Strategically Thinking Volume 4

12 December 2017

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Welcome to the fourth edition of Strategically Thinking, a periodical presentation of original research and analysis by JLT Re's global Strategic Advisory team.

The stretch for yield and ETFs

Even as the U.S. Fed recognized in its 29 November 2017 commentary on economic conditions that inflation is again taking hold, insurers’ struggle against low interest rates and anemic investment yields is grimmer than ever. Despite holding dramatically riskier investment portfolios (including a sharp move into longer duration and lower credit quality bonds) since 2009, investment yields have fallen a full 100bps (one percentage point) through 1H2017. At YE2016, bonds accounted for 65%, equities 23% and other investments, including exchange-traded funds (ETFs), 12% of U.S. general insurers’ total investments.

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While ETFs were introduced in 1993, insurers only started making meaningful investments in the assets in 2007. Since then, investments in ETFs by insurers have grown at a compound average growth rate (CAGR) of 12.4% through 3Q2017 (Life insurers: 18.3%, General: 10.8%). Although ETFs accounted for only 0.4% of general account assets at YE2016, ETFs continue to gain traction due to the risk diversification and liquidity they offer relative to other non-equity asset classes. The NAIC’s (the U.S. National Association of Insurance Commissioners) April 2017 decision to allow favorable accounting treatment for bond-based ETFs removes one of the barriers that previously limited the asset’s attraction for insurers.

Due to the preponderance of equity investments underlying ETFs (about three-fourths of ETF assets under management are equities), all ETFs were valued at acquisition cost and carried high Risk-based Capital (RBC) charges in the U.S. Now, some bond ETFs qualify for favorable accounting treatment, similar to direct investments in bonds. Insurers can choose to calculate the qualifying bond ETF’s YE2017 value based on the cash flows of the bonds held by the fund, deriving a fair market value.

The current RBC charges for bonds, equities and “other” investments are outlined in the following table. Equities and other investments are charged more than all but the most distressed bond investments, leading even well-capitalized insurers to constrain their allocations to this class, including, until now, all ETFs. PIMCO estimates that the net effective equity charge of ETFs held by insurers is about 2.3% (versus the 15.0% baseline now assessed), just higher than charges on BB-rated (“junk”) bond investments. The accounting change means that bond ETFs will be charged at much lower rates for 2018 and subsequent RBC calculations.

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It’s no surprise that asset managers are pleased with the changes: BlackRock Inc., the asset manager who worked with the NAIC for four years to adjust the accounting rules, expects additional investments of USD 300bn into bond ETFs over the next five years, bringing the class AUM to nearly USD 1tn.

Although the accounting change is positive overall, there are a few factors that may cause insurers to remain cautious of bond ETFs. ETF issuers must first get the securities approved by state regulators and insurers will need regulatory approval for each individual security prior to applying the changes. And even when the ETF issuer is approved, some state insurance commissioners may require insurers to report the ETF as an equity investment per local guidelines.

ETFs are not the solution to low yields

Simply put, a bond ETF is like a portfolio of bonds that is listed on an exchange like a common stock. Bond ETFs purport to provide liquidity, transparency and diversification benefits over direct bond investments. Ease and speed of trading are primary attractions. It is not surprising there has been a steady flow of money invested in these funds, and that these flows should increase with more favorable treatment by regulators.

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While a bond ETF may offer convenience, lower transaction costs and—potentially—liquidity, however, even the most aggressive traders will stop short of claiming superior yields. Our analysis of the total returns on different classes of bonds against a diversified index of bond ETFs suggests substantially lower volatility-adjusted yields relative to many other bond indices. As shown in the chart above, the bond ETF Index has deeply underperformed all but the “risk-free” 1-3 year Treasury index in terms of yield, while it has exhibited high correlation with the volatility of other bond indices. The total return from June 2008 through June 2017 was 12% (a simple annual return of 1.3%) and the bond ETF index’s Coefficient of Variation of 12.64 was the highest of all of the several indices we studied and well above the next-highest, 5.04 for Barclays Index of 10-20 year U.S. Treasury bonds. This indicates that bond ETF investors have carried significantly higher risk per unit of return.

Research by Greenwich Associates shows that insurers use bond ETFs primarily to maintain market exposure while changing asset managers, to make short-term tactical adjustments in the portfolio, and as a replacement for direct bond investments for long-term passive exposure. Other prominent uses include rebalancing and liquidity improvement.

As we have argued, historical volatility-based capital factors used by regulators and rating agencies are woefully out of touch with our current ultra-low interest rate environment. These factors are based on standard deviation, an almost meaningless measure of volatility, which is, in-turn, an even less meaningful proxy for risk. In more practical terms, a heavy concentration in long-term bond investments today is demonstrably more risky in terms of potentially permanent capital impairment than a well-diversified portfolio that includes robust dividend and total return equity investment strategies. Bond ETFs may have their uses within well-diversified portfolios but they are not here to save the day and could simply distract from more meaningful diversification if managers buy into the hype.

We hope you enjoy Strategically Thinking. Our goal is to provoke thoughtful discussion on a wide range of issues that concern the global risk management and (re)insurance community. Feedback is always welcome.

“More money has been lost reaching for yield than at the point of a gun”
– Raymond F. DeVoe, Jr


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