Portfolio Construction: Portfolio Construction: Considerations in Today’s Investment Environment Environment Marco Bravo CFA Marco Bravo, CFA Portfolio Manager AAM Company The 2014 Executive Education Roundtable Series
Portfolio Construction Considerations o t o o Co st uct o Co s de at o s Asset, Liability & Underwriting Expected Objectives & Constraints j Returns, Tax Rates, Capital Structure Returns Tax Rates Capital Structure Regulatory Applicable Insurance Laws Capital Adequacy NAIC RBC, AM Best BCAR Accounting STAT & GAAP Financial Objectives Peer Comparisons P C i Evaluation of Peer Holdings E l ti f P H ldi Macro-Economic Environment, Expected Asset Allocation Risk-Adjusted Returns, Yield Curve Risk Adjusted Returns, Yield Curve Structure 2 The 2014 Executive Education Roundtable Series
Portfolio Construction Considerations Portfolio Construction Considerations Key considerations in today’s investment environment: � Investment Policy Objectives & Constraints � Key Risk Measures � Asset & Liability Management � Taxability � Asset Allocation � Fed Policy Fed Policy � Relative Value Assessment � Risk Assets � Risk Assets 3 The 2014 Executive Education Roundtable Series
Credit Risk Considerations Credit Risk Considerations Cumulative Default Rates (1983-2013) � Low rate environment pushing 60 i insurers to search for yield by h f i ld b 5yr 50 going down in credit quality 10yr � Default rates and volatility of Default rates and volatility of 40 15yr 5y default rates do not increase 30 linearly as rating is decreased 20 20 � Set portfolio concentration limits that take into account 10 default and recovery rates y 0 0 AA A BBB BB B Source: Moody’s Annual Default Study (Feb. 2014) 4 The 2014 Executive Education Roundtable Series
Interest Rate (Duration) Risk Considerations Interest Rate (Duration) Risk Considerations � Fear of rising rates has led Implied Forward Rates Rate (%) ( ) i insurers to consider shortening id h i 4.0 portfolio duration 3.5 � Staying short has been costly Staying short has been costly 3.0 and forward yield curves 2.5 pricing in higher rates 2.0 � Volatility of economic surplus a 1.5 consideration when setting 1.0 Current Yield Curve duration target for assets g 0 5 0.5 3-year Forward Yield 3 year Forward Yield � Limit amount of duration Curve 0.0 1yr 2yr 3yr 5yr 7yr 10yr mismatch to maintain Maturity i investment discipline t t di i li Source: Bloomberg, data as of 05/12/2014 5 The 2014 Executive Education Roundtable Series
Liquidity Risk Considerations Liquidity Risk Considerations � Liquidity risk tends to be a bigger concern for P&C companies than Life/Health Companies h if / l h C i � Increase in surrender activity for annuity writers is a concern if rates move above current crediting rates rates move above current crediting rates � Manage liquidity risk through laddered maturity investment profile with ranking of liquid assets profile with ranking of liquid assets � Consider liquidity back-stop facility such as membership in Federal Loan Bank 6 The 2014 Executive Education Roundtable Series
Asset & Liability Management Considerations Asset & Liability Management Considerations � Risk of asset duration extending in a rising rate environment � Increasing investment leverage increases importance of asset/liability duration match � Compare assets and liability cash flows under various interest � Compare assets and liability cash flows under various interest rate scenarios � Interest sensitive assets and liabilities requires the use of effective duration versus modified duration � Segregating liabilities by product line imposes pricing discipline so that long term yields do not get used for pricing discipline so that long-term yields do not get used for pricing short-term liabilities 7 The 2014 Executive Education Roundtable Series
Tax Considerations Tax Considerations Federal Tax = AMT AMT > Federal Tax � Objective: Objective: Federal Tax > AMT me After-Tax Incom Establish Target Ranges for tax-exempt allocations Municipal Allocation 250 � Primary Consideration : 200 of Trials 150 Understanding of # o Underwriting Profitability 100 50 0 0.88 0.89 0.90 0.91 0.92 0.93 0.94 0.95 8 Combined Ratio The 2014 Executive Education Roundtable Series
Why Consider Tax Exempt Municipals? Why Consider Tax-Exempt Municipals? 180 170 160 150 140 asuries 130 130 10 Year Spread to Trea 120 110 100 Tax Adjusted 1 90 80 70 60 50 10yr Municipal Spread 9 Source: Bloomberg, Thomson Municipal Market Data as of 4/8/2014 The 2014 Executive Education Roundtable Series
Fed Policy Considerations Fed Policy Considerations � � Timing Balance Sheet � � Short and Long Term Interest Rates Asset Class Returns Fed Balance Sheet Fed Funds Rate (%) Fed Funds Futures Fed Funds Futures 5 000 5,000 2.00 Fed Agency MBS Purchases 4,500 Liquidity to Key Credit Markets 1.80 Lending to Financial Institutions 4,000 1.60 Long Term Treasury Purchases 3,500 1.40 Traditional Security Holdings 1.20 3,000 Billions 1.00 2,500 0.80 2,000 0.60 1,500 1 500 0.40 1,000 0.20 500 0.00 Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec 0 2014 2014 2015 2015 2016 2016 10 Source: Bloomberg, Cleveland Fed, Chicago Board of Trade The 2014 Executive Education Roundtable Series
Tighter Monetary Policy and Interest Rates Tighter Monetary Policy and Interest Rates � Yield curve usually flattens when Fed is raising rates y g Rate (%) 9 Fed Funds 2yr 8 10yr 10yr 7 30yr 6 5 4 3 2 1 0 11 Source: Bloomberg, US Treasury
10yr Treasury Rates and Asset Returns 10yr Treasury Rates and Asset Returns � Comparison of various asset returns during periods of rising p g p g 10yr Treasury Rates 09/93 thru 12/95 thru 9/98 thru 5/03 thru 6/05 thru 12/08 thru Period 11/94 3/97 1/00 5/04 6/06 12/09 10yr TSY Yield +252 bps +131 bps +224 bps +124 bps +123 bps +163 bps Bank Loans S&P 500 S&P 500 S&P 500 S&P 500 High Yield +9.63% +30.41% +43.19% +18.31% +8.62% +58.21% S&P 500 Convertibles Convertibles High Yield Bank Loans S&P 500 2.14% +14.97% +25.45% +11.89% +7.49% +26.45% High Yield High Yield Bank Loans Bank Loans Convertibles Convertibles 1.97% +12.59% +7.91% +6.95% +5.88% +23.88% 1-3Y Gov/Credit Bank Loans High Yield Convertibles High Yield IG Corp Bonds 1.03% +11.04% +4.12% +5.99% +4.80% +18.68% Convertibles 1-3Y Gov/Credit 1-3Y Gov/Credit 1-3Y Gov/Credit 1-3Y Gov/Credit Bank Loans -3.11% +5.82% +3.98% +0.96% +1.92% +13.65% Barclays Agg Barclays Agg Barclays Agg Barclays Agg Barclays Agg Barclays Agg -3.53% +3.05% -0.81% -0.44% -0.80% +5.93% IG Corp Bonds IG Corp Bonds IG Corp Bonds IG Corp Bonds IG Corp Bonds 1-3Y Gov/Credit -4.86% +2.25% -1.71% -0.44% -2.22% +3.82% 12 Source: Barclays, Bloomberg, CSFB Loan Index The 2014 Executive Education Roundtable Series
Asset Classes Relative Value Asset Classes Relative Value 5-year Historical Option-Adjusted-Spreads OAS, bps OAS bps � Asset spreads at or near 5- d 1,200 year lows Recent 1,000 � Prices seem to be pricing in Prices seem to be pricing in Average a benign credit environment 800 � Increased risk of a pullback 600 due to a change in investor 400 sentiment towards risk � Yield focused investors need Yield focused investors need 200 200 to be careful 0 IG CMBS Taxable HY Corporate Corporate Muni Muni Corporate Corporate 13 Source: Barclays The 2014 Executive Education Roundtable Series
Considering Risk Assets Considering Risk Assets � Is this the right time? P&C Investments in Alternative Investments 14 Source: SNL, 12/31/2013 The 2014 Executive Education Roundtable Series
Questions? 15 The 2014 Executive Education Roundtable Series
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