Total Return Versus Long Liabilities

Very briefly in my career, I was Chief Investment Officer of a significant life insurer.  Sadly, that was my dream job, and to have it and lose it was a blow that I accepted, because I did what was right.

At my first meeting with the new CEO, he expressed that investment returns had been inadequate.  I explained to him that that was false — the investment department, inclusive of defaults had provided returns 0.7% better than single-A bond returns, which was notable for the industry.  He insisted that was not good enough, and that he wanted to see us trade aggressively, and produce total returns.  I tried to explain to him that that was the wrong way to manage investments for a life insurer.  The right way was occasional trading for loss mitigation, and maximization of investment spreads over the term of the liabilities.  Being the sort of Brit that disdained Americans, he told me that I didn’t know anything, and that total return was the only way to go.

For the good of the relationship between our two firms, I let it drop, but he held a grudge against me after that, which led my firm to change my position to corporate bond manager, letting another of our group be the CIO, who solicited my feedback to a high degree, because he knew that I knew what was going on, far better than the CEO did.  This is just my guess, but I think the CEO resented that I could see through him and the way he and Chief Actuary manipulated accounting results.  (I eventually spilled the beans to the regulators.  The state in question was kind of lazy — I really think they didn’t do anything with it.)

Leaving behind the past, here’s the theoretical problem: total return is a wonderful idea, but vapid, because the challenge is gaining total returns over a time horizon, after which the assets will be used to fund a liability.  In a life insurer, yes, you could manage the bonds to maximize total return in the short run, which might maximize short-run GAAP income, but might destroy long-term economic value because as high quality interest rates fall, it becomes harder to meet the longer-term promises previously made using new money interest rates.  Yes, you can realize the capital gains today, but only at the cost of reducing future net income, until net income goes negative, and recoverability testing indicates you are locking in a loss, and you have to do a writedown of your deferred acquisition cost asset.

This is why I am skeptical of hedge funds and other total return investors buying life insurers.  Good investing at a life insurer means improving the investment income spread between assets and liabilities, over the term of the liabilities, while taking account of capital use, and avoiding defaults.

It would be very difficult now to be managing a life insurer that had a large deferred annuity block, particularly one with high guarantees.  Your flexibility is strained — if rates go down, you have to still fund the guaranteed rate, and if rates go up you will wish you were invested short so that your credited rates go up, and you don’t lose money because the income off your bonds is rising.

The only normal option in such a situation would be to run a barbell — short assets and long assets, with little inbetween.  Long assets for the guarantees, short assets for the crediting rate sensitivity.  And even that might not be adequate.

I started my career at a small life insurer that grew into a medium-sized one in three short years off of capital raised by its holding company issuing junk bonds.  The holding company, Southmark (spit, spit), knew something about investing, but not about running regulated subsidiaries.  What looks simple is actually very hard.  The cash flows of the assets and the liabilities are not freely available to be used through the consolidated company.  The regulatory limits of each subsidiary are applied separately, limiting what cash flow can be sent to the overly-indebted holding company.

In the end, after interlacing the capital of the subsidiaries, such that our insurer held a lot of the equity and preferred equity of other insurers, the holding company declared bankruptcy (a two-time loser there), and the life insurer went into conservation with the California Department of Insurance.

I was just a junior actuary then, and my investment knowledge was small but growing, so I didn’t get much of it then. The company took too much credit risk with junk bonds (the regulations were loose then), and mismatched their investments short (can’t buy long junk) versus long liabilities.  As rates fell, fell and fell, junk bonds defaulted or were called.  Each reduced income, but the guarantees remained the same.

Thus I remain a skeptic of clever investors trying total return strategies versus long term promises.  In the situations I have been in, it has not worked, and with bad management teams, it is another way to make things look good for a time, until things blow up.

Now, as for the two insurers that I mentioned, their management teams didn’t end well.  The first one that I worked with left to start another insurer, while bidding unsuccessfully for the firm they left.  They never went far.

The one I mentioned at the beginning of this piece — the entire management team was let go, except for the CEO, who was forced into retirement, and the CEO of the holding company was forced to resign for wasting money pumping it into the life company.

Good investing stems from matching assets to the eventual need to pay cash at a future date.  True for individuals and institutions.