Total return or book income:
finding the right balance
When PIMCO asks insurance executives, “Do you want us to manage your general account to optimize book income or total return?” the typical answer is “both!” This is not necessarily unreasonable. Both are ideal; income delivers a substantial part of total returns, and, in practice, many insurers shift their focus from income to total return as market conditions or objectives change. In certain markets (e.g., one with flat yield and spread curves that has traded sideways for several years) it may even be possible to optimize both, but generally trade-offs must be made. Thus, in the end, insurance executives need investment managers with the depth, breadth and expertise to balance these dual – and sometimes competing – objectives.
The income versus total return debate
Insurers are unique. They are asset/liability managers whose investment portfolio is earmarked for long-term liabilities, most of which cannot easily be accelerated. Insurers also operate under unique regulatory, accounting and tax regimes that are largely amortized-cost based rather than mark-to-market based. Finally, insurers must balance potentially competing interests of many constituents, both internal (management and the board) and external (shareholders, policyholders, regulators and ratings agencies).
Given these idiosyncrasies, there are divergent views about the best approach to managing insurance company general accounts. The debate can be framed as near-term earnings per share growth versus long-term book value per share growth.
At one extreme are those who focus exclusively on book income. They seek stable income that meets or beats the interest cost embedded in liabilities to generate the desired accounting return on equity (ROE).
At the other extreme are those who focus exclusively on total return. They believe yield does not equal return and look to cultivate capital appreciation opportunities via active management.
At times these competing objectives can coexist (i.e., you can have your cake and eat it too), although compromises are often needed to strike the right balance. Although an income objective may lead to generally less-actively-managed portfolios, active managers are still required to make adjustments as markets, economic outlooks and objectives evolve.
In our experience, an insurer’s investment focus often correlates to their liability type, as shown in Figure 1.
Insurers whose liabilities require high funding spreads, such as annuities, guaranteed investment certificates (GICs) and interest-sensitive life, tend to emphasize income because their business focuses on spread lending; it is important to have financials that depict a profitable interest rate margin. They often inhabit box 1 of Figure 1.
Health and property and casualty (P&C) underwriters, with business models driven by underwriting and expense management, have less need for investment spread and often straddle both styles. Some focus keenly on profits from underwriting and expense management and seek to avoid “noise” from their asset portfolios. These insurers often prefer income return and fall into box 3.
Others, such as conglomerates focused on maximizing the value of their insurance float, certain off-shore insurers or those who elect fair value accounting, may see their liabilities as an inexpensive source of funding and aim to enhance enterprise value by more actively (and typically more aggressively) managing assets. They often prefer total return and occupy box 4.
Box 2 is fascinating, if a bit lonely. The U.S. life and annuity market has recently attracted some private equity entrants who see liabilities as a sticky source of funding. Thus, they often take a more active and aggressive total return approach.
Are these investors looking to have their cake and eat it too? Perhaps. An investor straddling the two styles may be doing just that. At PIMCO, our job is finding the right balance between these objectives.
Balancing potentially competing goals
We believe communication between insurer and investment manager is key. Assessing your spot on the spectrum, or the quadrant you fall into in Figure 1, is an essential exercise that can help identify how best to meet your goals. Many insurers move along the horizontal spectrum as market conditions, circumstances and objectives change.
The past five years also have shown the value of a manager with the skills, tools and resources to pivot between total return, income and all points in between. Sustained low interest rates have pressured insurers’ net investment income. Yet, interestingly, PIMCO has observed two starkly different reactions.
Some insurers battened down the hatches and shifted strongly to the left (income). The goal was to minimize active management to maintain as much accounting income as possible. Another group did the opposite. They decided that natural book yield degradation was so powerful and market yields were so low that the pursuit of total return alpha was paramount.
Most recently, however, higher rates have provided insurers with the long-awaited chance to slow down (or better, reverse) the multi-year decline in book yield. Many insurers are shifting toward the income end of the spectrum.
Importantly, however, it is not enough to focus on the types of return, or the reward side of the equation. Managers also need the ability to carefully identify, quantify and analyze risk, particularly in the context of the varied risk tolerances of different insurers. Thus, regardless of where one sits on the spectrum, it is imperative that insurers stay true to their investment views and risk tolerances. Creating a target portfolio requires an investment manager to have a robust investment process underpinned by a forward-looking view of the economy and capital markets, and an extensive risk management process with analytics that can stress-test portfolios and identify tail risks. Anchoring a forward-looking target portfolio and setting risk limits help ensure that an insurer will pursue portfolio-driven trades, rather than ending up with a trade-driven portfolio.
Back to the return side. Quantifying a manager’s level of success in meeting a client’s return objectives is crucial to a successful relationship – whether it is income, total return or a combination. Tracking and attributing total return alpha has long been well understood. However, it is equally important to quantify manager contribution to income return – and PIMCO has developed a robust platform of analytics to do just that.
Quantifying the income objective
When managing to an income objective, the age-old challenge is to measure how well this objective is being met (or not). Unlike measuring alpha in a total-return-focused mandate, which is routine, the process of measuring accounting income alpha can be problematic. The basic challenge is the lack of a practical book-yield benchmark. (Several attempts by credible index providers and consultants to introduce a set of book yield indexes failed because of technical challenges exacerbated by the bespoke nature of client benchmarks.)
PIMCO, however, has developed a book yield attribution model that deepens understanding of and improves transparency into changes in accounting yield. Similar to total return attribution, the model seeks a granular explanation of changes in book yield over a given period – both for actual portfolios and passively invested benchmarks. Combining accounting income and total return attribution and providing a summary of portfolio risk metrics renders a much more complete picture of portfolio performance and risk.
Figure 2 shows the many factors used to decompose book yield. The left side of the table shows the attribution of the actual change in portfolio book yield. These are the facts as to what actually happened. The first six rows can be considered non-discretionary factors, where the manager cannot necessarily control the magnitude or timing of the event. Their impact on overall portfolio yield is quantified and adds perspective to the roll-off of book yield from maturities, pay-downs, etc. The final three rows largely represent active decisions being made by the portfolio manager – buys and sells, along with deployment or accumulation of cash balances.
The right side of the table attributes factors in a passive investment approach, representing what would have happened had the portfolio been managed on a completely passive basis. Buys are assumed to occur only upon reinvestment of principal and interest, pay downs and new deposits. Sells occur only to fund outflows. Passive purchase yields are assumed to occur at the index market yield. Sale yields are based on the average portfolio book yield. Essentially, comparison to passive estimates isolates the impact of the active trades. While the passive estimate is not a true benchmark, it does offer a valid comparison to the actual result decomposition. This provides significant context to help assess whether or not active portfolio management has added or detracted from book yield over the period.
This framework allows insurers to carefully assess a manager’s active contribution to excess book yield return. Combining this transparency and accountability with individualized investment objective can underpin a robust investment process with a long-term view and rigorous risk management. This is PIMCO’s recipe for success in helping insurers meet their long-term obligations, and, potentially, have their cake and eat it too.