We chose these topics for discussion because low interest rates have led to accusations of market manipulation by central bankers and to fraudulent behavior by issuers of some bonds. A few comments about politics are warranted because it is ‘the season.’ The world has been living with low interest rates for nearly a decade and confidence that we will return to a 1990’s type of interest rate environment any time soon is certainly lacking. Some economists and market strategists are questioning if central bankers have been experimenting with financial markets too much with too little to show for it. Finally, while misinformation, stretching the truth, and omitting important facts are part of being human, we will confine our remarks regarding fraud to how it impacts investors, not politicians!
The Great Recession officially started in December 2007 and ended in June 2009. Since then, central bankers around the world have worked tirelessly to prevent a deflationary depression and to foster sustainable economic growth. Most of their efforts involved buying bonds in the open market which reduced the supply available to investors, which in turn drove prices of remaining bonds higher and interest rates lower. Central bankers expected, or hoped, that low interest rates would spur investment and economic growth, would raise asset prices, and most importantly, would prevent deflation. According to JP Morgan, central banks now own almost half of the $43 trillion in developed world government bonds. Practical limitations on accumulating a lot more debt are related to (a) exhaustion of willing sellers (banks and insurers have to hold long-term, low risk assets for both capital adequacy and liquidity purposes), and (b) the corrosive impact of negative/ flat yield curves on European and Japanese banks, insurance companies and pension funds. The US is in better shape than Europe and Japan, but is not immune to their problems, since investors will shift investments to the US if the spread between their home country bonds and US bonds is wide enough. This is likely part of the reason for the Federal Reserve’s September decision to yet again delay raising rates. We believe that based on recent economic statistics, the US could certainly absorb a quarter point rise in interest rates, but apparently the Fed believes otherwise—possibly because of concern that higher yielding, safer US bonds would attract too much foreign investment which would then further strengthen the US dollar.
Central bankers may be running out of options and even the Fed has said that monetary policy alone cannot solve the world’s economic growth problems. Fiscal policy initiatives are most likely next in line and could involve anything from tax changes to massive infrastructure spending to even helicopter money, where all citizens are “given” money to spend. The success of such untested actions is obviously uncertain. But, what is certain is that the world is likely stuck with low interest rates for many years to come. Looking at the US, we believe that a gradual upward move in interest rates is the most probable path. Clearly today’s environment is different than 70 years ago, but looking at a prior cycle gives some insight as to what is possible or even probable. The Fed is intent on raising inflation, in part to help devalue our existing debt over time. IF they are successful, and IF our economy continues to grow, rates could follow a path similar to what was experienced in the 1945-1978 period. As can be seen in the chart, the secular trend was a rise of about 2 percentage points per decade despite sharper shorter term cyclical moves during expansions and recessions. (We believe that the likelihood of another 1978-84 inflationary period is very remote, since it was the only occurrence of that magnitude in the US since 1790.) Interestingly, during the last 35 years, the secular decline has also followed that 2% per decade path. Should this relationship continue, we would not be surprised if 10 year US Treasury yields were only in the 4.0-4.5% range by 2025. This will have major implications for investors, governments, and politicians. Many promises have been made and without potentially higher investment returns from bonds, trouble lies ahead.
While many may believe that politics and fraud go hand in hand, we are not that cynical. Our discussion of fraud relates to a recent Securities and Exchange Commission case which will undoubtedly impact issuers of tax-exempt bonds. By now, most investors should be aware of the precarious financial position in which some state and local government entities exist. Detroit and Puerto Rico come to mind, but many states and cities struggle with their budgets in large part because of unfunded pension liabilities. In more normal times—when interest rates were higher—pension plans were able to assume long term investment returns of roughly 8% annually. In our current low interest rate environment, that 8% is no longer realistic, and thus the anticipated investment returns must be made up by either higher contributions to the plans or lower benefits paid to retirees. Historically, buyers of municipal bonds rarely questioned the safety of investment grade rated bonds, and for the most part, that remains true. However, we are beginning to see that in some cases, the ratings agencies may not have been getting the complete financial picture. In 2013, the SEC filed a lawsuit against the City of Miami and its former budget director for securities fraud in the sale of over $150 million in municipal debt in 2009. Charges were brought after the agency found that in three 2009 bond offerings, the city and budget director had made materially false and misleading statements and had omitted various interfund transfers which had the effect of making Miami’s financial condition appear better than it actually was. A couple of weeks ago, a jury returned a guilty verdict and currently the SEC and City of Miami are in settlement discussions to avoid further litigation. Furthermore, on August 24, 2016, the SEC announced enforcement actions against 71 municipal issuers for violations in municipal bond offerings. The Director of the SEC Enforcement Division was quoted “The diversity among the 71 entities in these actions demonstrates that continuing disclosure failures were a widespread and pervasive problem in the municipal bond market.” All of this will ultimately be good for investors. Better disclosure will also raise interest rates for those issuers who do not have their financial house in order.
Finally, Politics. The Presidential election so far has undoubtedly been unlike any that we have witnessed before. Some in the past may have been hard fought and ugly, but to have two candidates where a majority of the voters would like to vote “neither” is probably unprecedented. Even in the 1960’s with the country so polarized with the Vietnam War and Civil Rights movement, people were voting for one candidate or the other. Our country is clearly divided and social unrest has been heightened, but we do have faith that whoever is elected, the country will survive and prosper. Leadership is clearly important, but as long as the checks and balances set forth by our Constitution remain, our country will continue to move forward and deal with whatever problems arise. The United States has faced many challenges during our history and most of these have made us stronger. We believe that this election will rank in the minor leagues of challenges and that we will eventually be better off. Regardless of who wins, we should all remember Friedrich Nietzsche’s quote: “That which does not kill us, makes us stronger.”
Insurance’s Role
Insurance plays an important role in everyone’s lives since it allows people to protect their assets and income. However, we have noticed that clients’ insurance policies are often not optimized to meet their existing needs.
Insurance is most effective when it is used to protect against the consequences of a low probability event with dire consequences. Term life insurance for the breadwinners of a family with young children is an example of effective insurance. For instance, consider two 40 year-olds where both spouses work with two children ages 5 and 2. The premature death of either spouse would be catastrophic since an income would be lost and the surviving spouse would have to spend much more of his or her time with childcare in addition to managing the emotional pain of losing a loved one. Both spouses could insure themselves for $2 million by paying roughly $1,500-2,000 each per year in premiums for a period of 20 years. If one spouse passed away, the policy could help pay for living expenses and also cover future needs such as college financing.
Insurance is much less effective when it is used as an investment vehicle. Insurance companies are investment management companies. They collect premiums from a multitude of insureds and then invest the premiums that they collect to grow their asset bases. The insurance companies then have many policies which they have to pay out of their investment pool. Therefore, the goal of any insurance company is to make money by paying out less than their premiums and investment gains. The wider this spread, the more money they make.
Simple annuities are the easiest insurance products to understand. These annuities require someone to buy a policy with a lump sum of money in order to get a fixed annual income for a set number of years. As indicated above, the insurance company’s goal is to earn money on the spread between its investment gains and what it has to pay out. Insurance companies also do not have superior investment knowledge that allows them to outperform other professional investment managers. Therefore, an investor will usually do much better investing his or her own money and paying a transparent management fee rather than holding assets through insurance vehicles.
Insurance companies combine annuities and life insurance into hybrid products which can be quite complex. These policies often appear to be much safer than they are in actuality because of the life insurance benefit which does not take effect as long as the insured is alive. Therefore, the better strategy is to separate the transactions and buy the life insurance and invest directly in the markets.
Insurance investments also suffer from a lack of transparency and aggressive sales culture that are inter-related. All insurance policies are very complicated legal contracts with hundreds of specific terms. These terms dictate how the policies will pay out and under what circumstances. Fees and penalties are also covered along with the length of the agreement.
Insurance companies employ armies of brokers to sell their policies. In order to induce investors to buy policies, the insurance companies need to provide very lucrative commissions to the salespeople that sell the contracts. Most of these commissions are paid instantly to the broker once the insurance contract is signed. This compensation structure is the reason that policies have such high cancellation fees. These fees often start at 7% of the contract value and decline over a period of five to ten years.
Every investor should review all of his or her insurance policies owned and ask the following the questions:
• What risk am I insuring against?
• How much am I paying to protect myself?
• What risks am I exposed to through this investment?
• How long am I tied to this contract?
• How much administrative complexity am I assuming by remaining in these policies?
• Could I invest better outside the insurance contract?
We would be happy to review any existing or contemplated insurance policies within the context of your specific circumstances.
Please note that we compete with insurance companies for investment dollars and this competition affects our views of the merits of these offerings. Regardless, all of us own insurance to protect against specific risks, but our use of these products is limited. We recommend reduced investment in insurance products to produce superior financial outcomes over the long term.
Insurance Companies as a Portfolio Investment
When contrasted with social media or retailers or multi-national industrial companies, insurance companies, as a business, are often viewed by investors as about as exciting as watching paint dry.
However, “boring” can often be a virtue in investing. The insurance business model—in its simplest terms—is the collection of premiums from a large number of customers to cover the risk of claims from a select few customers who experience unexpected or catastrophic events. Premiums are collected—whether it be insurance for auto, life, health care, or property & casualty—based on the risk of future claims. The premise is that if an insurance company collects premiums from enough lower-risk individuals, they will have more than enough cash flow to pay out claims that come from a few unluckier policyholders. What remains after equals underwriting profit. Sounds simple enough. But, underwriting profits can often turn to losses in any given year. Enter the second, and even more important profit driver, the ‘float:’ the cash collected from customer premiums that sits in insurance company coffers before being used to pay any customer claims. Investment profit from the ‘float’ often comprises the lion’s share of an insurance company’s profits. This was Warren Buffet’s famous epiphany and his impetus for purchasing Geico when he referred to the float as ‘free money’ on which a return could be earned.
So does the insurance company business model make for a good stock investment? At times. The problem with the float is that the majority of an insurance company’s portfolio must be placed in lower risk investments because the portfolio can be hit in any one year with far more in unanticipated claims than they collect in premiums. Thus, insurance companies must hold excess capital to cover future losses and must invest the ‘float’ largely in lower risk fixed income investments. Post 2009, regulators also want higher reserve capital which also weighs on returns. Warren Buffet’s Berkshire Hathaway represents a famous, but very rare, outlier example of where the float was used to make concentrated bets in riskier investments (stocks) that worked out over a long period of time.
We have had a less than enthusiastic view on insurance stocks for two reasons. The first: most of the profit comes from investment portfolio income. However, ultra-low rates has created the same conundrum faced by retirees and pension fund managers—net yields on life insurers’ investment portfolios have fallen more than 20% since 2007. This has hurt profits and forced insurance companies to move beyond traditional assets classes into less liquid/risky choices, like real estate and hedge funds, in the pursuit of increased returns. Second, while there are exceptions in terms of branding and product innovation, insurance for the most part is a commodity product without much differentiation. We tend to prefer investments with something unique in terms of their competitive positioning. Pricing tends to be quite competitive when insurance industry capital is readily available and flowing into the group—as it has the past few years. Opportunities in the stocks tend to present themselves when capacity retreats from the industry following major risk events which allow for higher premiums.
In the past several years, we have owned one insurance stock— United Health Care (UNH), based on a positive view of lower health care utilization by patients combined with growing numbers of insured (Affordable Care Act). However, UNH is also uniquely benefiting from rapid growth in a health care information services and software business (Optum) whose services are in great demand. This subsidiary also carries margins far higher than the core business, so its growth as a percentage of the overall company is driving profits. Overall, Insurance stock valuations vs their history look reasonable right now, but our view is that low interest rates and muted GDP growth will continue to limit profit upside for the group.