Investment Expertise. Tangible Results. Is Your Portfolio Prepared FOR AN EQUITY MARKET DOWNTURN?
PAGE 02 MARKET DOWNTURN TODAY S MARKET ENVIRONMENT The key to a successful insurance investment management program is determining an appropriate investment strategy that properly allocates the insurance company s assets across suitable asset classes in the right proportions. Proper allocation will provide alignment of portfolio strategy with business objectives and help diminish impacts from market volatility. Effective management of each asset class is important as well, but clearly secondary to an appropriate asset allocation strategy that will help insurers weather all business and market cycles. Bond yields have enjoyed a 30-year bull run and remain near record lows. The continued modest economic data and low inflation numbers have not supported a promising pace of Federal Reserve (Fed) rate increases. And, global QE efforts continue to keep non- U.S. bond yields down. Not too many months ago nearly $15 trillion of non-u.s. bonds were trading at negative interest rates, increasing demand for higher yielding U.S. bonds and suppressing our rates. The U.S. equity markets have also enjoyed a seven-year bull market cycle, and are up over 220 percent compared to a traditional bull market cycle of approximately 100 percent appreciation.¹ The strong equity returns have been driven primarily by PE multiple expansion and Fed accommodation, rather than by the traditional GDP and profit growth. And, tepid global growth and massive stimulus programs have driven flows into the U.S. Some now fear that markets may be artificially propped up. As shown in Figure 1, equity market valuations have not historically continued to grow without underlying profit support. In fact, as corporate profits as a percent of GDP have historically decreased, the S&P 500 has typically followed suit within the following 24-36 months. Given the lack of direct U.S. economic support for the continued market highs, the current bull market environment may not be sustainable. Figure 1. Corporate Profits vs S&P 500 Growth 0.12 Recessions Corporate Profits/GDP (Left Axis) S&P 500 (Right Axis) 2,400 0.10 2,000 0.08 1,600 0.06 1,200 0.04 800 0.02 400 0.00 1990 1995 2000 2005 2010 2015 0 Sources: Miles Capital, Bloomberg¹ Past performance is not indicative of future results.
PAGE 03 MARKET DOWNTURN HISTORICAL NORMS & A POTENTIAL SHIFT As shown in Figure 2, throughout market history, the Fed Funds rate and the S&P 500 have tended to enjoy regular periods of mean reversion where the correlations of the moves shift back and forth. Two notable exceptions have been during the 1980s early 1990s when equities and fixed income both enjoyed a strong bull market - and during the current environment. It s not unprecedented for both the equity and fixed income markets to rally at the same time, but the length of the current market cycle is fairly unprecedented. The shifts from equity market boom to bust typically result from smaller events that reveal underlying market frailties. Consider the real estate downturn and credit squeeze that laid bare the runaway risks in securitized products and led to the financial crisis. With the current increased geopolitical volatility, continued weakness in global growth, and prolonged U.S. corporate profit strains, the equity market may be stretched. Either the removal of Fed intervention or the potential inflationary risks of new policies could also be negative catalysts. The path to higher rates has already been outlined by the Fed. While they continue to delay significant increases, it is clear overnight rates will increase gradually. The impacts of less accommodative policies will be slower to manifest for longer-term bonds, but will eventually be felt. The point is not to correctly call the details of a market downturn, but rather to understand the impact if a downturn were to occur. Figure 2. Shifting Correlations and Reversions to the Mean: S&P 500 vs. Fed Funds Rate Reversing Periods S&P Fed Funds Rate 1,000 25 100 20 15 10 10 5 1 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 2014 0 Sources: Miles Capital, Bloomberg Past performance is not indicative of future results.
PAGE 04 MARKET DOWNTURN IS YOUR PORTFOLIO PREPARED? As long-term, conservative investors, insurers may believe they are fairly inoculated against a major market downturn. It is true that these periods tend to alternate with periods of sustained increase. But insurers face challenges during market downturns that other long-term investors may not. For example, it is common for disintermediation risk to increase during a deep market dislocation. In the asset portfolio, property & casualty and healthcare insurers as heavier investors in equity could face significant equity losses. As has happened during several historical periods (see Figure 3), this would result in surplus contraction, thereby impacting several key ratios and potentially forcing insurers to curtail new business. Challenges to ratios and surplus can trigger increased regulatory scrutiny or a negative ratings outlook as well. Figure 3. Historical Negative Equity Market Periods and Corresponding Dollar Impact to Surplus Financial Crisis Tech Bubble -50.9% -32.8% Surplus Impact* ($25,450,000) ($16,400,000) 3Q-2011 2Q-2010 1Q-2009 4Q-2008 3Q-2002 2Q-2002 3Q-2001 1Q-2001-13.9% -11.4% -11.0% -21.9% -17.3% -13.4% -14.7% -11.9% ($6,950,000) ($5,700,000) ($5,500,000) ($10,950,000) ($8,650,000) ($6,700,000) ($7,350,000) ($5,950,000) -60.0% -50.0% -40.0% -30.0% -20.0% -10.0% -0.0% S&P 500 *Assumes equal weighted portfolio of $50mm in equity or 20% of a $250mm investment portfolio. Sources: Miles Capital, Bloomberg Past performance is not indicative of future results. The result may be both decreased business and portfolio flexibility at an inopportune time. Making changes once the surplus deterioration has already occurred is too late. Insurers that take steps to develop a smarter allocation and prepare their portfolios and their businesses ahead of time may be better positioned to protect against damage to precious capital, but also to treat that volatility as a competitive opportunity.
PAGE 05 MARKET DOWNTURN DEVELOPING A SMARTER ALLOCATION Rather than focusing on point-in-time asset class risk and return metrics, effective asset allocation should recognize the core needs of the insurer and directly align the investment strategy with the desired business outcomes. In Figure 4, we detail our view on the four core needs common to all insurers. We believe an insurance-based asset allocation should address all four needs. Many insurers portfolios are primarily allocated to fixed income and equity, which address yield and growth. This allocation may be overly narrow and neglect considerations like risk mitigation completely. In addition, traditional allocation methods do not take into consideration the strategic business objectives of the company or align investment strategy with needs and desired outcomes. Insurers need to understand which asset classes they should have, in what strategies, and in what amounts to both address these core needs and help meet strategic business objectives. Figure 4. The Four Core Needs of Every Insurer YIELD GENERATION Support asset/ liability matching, net investment income generation, and capital treatment. GROWTH Grow the cumulative surplus to support core business needs. RISK MITIGATION Balance business line and portfolio risk. INFLATION PROTECTION Offset inflation risks inherent in actuarial assumptions, protect purchasing power. WHAT CAN INSURERS DO TO PREPARE? No market watcher will be absolutely correct on the timing, length, or severity of any market downturn. However, many do agree that the risk level has increased, and that the time to review and buttress portfolio construction is now. We believe it is critical for insurers with their asset managers to fully understand the risks of the portfolio and its impact on their business. Building a portfolio that helps mitigate the potential equity market risk will help preserve much needed capital and support key ratios. Several options are available. 1. Adjust equity exposure: Unfortunately, reducing equity exposure is tactical in nature, reduces the overall growth potential of the portfolio, and requires the ability to make two perfectly timed decisions: when to get out and when to get back in. Similarly, diversification across public equity does not reduce volatility significantly, given the high correlations among equity asset classes. 2. Hedge direct equity market risk: The use of portfolio hedging and options can dampen volatility and help mitigate equity market tail risk. However, these strategies can be expensive to employ and require market timing as well. 3. Introduce uncorrelated assets (a smarter allocation): Allocating to risk mitigating strategies has historically been shown to lower downside risk and dampen volatility, which helps provide a buffer for surplus protection. These strategies can include certain types of hedge funds. Figure 5 demonstrates the potential surplus benefit from allocating a portion of assets to risk mitigation. In order to successfully weather market downturns, insurers should consider ways they can alter the distribution profile of their potential returns and prepare for the next stage before it comes.
PAGE 06 MARKET DOWNTURN Figure 5. Adding Risk-Mitigating Strategies Improves Returns During Negative Equity Markets and Results in Corresponding Improvement in Surplus* Financial Crisis Tech Bubble 3Q-2011 2Q-2010 1Q-2009 4Q-2008 3Q-2002 2Q-2002 3Q-2001 1Q-2001-50.9% -45.6% -32.8% -26.9% -21.9% -19.2% -13.9% -12.5% -11.4% -9.7% -17.3% -14.3% -11.0% -8.7% -13.4% -11.0% -14.7% -12.4% -11.9% -9.6% Surplus Impact* ($2,650,000) ($2,950,000) ($700,000) ($850,000) ($1,150,000) ($1,350,000) ($1,450,000) ($1,200,000) ($1,150,000) ($1,150,000) -60.0% -50.0% -40.0% -30.0% -20.0% -10.0% -0.0% S&P 500 80/20 Equity/Alts *Assumes equal weighted portfolio of $50mm in equity or 20% of a $250mm investment portfolio vs. $40mm equity / $10 mm alternatives. Alternatives are represented by HFRI Fund Weighted Composite. Sources: Miles Capital, Bloomberg, S&P 500, HFRI Fund Weighted Composite Past performance is not indicative of future results. There can be no guarantee that any investment strategy discussed in this Presentation will achieve its investment objectives. As with all strategies, there is a risk of loss of all or a portion of the amount invested. CONCLUSION Proper insurance asset management should provide a comprehensive analysis across asset classes, a plan for volatility mitigation, and strategic alignment between objectives and the investment portfolio. Done correctly, a true insurance-based asset allocation approach can position the investment portfolio to support and enhance the insurer s strategic outcomes. Done incorrectly, the investment portfolio may significantly detract from business results, potentially leaving the insurance company with asset management gaps or at a competitive disadvantage. The turbulent market and business environment requires a proper approach to thoughtful asset allocation to help prepare insurers for volatility. Our proprietary process considers the four core insurance company needs and seeks to organize the portfolio to support the business in all cycles. FOR MORE INFORMATION ON WHAT AN INSURANCE- BASED ASSET ALLOCATION APPROACH COULD DO TO HELP SUPPORT YOUR BUSINESS OUTCOMES, CONTACT US TODAY. Insurance Expertise. Tangible Results. The information provided herein is furnished by Miles Capital, Inc. and is confidential. It may not be reproduced or distributed to anyone else without prior consent. The HFRI composites are being used under license from Hedge Fund Research, Inc., which does not approve of or endorse any of the products discussed in this communication or the contents of this report. This material is for informational purposes only and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer, or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information herein is based on sources which Miles Capital believes to be reliable, but is not guaranteed to be accurate or complete. The strategies described in the presentation may not be suitable for all investors. Investors are advised to thoroughly and carefully review financial, legal, and tax consequences of all investments to determine suitability. There can be no guarantee that any investment strategy discussed in this Presentation will achieve its investment objectives. As with all strategies, there is a risk of loss of all or a portion of the amount invested.