Beyond the Efficient Frontier: An Introduction to Liability Driven Investing for Insurance Companies Presented to September 13, 2011 Presented by 231 South

Beyond the Efficient Frontier: An Introduction to Liability Driven Investing for Insurance Companies

Presented to

September 13, 2011

Presented by

231 South Bemiston, Suite 200 Clayton, Missouri 63105

(314) 726 9911

13506 Summerport Village Parkway #406Windermere, Florida 34786

(321) 939 1372

150 North Wacker Drive, Suite 2660 Chicago, Illinois 60606

(312) 212 4000

CHICAGO ORLANDO ST. LOUIS

2110913-BDV CPA MN Presentation

TODAY’S DISCUSSION

Introduction

Insurance vs. Pension Investing

• Strategy in the Context of Liabilities

• The Impact of Constraints

How are Insurance Companies Investing in the Current Environment?

• Income Enhancement

• Inflation / Rising Interest Rates

Conclusions


INTRODUCTION


TODAY’S PRESENTERS

Matt Heintz, CFA, Managing Director

Matt’s primary responsibilities for Cardinal are client service and manager research. Matt currently serves 6 clients. Matt also covers the fixed income and real estate areas of manager research.

Matt joined Cardinal in 2004 from the Edward Jones corporate headquarters where he performed research on firm investment products and processes. In addition, he was a licensed investment representative managing client accounts. Matt holds a BA in Economics from the University of Illinois and is a 2012 MBA Candidate at the University of Chicago; he received his CFA charter in 2006.

Marc Tourville, CFA,CIPM, Managing Director

Marc’s primary responsibilities are client service and research. Marc currently serves as Primary Consultant on 8 accounts.

Marc joined the Cardinal team in 2004 from LPM Financial Advisors where he was a founding partner advising insurance company executives. Prior to LPM Marc worked in the Insurance Analytics Group at SS&C Technologies managing the Dynamic Financial Analysis (DFA) model group. Marc holds a B.S. in Engineering from the United States Air Force Academy and an MBA from The Ohio State University. He received his CFA charter in 2005.


INSURANCE VERSUS PENSION INVESTING


CHARACTERISTIC INSURANCE ASSETS PENSION ASSETS

Regulator and Rating Agency Oversight

NAIC, AM Best, S&P ERISA

Taxes Taxable Non-taxable

Time Horizon Between 3 months and 9 years Long time horizons

LiquidityProfitabilityHard/Soft MarketsCatastrophes

Current benefit payments

Inflation / Interest Rates

Limited impact on claims paymentsHeavy fixed income assets

Wage inflationDiscount rate

Investment Objectives

Liquidity to meet claim paymentsStable incomeProtect principalGrow surplus

Meet future benefit obligations Minimize company contributions Strengthen funding status

Source: Cardinal Investment Advisors analysis

INSURANCE VS. PENSION INVESTMENTS


INFLUENCE OF LIABILITIES ON PORTFOLIO STRATEGY

Different lines of business have different types of liabilities:• Predictability or volatility of results• Duration of liabilities and their tails

Liabilities tied to interest rates have greater impact on investment portfolios: • Maintaining spreads on life products, annuities, long-term care

Sur

ety

Fin

Gua

rant

ee

Acc

iden

t & H

ealth

Gen

eral

Lia

bilit

y

Wor

kers

Com

p

Fire Aut

o Li

abili

ty

Med

Mal

prac

tice

Inla

nd M

arin

e

Fide

lity

Cre

dit

Aut

o P

hys

Dam

age

“Short-Tail”

(45 days – 1 year)

“Long-Tail”

(1-5 years)

Source: Assessing the Interest Rate Risk of P&C Companies. Babbel, Klock, and Polachek, Goldman Sachs, 1988.,Cardinal Investment Advisors analysis


LOSS AND LOSS EXPENSE PAYOUT BY YEAR

Source: Schedule P, Client Annual Statement Schedule P, Cardinal Investment Advisors analysis

Auto & HomeownersDuration = 2.0 Years

55.8%

19.0%

8.9%6.2%

3.9%2.1% 0.8% 0.5% 0.3% 0.2% 0.1%

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11+

17.9%

22.8%

14.5%

10.2%

6.7%5.4%

2.2% 2.1% 2.3% 2.0% 1.4%


4.0%

24.4%25.6%

23.0%

10.7%

5.7%

3.3%1.6%

0.1% 0.0% 0.1%


Workers’ CompensationDuration = 3.3 Years

Medical MalpracticeDuration = 3.5 Years


IMPACT OF CONSTRAINTS ON THE EFFICIENT FRONTIER

Source: Client Asset Allocation Review, Cardinal Investment Advisors analysis

Client Current

0%

2%

4%

6%

8%

10%

12%

14%

0% 10% 20% 30% 40% 50% 60%

Risk (Standard Deviation)

Exp

ecte

d R

etur

n

AFTER-TAX

PRE-TAX

50% Investment Leverage

6% Basket Clause


LOCATION, LOCATION, LOCATION

Source: State Regulations, Cardinal Investment Advisors analysis


OUR CLIENT ALLOCATIONS

Source: Company Financial Statements, Discussions with management, Cardinal Investment Advisors analysis

Asset Class Insurance Client Average Pension Client Average

Cash/Short Term 6% 1%

Fixed Income 79% 38%

Equity 15% 56%

Alternatives ~0% 4%


INVESTING IN THE CURRENT ENVIRONMENT


CUSTOM BENCHMARKING FOR YIELD OPTIMIZATION WITHIN LIABILITY LIMITATIONS

Pretax Yield to Worst 4.74 4.86 4.49After Tax Yield 3.31 3.39 3.14Volatility Adjusted Duration 4.72 4.87 3.89Convexity -0.39 -0.40 -0.45Average Credit Quality AA1/AA2 AA1/AA2 AA1/AA2

20%20% 20%

20%20%

30%30%

30% 30%

80%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Current Benchmark Alternative Benchmark Shorter Alternative

Aggregate

MBS Fixed Rate

U.S. Credit

Intermediate Credit

U.S. Government

Intermediate Gov't

Municipal

Muni 3-15 Yr Blend

* Volatility Adjusted Duration adjusts municipal duration downward because of their lower volatility relative to taxable bonds.Source: Barclays Capital, CIA analysis


Municipal Index

Taxable Index

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

0 2 4 6 8 10 12 14 16

Aft

er

Ta

x Y

ield

(%

)

Volatility Adjusted Duration (Years)

MUNICIPAL AND TAXABLE BONDAFTER TAX YIELD CURVES

After-Tax Municipal Index Yields

Aggregate Taxable Index Yields

Source: Barclays, Cardinal Investment Advisors analysis


HIGH YIELD BONDSBENEFITS FOR AN INSURANCE PORTFOLIO


Given the historic yield and return advantage over investment grade issues, it may be used incrementally to enhance portfolio yield.

Low correlation to investment grade segment of fixed income market, which dominates an insurance portfolio.



EMERGING MARKETS DEBTBENEFITS FOR AN INSURANCE PORTFOLIO

High potential returns with spreads over domestic bond markets.

Behaves more like equity with favorable risk-based capital treatment (if dollar denominated).

If local currency used, it can provide diversification from the U.S. dollar and U.S. yield curve.

Low correlations with traditional insurance portfolio market instruments.



DIVIDEND TILT EQUITIESBENEFITS FOR AN INSURANCE PORTFOLIO

May be considered as an alternative to fixed income for some insurance portfolios.

Less sensitive to rising rates and inflation than bonds.

The dividend yield may provide better after-tax yields than bonds due to the dividends received deduction.

May protect better in down markets than broader equity exposure.



CONVERTIBLE BONDSBENEFITS FOR AN INSURANCE PORTFOLIO

They capture a portion of equity upside with downside protected by bond “floor”.

At times may provide more income than straight equity.

Lower risk-based capital required relative to common stocks, as they are treated as a bond by the regulators.

Small, inefficient market provides active opportunities.


YIELD CURVE SHIFTS AND TWISTS

Source: Brown Brothers Harriman, WSJ Economic Forecast, Cardinal Investment Advisors analysis

Base Case

Halfway to Historic

Fully to Historic

-

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

0 5 10 15 20 25 30

Yie

ld (%

)

Maturity (Years)

Yield curve Changes

2 to 5 Year Slope 2 to 10 Year Slope 2 to 30 Year Slope 5 to 30 Year Slope

20 Year Average 58bps 103bps 144bps 87bps

Today 68bps 177bps 305bps 237bps


PORTFOLIO IMPACTS OF SCENARIOS

$277 M bond portfolio, duration 4.30 Sector allocation:

• Treasuries 2.8%• Governments 1.6%• Corporates 33.8%• AGY Passthrough 21.5%

• CMO 8.6%• CMBS 17.3%• ABS 2.9%• Municipal 11.5%

Source: CMS BondEdge, AAM analysis

% $ % $ % $ Total Return 3.65% 10,095 -0.32% -882 -4.91% -13,588 Income Return 2.51% 6,945 2.82% 7,788 3.01% 8,331 Price Return 1.14% 3,150 -3.14% -8,671 -7.93% -21,919

Price Return - Chg in Parallel Rates 1.01% 2,788 -2.72% -7,509 -5.98% -16,539 Price Return - Chg in Slope -0.43% -1,181 -0.98% -2,710 -2.49% -6,898 Price Return - Yield Curve Roll 0.56% 1,543 0.56% 1,546 0.55% 1,518

Mkt Val (USD 000) 276,577 286,672 275,694 262,990 Mkt Val Diff (USD 000) 10,095 -883 -13,587

Fully to HistoricHalfway to HistoricBase CaseStarting Portfolio


-1.00

-0.80

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

Co

rrel

atio

n C

oef

fici

ent (

-1.0

to

+1.

0)

Inflation Hedge Efficacy - Historic Annual Correlation through 2010

Inflation Unexpected Inflation

INFLATION HEDGE ASSET CLASSES

Some assets protect against actual inflation with positively correlated returns.

A subset produces an even larger positive correlation to the impacts of unexpected inflation.• Commodities• HY Bank Loans• TIPS

Cash offers a reasonable inflation hedge due to its short-term nature. However, in most yield curve environments its inflation hedge properties come with a very low absolute return.• This is also the case with TIPS in

the current yield environment.

Source: Investworks, Venture Economics, Cardinal Investment Advisors analysis



COMMODITIESBENEFITS FOR AN INSURANCE PORTFOLIO

Consistent positive correlations to inflation (actual and unanticipated).

Diversification properties versus bonds could benefit during rising inflationary environment.

Low, often negative, correlations to other asset classes.



The floating rate component (tied to LIBOR) makes it a nice diversifier for a large fixed income portfolios.

Attractive spreads in addition to LIBOR floors make it a possible return enhancer.

Generally senior secured debt, so relatively high recovery rates in the event of default.

Low correlation with other core assets for insurance portfolios.

HIGH YIELD BANK LOANSBENEFITS FOR AN INSURANCE PORTFOLIO



TIPSBENEFITS FOR AN INSURANCE PORTFOLIO

Correlation to traditional asset classes is very low, or negative for many.

Positive correlation to inflation (actual and unanticipated).

Same guaranteed credit quality of US Treasuries.

Very liquid, transparent strategy with low investment management fees.


CONCLUSIONS

In addition to their short duration liabilities, regulatory and accounting constraints can have a meaningful impact on insurance company investment strategy.

There are non-traditional asset classes and optimization strategies that can help preserve book yield in the low rate environment.

While rates are low, the steep yield curve and the resulting “roll-down” effect makes it challenging to stay short of liability or benchmark durations.


Documents

Beyond the Efficient Frontier: An Introduction to Liability Driven Investing for Insurance Companies Presented to September 13, 2011 Presented by 231 South