nvestment teams at healthcare insurance firms continue to encounter challenges, opportunities and ambiguities resulting from the low-interest-rate environment and balance sheet effects from the Affordable Care Act (ACA). This confluence of market and regulatory events has a meaningful impact on investment strategies across the $166 billion in cash and invested assets held by health insurers (Source: SNL, April 2015).
The impact from low rates is measurable, but to gain a deeper understanding of the ACA’s investment implications, PIMCO conducted a survey across a subset
of U.S. health insurance companies during the fourth quarter of 2014. Despite differences in the ACA’s operational impact based on company size, location,
product mix and other factors, two common themes emerged from the survey: Underwriting performance will be a larger factor in determining asset allocation
changes, and liquidity and income will be emphasized to a greater degree.
At PIMCO, we believe the environment is ripe for health insurers to re-evaluate investment policies and positioning, with an emphasis on a broader
opportunity set of asset classes and enhanced cash management to help portfolios increase contribution to profitability while carefully managing risk.
Underwriting performance will influence investment goals
As the ACA increasingly affects underwriting performance for health insurers, it will also become a larger driver of asset allocation decisions (see Figure
1). Changes in the size and characteristics of insured populations will influence cash flow, profitability and risk-based capital, which in turn will
affect investment strategies.
In PIMCO’s survey, 95% of respondents expect premium volumes to increase as a result of the ACA. However, this growth may come at the expense of lower margins (see Figure 2).
On the asset side, margin pressure is driven by low reinvestment yields. On the underwriting side, margin pressure may result from an evolving insured mix/Medicaid expansion, increased competition (Source: Dept. of Health and Human Services), the “three Rs”and the Medical Loss Ratio rule. The “three Rs” are risk adjustment, risk corridors and reinsurance – risk-sharing programs put in place to mitigate the cost of adverse selection that may also incentivize aggressive pricing. Meanwhile, the Medical Loss Ratio rule imposes a minimum medical loss on health insurers, below which insurers are required to issue rebates to enrollees.
The investment implications are not clear-cut. While the expansion of new liabilities may elicit a more cautionary stance toward liquidity, the potential decline in operating margins may push insurers to look to their investment portfolio for higher income/returns.
Survey responses on intended asset allocation changes are consistent with this liquidity/return paradox, as insurers indicated larger increases in allocations to enhanced cash and, on the other end of the risk spectrum, emerging markets and private equity. Respondents also identified expected decreases in allocations to core bonds, largely driven by the low-rate environment (see Figure 3).
At PIMCO, we believe the Fed is moving closer to its first rate hike since 2006, which will be welcomed by portfolios struggling with record-low yields.
The 2014 net yield on invested assets for health insurers stood at 2.06%, less than half of its 2006 level. However, even if rates begin to rise in 2015,
they are unlikely to rise fast enough to provide a meaningful boost to yields. Expansion of global central bank balance sheets and cautious Fed policy will
continue to support Treasury prices in the near term, and PIMCO expects the longer-term trajectory for the fed funds rate to be lower than in prior cycles
due to structural factors including high debt levels and lower potential growth. In such an environment of lower expected returns and growth, alpha
generation will become more important, and potentially a larger share of overall returns.
So how might insurers improve investment performance?
Look beyond domestic borders. As of year-end 2013, only 5% of health insurers’ bond exposure and 2% of their stock exposure represented
foreign issuers. For investors willing to ease home bias, the divergence in global monetary policies has created attractive opportunities in global
interest rates, credit, foreign exchange and equities.
- Avoid external ratings bias. Below-investment-grade, or high yield (HY), securities tend to be avoided or minimized by insurers until
they become upgraded into investment grade (IG). Similarly, many insurers exit investments downgraded below IG due to punitive capital charges, perceived
impairment risk and/or optics. This creates a “buy high, sell low” dynamic.
Since 2007, this ratings sensitivity, in the context of declining interest rates, has led health insurers to migrate down in quality within the investment
grade spectrum (i.e., BBBs) to make up for lost yield (see Figure 4), which may not be optimal in light of tighter valuations. Insurers with comfortable
liquidity/capital positions should consider utilizing the entire quality spectrum to find value, as select HY issuers with improving balance sheets may be
a better investment than IG rated credits that are vulnerable to re-leveraging risks. An overreliance on external ratings provides a false sense of
Include a broader range of fixed income assets in your portfolio. The myriad of regulations and capital measures imposed on global banks
has led to meaningfully stronger balance sheets, which typically benefit bondholders. Concurrently, many nonfinancial issuers have taken advantage of low
yields to increase leverage and shareholder return. These balance sheet dynamics are not always appropriately priced across industries and capital
structures, offering compelling opportunities for investors who can identify optimal points of risk and return along the debt/equity continuum.
Many health insurance investment policies focus fixed income investments within a narrow range – choosing instead to take equity-like risk in their stock
portfolios. Utilizing a mix of bank loans, preferreds, hybrids and other subordinated debt structures can help improve risk-adjusted yield/return.
- Consider your “alternatives.” The effects of the ACA on balance sheets and profitability, in addition to low reinvestment yields, may
force portfolios into a liquidity/return barbell, which suggests reserves not pledged toward increased operational needs may benefit from investment into
more opportunistic (less liquid) strategies. This is especially true when valuations for bonds and public equities have continued to richen. Alternative
investments, including unconstrained strategies and distressed funds, among others, can fill this gap – and indeed represent a growing area of interest
among health insurers.
The bottom line is that health insurers operate in an environment of elevated uncertainty on both the liability side (fluidity of the ACA) and the asset
side (central bank policies and associated volatility). This environment calls for having a well-diversified portfolio with flexible guidelines, reaching
beyond domestic markets and crowded asset classes.
Enhanced cash and liquidity management
Working capital has always been a higher burden for healthcare insurers compared with property and casualty (P&C) and life insurance companies. This
burden increased further for those that used operating cash, bank lines of credit and/or tapped the investment portfolio to cover ACA-related expenses.
Liquidity is further stressed due to the timing mismatch between medical claim payments and government reimbursements, which will increase for many due to
the expansion of Medicaid. Additionally, the ACA’s competitive dynamics have accelerated mergers and acquisitions (M&A) and capital investments in
complementary health products/services, both of which represent additional uses of cash. All of this, compounded by low interest rates, explains why our
survey participants emphasized liquidity and income as growing investment priorities associated with the ACA (see Figure 5).
From a liquidity perspective, increased financial regulation post-2008 has led to reduced dealer balance sheets, generally increasing the cost of trading longer-dated debt. In addition, money market mutual fund reforms effective in 2016 alter the concept of “cash equivalents” by establishing floating net asset values on institutional prime and institutional municipal money market funds, and may even apply liquidity fees and gates on redemptions in more extreme scenarios. These operational costs of liquidity are exacerbated by economic costs (i.e., low policy rates, negative real rates) for income-sensitive investors such as health insurers.
To address the conflict between maintaining conservative liquidity buffers and enhancing income, we advocate insurers implement appropriate liquidity tiering among cash equivalent, core, core plus and other strategies. The magnitude of each tier should be scaled based on both the level and uncertainty of working capital requirements (see Figure 6).
In case large liquidity needs require sales from the investment portfolio, insurers should be aware of the risk profile of the residual assets, as
portfolios could become out of balance in terms of credit and/or interest rate exposures. Using an overlay to hedge unintended risks may be a viable
approach that can allow the general account to efficiently normalize positioning over time.
Re-evaluate investment policies and remain nimble
Five years since the ACA was signed into law, the fluidity of the regulation and ongoing political challenges ensure the only thing that’s certain about the ACA is further uncertainty. The broader investment implications have also been complicated by the Fed’s zero interest rate regime. For now, health insurers generally expect increased premium volumes and shifts in insured profiles, which call for an increased emphasis on liquidity and income.
Re-examining investment policies and tiering liquid assets can help health insurers’ investment portfolios maintain flexibility while potentially contributing more to the bottom line.