Episode 296: AM Best’s Insurance Industry Outlooks and Potential Impact on Investment Risk

 

Stewart: My name's Stewart Foley, I'll be your host. Hey, welcome back and thanks for joining us. We've got a great podcast for you today. I want to get to that just as soon as I get through reminding you that we have an event in Philadelphia on May 7th and 8th focused on ABF real estate and infrastructure. We have a couple of LP spots remaining for insurance investors only, and you can sign up or get a registration packet by emailing us at events@insuranceaum.com.

So, we look forward to seeing you all very shortly in Philadelphia. To prepare you for this podcast, back in the day there was a company called EF Hutton, and EF Hutton ran a TV commercial back where I grew up, when there were exactly three channels. And so the setting was always the same. There were two people in a crowded area and it was noisy and one of 'em gets up and says: “my advisor is EF Hutton.” And when EF Hutton says, everybody would stop talking and lean in to hear. And the punchline was “when EF Hutton talks, people listen.” And that is exactly the same situation that we have today with our guest. And the title of today's podcast is AM Best's Industry Outlooks and Potential Impact on Investment Risk. And we are joined by Ken Johnson, CFA, CAIA, FRM, senior Managing Director and Chief Ratings Officer at AM Best. Ken, welcome. Thanks for taking the time. I appreciate you being on. We're thrilled because when AM Best talks, people do listen, so thanks for being on.

Ken: Yeah, no, absolutely appreciate the invite and the opportunity to talk. And I do remember that commercial, Stewart.

Stewart: Yeah, we're kind of dating ourselves a little bit there I think, but that's okay. I actually ride a motorcycle with some guys who are a little younger. They have affectionately called me the old man. I think maybe it's because of my white hair. Maybe it's because I fill the bill. But before we get going too far, I'd love to know where you grew up and what was your first job, not the fancy one.

Ken: Sure. I grew up in the streets of Brooklyn playing all the street games that kids played back then, and my first job was also in Brooklyn. My friend's parents actually owned a deli and so I had the opportunity to work there soup to nuts, from cleaning up to stocking shelves and eventually working behind the counter. And the one thing I really learned from there is really how to deal with people. We had all sorts coming in the door there and it was quite an education from that standpoint.

Stewart: Yeah, I can imagine. Just kind of turning to career journey and your role at AM Best, you've been on a fascinating path. You've been on the capital market side and you've now on the AM Best rating side. Can you walk us through that journey and tell us what your role as Chief Ratings Officer entails today?

Ken: Sure. I think like most of us, we start out thinking there's some linear path to follow to get to the vanishing point of your career, but there were milestones along the way where people are always asking your three to five year plan, but I wasn't sure, I didn't have anybody in my family who was in business. I had one brother-in-law who was an accountant, so that was my guiding light. I took accounting and joined the bank in their controller's department, but I did get the opportunity to go through their credit training program and moving from accounting to corporate finance was really much more exciting for me. So the only downside, I guess, was I was placed in the insurance group and Stewart, as you know, I don't think anybody actively chooses insurance when they were young, but it was a great path for me. I learned a lot, I really enjoyed it.

And I did that for several years right up until the great financial crisis and I was just looking for a home to park myself, somebody with insurance knowledge and AM Best gladly took me on and I really thought it would be a short state, but I ended up really enjoying it. They gave me a lot of opportunity to grow and implement some things. And here I am 16 years later culminating with getting the opportunity to be the Chief Ratings Officer, so responsible for well over 2000 ratings globally, now. I have about 170 analysts globally as well covering the insurance industry. And you may or may not know AM Best is the oldest rating agency out there. We just celebrated our 125th anniversary last year, and all things, all systems go. 

Stewart: Yeah, it's super interesting. I don't think I'm talking out of school here, but your building in  Oldwick New Jersey has a replica of the original office from Mr. Best. Is that still there?

Ken: Yep, it's there. So we have two buildings and the walkway between the two of them is actually where they have that replica of that office. And if you were there, hopefully you got to see it.

Stewart: Yeah, we did. We were guests of John Webber and Lee McDonald there. And shout out to both of those folks. We appreciate all the hospitality we get out at AM Best. So let's talk a little bit about the P&C sector outlook and let me just get right into the meat of it. So AM Best recently affirmed the P&C industry outlook. What are the key drivers behind that rating and what risks are you most closely watching?

Ken: It's sort of a bottom-up approach. We rate several sub-sectors there. So for example, on the personal side, we rate the auto business, which is stable, and we currently have the homeowners still at negative. The main drivers are the profitability potential, the regulatory environment on which insurance companies are operating within that environment. Now, you have to remember these are segment outlooks, so they're sort of like a 12-month view of the conditions that the insurance companies are operating in. But you can have a company within that negative segment view that still gets a stable or a positive outlook because they're outperforming that segment. So there are two different outlooks that we do. One is up broadly on this segment, and one is on the insurance company's rating itself. So the auto industry kind of benefited from price increases they've been able to get, which has restored their profitability, whereas homeowners, that's been a little tougher slog.

Stewart: There's been a fair amount of cats in the homeowners segment as well. So that's interesting. Let's talk about life and annuity for a moment. How does the life and annuity sector compare, and are there unique capital or investment pressures shaping the outlook there?

Ken: Yeah, I mean, you would know Stewart, in the old days, life was a very simple long-term product. You sold it, you put it up on the shelf, you matched it with a long asset and you moved on. But today's insurance industry on the life side is so much more dynamic, so much more interest-sensitive for the products that they write. So the growth is clearly driven by the annuity product, which only accelerated when rates rose in 2022. So the growth on the top line has been tremendous and what it really has forced it is a need for more capital to continue writing that business and has forced a whole cottage industry of small reinsurers set up to take on those books of business so the primary guys can keep writing. So there is a lot going on in the industry right now.

Stewart: Yeah, I mean it kind of leads to the rise of private equity and asset manager-owned insurers and it's one of the hottest topics in our world. What's the best take on the rise of backed and asset manager-owned insurers and how are you evaluating the implications from a ratings and risk standpoint? I said a while ago, the life insurance business has changed more in the last three to five years than it has in the last 30 to 50 years. It's quite a development.

Ken: Absolutely. And as you know, since we're rating almost 95% of the industry, we see all types of ownership structures, and they all get looked at through the same lens from our rating methodology standpoint, but this sort of combination or partnership in some cases with the asset managers has really taken off. So originally you had the insurance guys who owned their own asset managers, like Prudential owning PGIM, right? So that was kind of the standard. And then you had Apollo come in and take over with Athene and KKR with Global Atlantic, so you had that ownership now, direct ownership of insurance companies, you have other situations like Blackstone and Corbridge, where they're basically managing a very large book of business for those companies. Maybe they took a smaller stake from an equity standpoint, but that gave them access to billions in asset management. And then the fourth case is the more recent case where Prudential joined forces with Warburg Pincus and set up a reinsurer. So there's sort of four ways these guys are getting together, but fundamentally it's the same thing to take on sort of intra-sensitive reserves from the traditional carriers and use their origination capabilities to do a really strong ALM match for those products. And maybe I'll stop there.

Stewart: That's interesting, and it seems like we could talk about that quite a bit more. Is there anything else? I mean, I've never really heard it delineated in those four forms. It seems like from the regulatory perspective, which I want to make sure I make clear, AM Best is not a regulator, it is a rating agency. It seems as though the regulator is concerned about the shift to private assets. And I'm going to touch on that in a moment, but is there anything that you guys have noticed about any of those four structures that give you cause for pause at first glance?

Ken: Yeah, at a high level, the allocation is a little bit different for  those guys, it is much more skewed to your point, to the private asset market, because that's sort of the origination strength of those entities. So I would say if there's a pause, it's more so on the lack of transparency. We understand private credit is not one monolithic type of asset. You have direct lending, you have asset-based financing, you have infrastructure, right, and within each one of those, you have different cuts of credit quality. So we don't have a negative view of private credit as an asset class, but the loss of transparency makes it a little more difficult for us. At the end of the day, we're trying to protect policyholders and if we don't have a clear line of sight into the credit quality and the liquidity or illiquidity of this particular asset class, it just makes us work a little bit harder.

Stewart: Yeah, it makes sense. And just kind of shifting over to allocation shifts and offshoring, we're seeing clear shifts or trends, more private credit, real estate debt, and then there's offshore reinsurance from your chair. How do those trends affect balance sheet risk and rating stability?

Ken: Yeah, there's a couple things within that, Stewart. So one of the things that we do when we do our credit analysis is we will work bottom up and top down. So there will be a view taken where that business is actually brought back onto the ceding company with the assets that are used to back the liabilities to see what that looks like. Because what happens is we get a bit of a change in accounting. If they're working in the US and there's statutory accounting, it's very conservative and there's a close look at both the reserves that are set up and the assets that are backing. When you move that offshore, you lose that a little bit. And I'll use Bermuda, for example. They're setting it up on an economic basis, the reserves, so there's a little less conservatism there. And then on the assets side, there's a little more leeway for what they can do on that front too. Now I'll give some credit to Bermuda. They've tightened up their own regulatory environment a little bit last year and they are taking a closer look at the asset side of the balance sheets down there as well.

Stewart: That's super helpful. If we can, I'd love to shift over to the regulatory landscape. As a co-founder of the investment working group, how is AM Best viewing the evolving global regulatory environment? You just touched on it with Bermuda, whether it's NAIC, solvency regimes abroad, or local market changes. What matters the most right now and it really goes to the CIO community that makes up a portion of our audience. There are a lot of moving parts right now. Where should they be focused?

Ken: Yeah, I think I’ll try to blend in our investment working groups. I think it's unique and I'd like to make sure that I talk about that a little bit in responding to your question. We work closely with a lot of the asset managers. In fact many of the individuals you've had on your podcast, we also speak with just to get a feel for what's going on in the market. AM Best is a rating agency. So we're not in the market every day, so we need these kinds of catch-up, but we also understand that the role there for the asset manager is to try to get exposure to a particular risk in the most capital-efficient way. So what we did was we set up this working group internally to sort of take look-through approach to some companies where a company has exposure to say some structured credits or non-traditional assets.

We'll ask a couple of more questions and we'll try to give a fair treatment to it. Our capital model is going to hit it with a sledgehammer. So we understand that. Alright, let's take a closer look and try to get an understanding of what the risk really is. So the working group was put together globally to try to get to the right place with the charge. From the regulatory environment. A lot of it, especially in the US, is focusing on more transparency and we champion any cause that tries to get more transparency. Our aim is to be fair, and if you give us more information, we think we get to the right answer better. So for example, what the NAIC is doing, we're a user of the financial statements. So if they're looking for more transparency, that's going to help us on the backend from that standpoint. But when you talk about regulatory, maybe at a tactical level, maybe what's going on in California where homeowner and auto companies are having a lot of trouble getting rate increases, we watch things like that closely because what that does is is it affects the underwriting profitability and if they're not getting it on the underwriting, they may start to take more risk on the investment side to make up that difference. So there is a cause and effect that we have to be careful doesn't start to occur.

Stewart: That's super helpful. If you were to just summarize a couple of key takeaways for our audience, I don't want to make it too difficult. If you could give us one for P&C and one for life, that would be ideal. But a couple of key takeaways that you want our audience to leave with.

Ken: I think one of the main ones, and it probably crosses both sides, is that we don't dislike any particular asset. And what we want to do is be open in communication, both with our insurance clients and their outsourced asset managers, on what information would help us to get to the right place. So we understand the increase in private credit, but we want to know what the liquidity that that company has? We understand the secondary market is growing, right? They're taking some of the technology used in private equity and moving it over to private credit, but we have to look at it,  What if everybody's running to that door at the same time? So I think it's really important to be able for the insurance company, even if outsourcing just to be able to explain their investment strategy to us and what they're looking to accomplish and what sources of liquidity they have available for sort of stress scenarios.

PC obviously depends on the line of business. You have shorter tail business where you have event risk, and we would expect the portfolios to sort of reflect that. And then on the longer-term lines, there's a little more room to play with the illiquidity, which the insurance industry has been sellers forever into the illiquidity market. And on the life side, it really does come down to matching and liquidity as well. There really hasn't been an arms race in this market, so you don't have somebody trying to run out ahead, which could create a huge surrender run. We have seen surrenders but not at any kind of pace that would give us any cause to pause at this time.

Stewart: That's super helpful. So one of the things we've been asking lately, Ken, is about adding to the people on your team, and you'd mentioned 170 analysts. When you're looking to add folks to your team, what characteristics do you look for when you're speaking with someone, not necessarily their hard skills like Excel or whatever, or the school that they went to, but really more characteristics of the person?

Ken: It's a great question, Stewart, because one of the things I look back on my career coming out of credit training, it's sort of level set, right? We're all taught how to do credit analysis and then we were thrown out into the world, but at least we had a base knowledge. What you see now and what we certainly see at AM Best is people are coming in with different backgrounds. So what we really try to look for or people who have intellectual curiosity, this is not a green eye shade type of job anymore. We really need people to look at something and say, “Hey, that doesn't look right,” or “I don't really understand the connection here.” So I think a couple of years ago we started what we call an AA program. We're taking kids out of college, and for two years, we run 'em through a rotation program through the different segments.

And I think that's really helped us bring what I said earlier, that level setting in talent, when we really start to give them some real juicy work to work on. So I think having that intellectual curiosity, being able to speak because the other thing that people underestimate is you're taking young people and you're sitting them across with the CEO of a company and saying, “Hey, I think you screwed up here” and it's not easy to do when you're young. So I think having people have the confidence in themselves and being able to talk to people across the table, it's really an underrated skill.

Stewart: I will go on my soapbox, Ken, if you'll hang on to me while I'm up here. Not only is AM Best a great place to work, but the insurance industry, I've been beating that drum for years with students. It's not necessarily the most well-known track, but it certainly has been good to a lot of people that I know, and I'd really encourage students who might be listening to consider the insurance industry and particularly AM Best when you're looking for a career. The fun one I have for you on the end is you can have dinner with up to three guests. They can go one, two, or three, they can be alive or dead. Who would you most like to have dinner with, alive or dead?

Ken: Interesting, and I think the first one, being a Brooklyn boy, I'd like to sit down with Branch Rickey and talk to him about his vision of sort of breaking the color barrier and what he had to do to work with Jackie to get through that. I think it would be fascinating. Secondly, maybe a younger Steve Jobs in today's market and maybe what he would be thinking about this whole AI, and what he thinks he could do in this type of market. And the third one's maybe a little more personal, but for my entertainment, I think Groucho Marx.

Stewart: Wow.

Ken: I have a pretty good sense of humor and a quick wit, but I'd love to sit with the master.

Stewart: That's so cool. What a great table that would be, huh? That's super cool. I really appreciate you. I really appreciate you taking the time. It's been great to have you on, Ken. I really have enjoyed the conversation. I've learned a lot. Appreciate you taking the time.

Ken: Absolutely, Stewart. Not only do I appreciate it, I want to say that I'm a big fan of your website and what you're doing for the insurance investment community, so always happy to chat.

Stewart: Oh, thank you so much. I really appreciate that. We've been joined by Ken Johnson, CFA, KAIA, and FRM, senior Managing Director and Chief Rating Officer at AM Best. Thanks for listening. If you have ideas for a podcast, please shoot me a note atStewart@insuranceaum.com. Please rate us like us and review us on Apple Podcasts, Spotify, Amazon, or wherever you listen to your favorite shows. We are the home of the world's smartest money@insuranceaum.com. We'll see you next time.