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By Dave Bomberger, Chief Investment Officer, Pinnacol Assurance, and
Mitch He, Chief Investment Officer, Chesapeake Employersâ€™ Insurance Company
Investments play an important role in the financial performance and strength of insurance companies. Insurers invest the funds they collect from premiums and then rely on income and principal from these investments to pay future claims. Investments, like most other aspects of the insurance industry, are highly regulated and subject to capital charges based on perceived riskiness. AASCIF members, in line with their counterparts in other property and casualty insurance lines, generally have a large portion of their assets invested in high-quality, investment-grade bonds. Based on a survey conducted by the AASCIF Finance and Investment Committee in 2016, AASCIF members had 73% of invested assets in fixed income securities. Within these fixed income security holdings, 95% were investment grade (75% were rated NAIC Class 1, equivalent to AAA, AA, and A ratings; and 20% were rated NAIC Class 2, equivalent to BBB rating). These high-quality investments generate a significant flow of interest income but generally offer limited opportunities for capital appreciation. This flow of interest income has declined dramatically over the past several years as interest rates have fallen to all-time lows, while central banks around the world have sought to stimulate their economies. At one point during 2016, nearly one-third of all governments bonds around the world were trading at negative yields.
The following is a brief review of financial markets in 2016 and a peek into possible trends to follow in 2017.Â
Despite a tumultuous year with a number of major market surprises, 2016 turned out to be a banner year for many markets. U.S. stocks, as measured by the Dow Jones Industrial Average, produced a 16.5% total return, while the S&P 500 posted a 12% total return. Total return is the combination of change in market value and income received. Most of the positive return from U.S. equities occurred following the 2016 general election as investors reacted favorably to Trumpâ€™s election and hopes of benefits from tax cuts, reduced regulation, and fiscal stimulus. For now, the markets have ignored the potential adverse consequences for the stronger dollar, rising deficits, protectionism trade policies, higher interest rates, and increasing inflation.
Developed Non-U.S. equities produced moderately positive returns in 2016, while emerging market stocks returned over 11%. The European Central Bank and the Bank of Japan have employed unprecedented monetary stimulus, bond purchases, and negative interest rates to try to revive their economies. Despite the benefits achieved, these measures have resulted in weak corporate profits and underperformance of European and Japanese banks and equities in general.
Oil rose 45%, and many commodities finished the year with gains. As 2016 ended, OPEC appears to be reducing production, which may provide a floor for oil prices.
The dollar ended the year near a 14-year high. The strong dollar is a result of stronger economic conditions in the U.S. compared to the rest of the world and yields, while very low, that are higher than other markets. A strong U.S. dollar makes products made in the U.S. less competitive than products made outside the U.S.
Interest rates ended the year higher. The U.S. 10-year Treasury ended the year at 2.44%, up from 2.27% at the end of 2015. The total return of the Barclays U.S. Aggregate Bond Index, a broad index of investment grade bonds, was 2.6%. High yield bonds returned 17% in 2016. There were wide swings in interest rates during the year. The 10-year yield was as low as 1.36% in July in response to the surprising Brexit results and soared to over 2.6% following the U.S. election. Despite increase in yield, interest rates are still at historically low levels. The current yield of the 10-year is half of what is was in 2007 and far below the all-time record of 15.819% experienced in 1981.
What does all of this mean for AASCIF members? Interest income from existing holdings continued to decline during 2016, and unrealized gains on investment grade bonds were reduced. Members who have moved away from â€śtraditionalâ€ť fixed income asset classes into structured securities, such as collateralized loan obligations (CLOs), high yield bonds, equities, and alternatives, benefitted in 2016. These members have not only benefitted from higher returns on these investments, but also improved the diversification of sources of investment risk and return.
Looking forward, the U.S. economy is expected to get a boost from reduced regulation, lower taxes, and increased fiscal spending, but these may take a while to work through the legislative process and be implemented. Consumer and business confidence may increase and lead to more consumer spending and more investment by business in plant and equipment. The potential adverse consequences of Trumpâ€™s policies, higher interest rates, trade sanctions, and rising inflation may take even longer to be felt. Improvement is expected in corporate revenue and earnings from accelerated growth. This should benefit corporate credit quality and equity prices. Nevertheless, these divergent forces imply another volatile year in the markets.
Outside the U.S., many developed countries are transitioning from â€śmonetary stimulus onlyâ€ť to a more expansionary fiscal policy, or at least less austerity. This should lead to improved economic growth.
Growth in China should be stable as the central government has sufficient tools to manage excesses as they may develop. Other emerging markets should stabilize and begin to grow.
While 2016 was a year full of surprises causing significant market volatility, we expect more of the same in 2017, hence more investment opportunities. Subject to various risk considerations and restrictions imposed by stakeholders such as state regulators and rating agencies, We believe that AASCIF members, as investors with long-term horizon, will continue to benefit from a more diversified asset allocation, with lower allocations to â€śtraditionalâ€ť investment grade bonds and a larger portion of portfolios in non-traditional fixed income securities, common stocks, below investment-grade credit, and other long term (alternative) invested assets.