(This transcript has been edited for clarity)
Total time: 24:08
Michael Walton: This is Michael Walton. I'm one of the Principals at Sage on the institutional side of our business. Today I'm joined by my good friend Mr. Greg Cobb. Greg is directly responsible for Sage’s investment solutions directed towards insurance companies. This is meant to be a deeper dive to talk about some of the issues and practical steps that are needed to have successful outcomes with insurance clients. One special treat, is a little bit of a teaser, is our Greg Cobb is, in addition to being an expert on all things insurance, he is also a whiskey aficionado. So for those of you who are committed enough to stay through the end of this podcast, I'm happy to tell you that Greg has some excellent recommendations for you.
00:47
In order to be successful in working with insurance clients from an investment manager’s perspective, or an investment consultant’s perspective, there's two things you have to know. You have to know the insurance industry, right? You have to understand the landscape. And you have to know the client intimately – you're not going to get hired unless you do. But that comes with a lot of complexities, right? Why is this industry so complex?
01:13
Greg Cobb: Well, because when you’re talking about insurance company portfolio management, it's not necessarily a product – they are not looking for a specific product, in most cases. If you're a large insurance company, say it's more than $5 billion in assets, they have a pretty good feel for the investment world, and they have a pretty good infrastructure for all practical purposes. But if you're a smaller insurance company, it's not necessarily a product you're looking for, you're looking for a solution. You know, as an investment professional, you have to understand that business objective, you have to understand the businesses itself. So, an investment professional, what makes it so hard in the insurance industry, is that you're managing assets at a box. And that box has four sides. You have the financial directives from senior management, you have actuarial considerations, you have accounting conventions, and then you have the regulatory environment. So, if you’re an investment manager, actually, what you have are four competing interests: financial directives, the actuaries, the accountants, and the regulators.
2:15
Michael Walton: How are they competing, though?
Greg Cobb: Well, because each one of them has their own objective. If you're, say, the CFO, “This is our profitability target, this is the amount of total contribution to profits, and we want this much from the investment portfolio – this is what we want.” Well, the actuary is saying, “Well no, based upon this particular product, let's say your duration has to be a little bit shorter,” “Well no, we want the duration to be longer, because we want more yield and income.” “No, the duration needs to be shorter.” You go to the accounting side of the equation, you're basically talking about some tax consequences. “In order to meet those profit targets, we have to restructure the portfolio this way.” Well, no, you can't do that because now you're going to generate too many losses. And then you go back to the rating agency or the regulatory environment, you may want to do something such as well, “Let's go down in quality and add some high yield.” Well, no, the regulatory environment, the state regulatory environment, says you can't do that. So, if you're the investment professional in the middle, you have to figure out how to satisfy those four competing interests. And at any one point in time, the skew may be towards one of those particular interests, and you have to manage it accordingly.
3:20
Michael Walton: There are tools that are used to help understand all these things. And I always think about how there are some things that are highly quantitative and some things that are highly qualitative. So how do we balance the quantitative analysis along with the qualitative analysis?
Greg Cobb: The quantitative analysis – I'll talk about your investment expertise, as a core manager, as a core plus manager, or even expertise in a particular asset class. And on the quantitative side we’ll also talk about the bringing forward of risk management capabilities, whether that be a dynamic cash flow analysis, stress test in the portfolio – how we can integrate with the liability side, asset liability management, bring it together in a more robust fashion. So, that's the quantitative side. And underneath that, not necessarily quantitative, but are your reporting capabilities, whether it’s investment reporting, accounting reporting, or the preparation of the annual statements for the regulators. That's the quantitative side, if you will. The qualitative side is ‘do you know the industry?’ Do you understand the insurance industry? Because when you walk into the door with an insurance company client, whether it's a small, mid-size, or a large insurance company, you have to understand their business profile. You have to understand their balance sheet. And you have to understand the operating performance. Because they don't want to teach you about the insurance industry, you have to know when you walk in the door.
4:44
Michael Walton: Let's dig into that a little bit. Because I think that's where unique knowledge of the insurance world makes a huge difference, right? Understanding the financial metrics. So, walk through some of the key financial metrics and try to talk about them in normal human being speak.
Greg Cobb: Alright, so there's kind of a cheat sheet. You have to understand the business profile, the balance sheet, and the operating performance. With respect to the business profile, you've got to take the time to understand the history of the company, its corporate structure, its affiliates, its geographical concentration, its agency model for gathering assets, or writing policies, I should say. If you're looking at the balance sheet, you're going to have to have a really good understanding of the underwriting leverage, the investment leverage, the liquidity profile, their capitalization. And on the capitalization side, they're really two – you have the NAIC’s risk-based capital requirements, but you also have, if they have a rating from AM Best, and even if they don't have a rating, many insurance companies look at it, are the BCAR ratios – the best capital adequacy ratio. So, you've got to understand the capitalization of the company. You have to understand the basic asset liability structure. And you have to have a pretty good understanding of the reserves, and the reserve development over time – longer term, medium term, and more importantly, more near term. And then finally, with respect to the operating performance, the only one that's probably easy to get your hands on is a net investment yield. But you've got to have a handle on the return, on surplus, the loss, the LAE ratios, the expense ratios, and how those come together to form the combined ratio, which is a really good overall summary of the profitability of insurance companies. So, it gets back to when you walk in the door, you really have to put your analyst hat on. I mean, it takes time, you have to do your homework.
6:32
Michael Walton: Let's be specific about P&Cs, and let's talk about the different ownership structures that are out there. And maybe get into some of the differences of those ownership structures and how that kind of guides the objectives of those insurers.
Greg Cobb: I think the two keys, whether it's a life and health company or P&C company, the two keys are between a company and a mutual company. And a stock company, it’s what it sounds like it, has stockholders or shareholders. And the company is managed for profit, for the benefit of the shareholders. And then you have a mutual company. A mutual company is run for the benefit of the actual policyholders and their beneficiaries. So, there's much more concern with longer-term solvency issues as opposed to short-term profitability. And with the profits on the mutual side, the policyholders actually share in those profits. They receive an annual dividend, which you can look at it as, almost like a premium reduction. Like if I pay $1 a year for my premium, but at the end of the year, I get 15 cents in a dividend, my premium I paid is really only 85 cents. So, the stock companies, it's the shareholders manage for profit, short-term gain, if you will. With respect to the mutual companies – the policyholders own it; it’s managed for the policyholders and the beneficiaries. And there's a much longer-term view with respect to the management of the company. So, it's two different mindsets.
8:12
Michael Walton: Got it. So, we talk broadly about the fact that working successfully with insurance companies is about understanding the frequency and severity of outflows. Right? Their claims experience. And so, just broadly talk about the difference between different categories in the P&C world: workers’ compensation versus commercial property.
Greg Cobb: With respect to the workers’ compensation, you're talking about someone obviously getting hurt at work. Maybe they can't work and there's some type of claim that has to be made. And those claims can vary. The claims can be very short, where they're paid out over a 2- to 3-year period, or they can be structured settlements, that are paid out over 5, 10, 15, 20 years. So, you have the short-term average life claim and you have the very long-term average life claim. So, within a P&C company, you can have one pool of assets, but those assets are supporting two very different types of policies.
9:16
Michael Walton: Yeah, and so obviously, from an investment management standpoint, and just particularly from the fixed income management standpoint, simply, it's important for your assets to reflect the nature of your liabilities, right?
Greg Cobb: And that's what actually makes it very complicated, because you have one pool of assets, in this particular case, supporting a short term and a longer term. So, delineating those two from a pool of assets becomes fairly complicated. So again, yeah, that's one of the key things that we do on the asset liability management side is the cash flows based upon either the overall portfolio supporting various products, or we can split it down to a portfolio, or asset portfolios supporting a particular line within the P&C company.
10:00
Michael Walton: Got it. And so, commercial property.
Greg Cobb: Commercial property. You know, most of our clients here at Sage are on the P&C side, and a lot of them are on the commercial property side. And that can really vary over time. You can have periods of two, three, four, or five years, where the claims you pay out, there aren't any issues, the claims you pay are very low. Then all of a sudden, you have claims that you never expected. And a really good example is commercial property in South Florida. We actually have a relationship with a company that has commercial property insurance in South Florida, in the Tampa Bay area. So, you're talking about coastal Florida, for all practical purposes. And there was a very, very good experience for two to three years in a row. But then all of a sudden, you have these events, 1-in-100-year events. Hurricanes. So, if you have one a year, that's pretty manageable. But then when you have a 1-in-100-year event in 2016, a 1-in-100-year event in 2017, a 1-in-100-year event in 2018, all of a sudden, your models don't work. And the claims are very, very high. And all of a sudden, the portfolio may need very, very unexpected liquidity. So, you can have years of claims that meet expectations, or are actually below expectations, and then all of a sudden, out of nowhere, you have claims that exceed your wildest imagination.
11:36
Michael Walton: So, two takeaways. One is you have to be aware of what we call fat tail risk, right? The big risks to your asset portfolio that come from claims experience that aren't supposed to happen very often. The other takeaway is that we shouldn't have another 1-in-100-year hurricane in Tampa for 300 years. Right?
Greg Cobb: Exactly. And that gets back to you have to know the underwriting, the lines of business and the underwriting philosophy at these companies. And in order to have an intelligent conversation about the portfolio. Otherwise, if you don't understand the underwriting process, you don't understand the line of business. You just sit in a room, you're like, “Just tell me what the duration of your liabilities is.” And that that doesn't work.
12:23
Michael Walton: Right. So, what I hear from you is that it just ends up being about balance. Like you have competing issues, right? And then you have to find a way to strike balance. So how do you arrive at that balance when you're engaging with an insurance client?
Greg Cobb: That's actually a good word, the balance, because every insurance company, for all practical purposes, is different. And it's different because of the balance of risk – the balance of pure insurance risk, or underwriting risk, versus investment risk. So that creates a culture of risk within the firm. And you really have to understand that culture. And the only way to understand that culture is to understand the company. You have to understand the business profile; you have to understand the nature of the liabilities. And if you're going in for the first time, you have to understand, of course, the investment portfolio. And so, when you look at across those three lines – the business profile, the liability analysis, and investment analysis – you really are taking a more holistic approach to understanding the culture of the insurance company. And that holistic approach is a more enterprise-wide approach. A good example is you can be a P&C company writing commercial property, we’ll go back to Florida. So, you're concentrated in South Florida in Tampa. You have concentrated risk in your underwriting, very concentrated geographically. And you're also subject to what's called cat lost or catastrophic loss, i.e., the hurricanes come through. So, if you look at your underwriting side, that's pretty aggressive, that's above-average risk in terms of the potential claims that you may experience. Well, if you're doing that on the underwriting side, look at the investment side of the portfolio. What do you have over there? A very conservative approach. So again, it's a balance of risk; more aggressive on the underwriting side, less so on the investment side.
14:22
And where you have a recipe for disaster is where, this happened I don't know, I guess maybe 25 years ago, I was involved with an insurance company that wrote substandard auto. I should back up – it was owned by a real estate developer. He bought this insurance company, it was substandard auto. So, you have a real estate developer who’s risk profile is pretty high. And he buys a substandard auto, where the claims profile can be pretty high and pretty rapid. And he wanted at the same time to invest primarily in equities and high yield. So, he was taking very significant risk on the underwriting side. But he also wanted to take significant risk on the investment side. And that balance never works out. You're trying to thread a needle every day. And so, we respectfully declined that particular mandate.
15:16
Michael Walton: Got it. So, digging into the investment side of things, and I'm going to make a generalization – two generalizations. One is that the market environment has sort of forced “insurers to add complexity to their investment management.” That's one thought. The second is that there's one common thing that we see on the fixed income side that seems to be fairly consistent when we do analysis of insurance companies that are looking for partners. One, there's almost always a mismatch between the nature of their liabilities and the duration of their fixed income. Two, they seem to be over allocated to munis. And three, they tend to not take advantage of the entire investment grade bond universe. So, I guess maybe those are two big things. But I guess one, can you speak to increased complexity? And then two, kind of what we normally see from a fixed income standpoint when we dig into the investment lineup, or the investment management of these insurance companies.
Greg Cobb: What we've seen over the last, you know, five, seven, or 10 years is greater complexity in the investment portfolios for insurance companies. Whether it's in the life and health side or the P&C side. And that's been a function of the decline to a low-rate environment. So with lower rates, you've had a situation where the investment portfolio is adding less and less and less to the bottom line, as rates have come down. And so therefore, insurance companies, to mitigate that loss and try to protect their book yield, have become more aggressive in their asset allocation. And you're now talking about taking a traditional fixed income portfolio, high-quality, relatively low-volatility portfolios, a lot of it to your point of the P&C side, overinvested in munis. Particularly given the amount of capital that they have, they could be taking more aggressive stances, and they've now done that. And so, you're talking about greater allocations to high-yield, levered loans. You're talking about greater allocations and private equity and private debt. In some cases, you've seen people move to alternatives and the hedge fund world, greater allocations and equity, preferreds, converts. So, it has become more complex, more difficult to manage, if you will. So, the risk management side of the equation has changed dramatically.
17:44
Michael Walton: Talk about how Sage – one, what does Sage bring to the table and maybe frame it all in the context of how we work with our investment consultant partners.
Greg Cobb: The one thing that we bring the table is a lot of credibility. You know, we've been managing assets in the liability-driven world, if you will, since the day we opened our doors. Our first two clients were insurance companies. So, we've been knee-deep in liability-driven investing, whether it's for asset liability analysis for insurance companies, or on LDI analysis for defined benefits. It really defines the nature of who we are. And on the insurance side, given who we are, we've been very fortunate to be pretty successful. Again, in terms of establishing a presence and credibility in the insurance world, we're talking about a little over 2.6 billion in assets, 35 distinct portfolios, and we're operating in 19 domiciles. And that means 19 regulatory environments, whether that be onshore or offshore. So, we have the presence and we have the credibility. So, when we walk in the door, we speak the language. We're very well versed and we're very well tested on the insurance side of the equation.
19:00
Michael Walton: You talked earlier about the need for not just financial diagnostics, but enterprise-wide analysis of the particular companies we might work with. So, can you talk about our capabilities there? I mean, because we've invested a lot in resources, in technology, and in people to bring those types of diagnostics to the table. But can you just kind of describe that and what that looks like?
Greg Cobb: Yeah, I think we have a really good blend of talent and technology here. A really good blend of the art and science, if you will, for the management of insurance company portfolios. Which, it's not a pure science by any stretch of the imagination if you go back to the four competing interests. That's very much the art of managing insurance company portfolios. But to your point, we have invested for the firm as a whole, quite a bit in our risk management capabilities, whether it's dynamic cash flow managing, stress testing, etc. We've also invested a lot of resources on the asset liability side of the equation, but also in terms of insurance-specific reporting capabilities.
20:07
Michael Walton: Right. Greg Cobb, there's other insurance asset managers out there, obviously. What makes Sage unique relative to some of those other insurance asset managers?
Greg Cobb: I think there are three differentiating factors. We do have the resources, we have the talent, and we have the experience in order to take a very effective, enterprise-wide approach to understanding your insurance company and creating investment portfolio. And that always leads to a very customized approach or a highly customized experience, if you will, overall. And with that, you also get direct access to the individuals that are actually making the decisions, whether it be in the investment side, the risk management side, or the reporting side.
20:47
Michael Walton: So, ability and willingness to take an enterprise-wide approach; we're going to customize not only the portfolios but customize the experience for folks. And then anyone working with us, whether it's the client or the consultant, gets access to the entire team and the folks that are actually doing the work.
Greg Cobb: Correct. And we're a lot of fun.
21:05
Michael Walton: Alright, so I promised everyone, Greg Cobb from Louisville, Kentucky, early on that if they stuck around this long that they would be gifted a wonderful treat of a couple bourbon selections. Just give us a few little nuggets that are achievable or findable in everyday searching.
Greg Cobb: That's always the hardest thing – people say, “What's your favorite bourbon?”
21:35
Michael Walton: Well, let me put it this way; you made a little hit list for me, right? I have a handful that I keep on my phone, I walk into a store, and I show them the list. Every now and then my dreams come true. So, give us a few that we can put on the list.
Greg Cobb: I will break it down. Let's talk about what's affordable. Right? What's less than $50? You've got Larceny, you've got Buffalo Trace. You know, Michael mentioned I'm from Kentucky. I hate recommending a whiskey from Tennessee, but it's Belle Meade. You got Four Roses, and then you've got the Old Forester of 1920, Ezra Brooks seven year, or my favorite and most affordable, less than $25; Old Grand Dad 114 – that's the OGD, 114. Now, if you want to step out a little bit, you want to spend a little bit more money. You know, you talked about the hundred-dollar range, Elmer T. Lee, Kentucky Owl, or the Joe Magnus Murray Hill Club. But then if you want to get really adventurous…
22:33
Michael Walton: Those last two are fantastic by the way.
Greg Cobb: The Kentucky Owl, oh yeah. Oh yeah. Well, these two are even more spectacular. If you can find a bottle of the A.H. Hirsch 16 year and you got $3,000 that's a really good one to try. Or the Black Maple Hill, anything that was bottled before 2010. You can spend another $3,000 if you want. So, it's always a price point.
Michael Walton: Those are the bottles you lock up and hide from your college-aged kids, right?
Greg Cobb: Those are the bottles that you lock up and hide from yourself. And that you go into your cabinet at night and just stand in front of your cabinet and say, “look what I own.” And that's it you know.
Michael Walton: Throw away the key.
Greg Cobb: You throw away the key.
23:11
Disclosures
Sage Advisory Services is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. This podcast is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results. For additional information on Sage and its investment management services, please view our web site at sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.
