment management is a humbling activity. Investment management is a humbling activity.

• Ask more questions - the “dumber” the better until...Ask more questions - the “dumber” the better until...

• You fully understand ALL aspects of the asset classYou fully understand ALL aspects of the asset class

• Remember:Remember:

• There is NEVER a dumb question, especially in a There is NEVER a dumb question, especially in a Committee or Board setting.Committee or Board setting.

30

The Risk Trap

TextTextTextTextTextTextText

•Other Questions:Other Questions:

• Will this play in Oldwick?Will this play in Oldwick?

• Ask for ideas from your peers, independent third parties, Ask for ideas from your peers, independent third parties, etc. etc.

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

31

The #1 Investment Challenge in Over 30 Years

32

The #1 Investment Challenge in Over 30 Years

TextTextTextTextTextTextText

•Low rates for longer gives us the opportunity toLow rates for longer gives us the opportunity to

• Reassess our asset allocationReassess our asset allocation

• Shed the blinders of ‘we’ve always done it this way’Shed the blinders of ‘we’ve always done it this way’

• Reassess the relationship between investments and Reassess the relationship between investments and reservesreserves

• Reassess the relationship between investments and Reassess the relationship between investments and product pricingproduct pricing

• Take a deep breath, step back and review the overall Take a deep breath, step back and review the overall investment processinvestment process

• Be better prepared for meeting future challengesBe better prepared for meeting future challenges

• Improve profitability over what it might have beenImprove profitability over what it might have been

• Get a ‘leg up’ over competitors - succeed where others Get a ‘leg up’ over competitors - succeed where others may failmay fail

• Develop a process for constantly improving your companyDevelop a process for constantly improving your company

33

The #1 Investment Challenge in Over 30 Years

TextTextTextTextTextTextText

Thank YouThank You

More updates at:More updates at:

LinkedIn: LinkedIn: www.linkedin.com/in/acogert

Twitter: Twitter: www.twitter.com/saa123www.twitter.com/saa123

www.www.insurercio.com

www.saai.com