Strategies Insurance Companies Continue to Contemplate in the Current Low Interest-Rate Environment

Topic Paper September 23, 2014 Strategies Insurance Companies Continue to Contemplate in the Current Low Interest-Rate Environment INSURANCE INVESTMENT INSIGHTS FROM FRANKLIN TEMPLETON FIXED INCOME GROUP Michael J. Materasso Senior Vice President Co-Chair, Fixed Income Policy Committee Franklin Templeton Fixed Income Group Christopher Franta, CFA Vice President, Senior Product Manager As insurance companies continue studying how to invest in today s low interest-rate environment, we have seen a few opportunities where these companies have been increasing activity. Because insurance company assets have been growing at about $0.5 trillion a year as of June 30, 2014, companies have been wondering where to put that money to work in this low interest-rate environment. We see life insurance companies concerned about disintermediation risk. Their assets grow by about $200 $300 billion a year and with most of them invested in investment-grade fixed income assets. How do these companies find other highly rated securities to complement how they currently invest? Do tax-exempt munis make sense even though insurance companies cannot take advantage of the taxexempt status? Do bank loans and high-yield securities make sense? Are the spreads too tight? Property and casualty (P&C) insurers have an interesting conundrum: Capital and surplus is at record-high levels and premium-to-surplus ratios are at record-low levels. Also, for the first time in the past few years, their average combined ratio was below 100%. This trend has led P&C companies to think about potentially adding munis or increasing their existing allocation to munis. Health insurance companies have also seen a growth in assets related to the Affordable Care Act (ACA). An increase in Medicare members resulting from aging baby boomers, an increase in the Medicaid population and annual medical inflation have led health company assets to grow by about $50 billion a year as of June 30, 2014. Health companies, with their short tail liabilities, high combined ratios and highly liquid assets, are also looking for solutions to increase overall net income on their investment portfolios. Although each insurance sector has different conundrums to deal with, all have one thing in common: How do they increase investment income without taking on too much risk in this low interest-rate environment? With these thoughts in mind, we plan to look at a few strategies that you may want to consider in the current interest-rate environment. First, let s take a step back and discuss what is currently going on in the market. US Expansion Poses Treasuries Quandary The aggressive monetary policy of the US Federal Reserve (Fed) may have distorted normal market signals and affected US Treasury yields. How can insurance companies position their portfolios for rising interest rates while still meeting their investment objectives? Having expanded at an annualized rate of 4.2% in the second quarter of 2014, the US economy continues to show solid growth as we move through the third quarter. Retail spending data were

slightly weak during July, and job growth was lower than expected in August according to initial estimates by the Bureau of Labor Statistics. The Fed s Beige Book survey of activity from US federal districts around the country signaled that economic activity largely picked up during the summer after the soft patch at the beginning of this year. The Beige Book survey, based on data collected before August 22, did assert that none of the districts pointed to a distinct shift in the overall pace of growth, suggesting that expansion was solid but not spectacular. Other measures of economic health released in recent weeks have been more resolutely positive. Record exports helped push the US trade deficit to its lowest level in six months in July, for example. And purchasing managers index (PMI) reports for August showed that activity in the US manufacturing and services sectors was growing much faster than in Europe or Japan, or even in China, while continued strong monthly job gains (which ran at over 200,000 per month for the six months up to July) suggest that consumer spending should pick up again. While the Fed has acknowledged the improvement in labor market conditions and the fading of downside risks to inflation, Fed Chair Janet Yellen presented a relatively balanced view of the direction of monetary policy during her address to the Jackson Hole, Wyoming, gathering of central bankers in late August. Yellen said that the Fed was not on a preset path but pointed out that while employment was improving, wages were creeping up at a glacial pace, which she took as an indication of lingering slack in the economy. In general, judging by the markets mild reaction, Yellen was deemed to have done nothing to change expectations that the Fed will start raising rates around the middle of next year. Expectations that the Fed will not move to normalize policy until well into 2015, and that the European Central Bank (ECB) will be forced to be even more accommodative before then, have dragged yields on benchmark long-term German Bunds below those for comparable US Treasuries helping explain why Treasuries have continued to deliver robust returns this year. Ultra-loose monetary policy in Europe and Japan has led to a strengthening of the US dollar, thus boosting returns for foreign investors in Treasuries. The continued rally in long bonds is also in part due to geopolitical concerns in the Middle East and Ukraine. Thus, the global reach for safety and yield is driving demand for long-dated Treasuries and trumping fundamentals. There is also widespread expectation that even after the Fed embarks on monetary policy normalization, rate increases will be modest. But Treasury yields have fallen below the point where even a dovish Fed has been saying rates will be over the next few years. The Federal Open Market Committee s (FOMC s) median projected level for the federal funds rate at the end of 2015 and 2016 has increased consistently this year, which indicates that the Fed but not the market sees a continuation of the progressive improvement in the economy. Thus, there is the suspicion in some quarters that the prolonged Treasury rally will quickly wither if the recent job gains stick and wages rise, thus forcing the Fed to tighten policy faster than expected. Already, the short-term unemployment rate, which tends to be a leading indicator for wages, has been falling, thus likely increasing inflationary pressures. Chart 1: US Treasury (UST) Yield Curve Year-to-Date Change Year End as of December 31, 2013 and Current as of August 31, 2014 Source: Bloomberg LP. 5Y 10Y 15Y 20Y 25Y 30Y UST Year End UST Current The yield curve has flattened in recent months, as short- and medium-dated US paper has not shared in the long-term Treasury rally. Reflecting the prospect of rate increases beginning in 2015, the two-year Treasury note yield was sitting close to a 27-month peak at the beginning of September an indication of growing concern over the timing for the first interest-rate hike. A flattening yield curve is often considered to be an indication that fixed income investors foresee an environment of slowing economic growth. But given the distortions caused by aggressive Fed policy, the signal may not be accurate. While some parties fret about a slowdown in the potential US growth because of the country s aging demographic structure and growing public debt, the United States continues to surprise. American corporates remain persistently efficient. The country s dependency on imported energy has diminished, turning oil from one of the most volatile commodities into one of the least. Together with the large expansion of renewables, shale extraction is creating more domestic supply, helping keep energy costs low for US businesses and consumers. Strategies Insurance Companies Continue to Contemplate in the Current Low Interest-Rate Environment 2

One can conclude from the above commentary that there seems to be a disconnect with the solid performance of the US economy and the level of yields on Treasuries as well as securities priced off of Treasuries such as investment-grade corporates, high yield and mortgage-backed securities. Factors pushing yields lower in the United States include easy global central bank policy, global tensions in Ukraine and the Middle East, the relative attractiveness of Treasuries versus southern European sovereign debt, and the dovish disposition of Janet Yellen. We believe investors ultimately will focus on economic fundamentals as the US economy continues to grow more consistently at or above trend, resulting in a lower unemployment rate and less deflationary slack in the economy. Over the next 12 months, we expect the yield curve to continue to flatten with rates rising across the entire maturity structure. How should insurance companies position their portfolios for rising interest rates while still meeting their investment objectives? Two sectors of the fixed income market that have historically had defensive characteristics with regard to a rising interest-rate environment but may still help maintain an attractive yield profile are bank loans and high yield debt. Both sectors provide attractive income profiles over Treasuries yields. One additional defensive characteristic these sectors share is that credit spreads on loans and bonds have typically maintained or tightened to Treasuries as the Fed initially raises rates (moves to neutral monetary policy) because the economy and corporations are performing well during this period. In addition, bank loans have minimal interestrate duration as their coupons float and are LIBOR based, and they should rise as the Fed raises short-term interest rates. Finally, the municipal bond sector possesses several of the positive attributes sought by many insurance companies, and is discussed in the Spotlight section below. Spotlight Focus: Municipal Bond Sector Over the past 12 months, the municipal bond sector has become more prominent in our discussions with insurance companies. In our view, this trend is due to a few key reasons. The first and most important reason is the relative value the sector has provided recently. Since the market is driven primarily by the individual tax-paying buyer, the market can be subject to periods of volatility due to extreme changes in demand. This is exactly what we saw in the second half of 2013 during which the muni market saw significant outflows that created a very strong buying opportunity. Insurance companies, both taxpayers and nontaxpayers alike, were able to take advantage of that opportunity as muni yields were much more attractive than other areas of investment-grade fixed income on a nominal basis as shown in Chart 2. Chart 2: Yields as of December 31, 2013 5.50 5.00 Source: Bloomberg LP. 2Y 5Y 10Y 15Y 20Y 25Y 30Y AAA Muni US Treasury AA Corp A Muni This opportunistic buying across the insurance industry proved to be very lucrative as the sector has rebounded off the lows in 2014, providing strong total return and income opportunities. These opportunities have been more frequent in the post-crisis period, which we expect to continue, highlighting the need to keep a constant eye on this unique sector. Another key reason we believe insurance companies have become more interested in the municipal bond sector is the recent change in their operating environment. Across the broad P&C industry, we have seen a strong improvement in operating metrics. This improvement, which has included a combined ratio below 100 for the first time since the financial crisis ended in 2009, has caused the tax situation for many of these companies to change. Table 1: P&C Industry Combined Ratio As of December 31, 2013 2009 2010 2011 2012 2013 Combined Ratio 100.41 102.52 108.35 103.15 96.35 Source: SNL Financial LC. Contains copyrighted and trade secret material distributed under license from SNL. For Recipient s Internal Use Only. Specifically, we have seen an increase in the number of P&C insurance companies that have become taxpayers. This trend has led to an increased focus on the municipal bond sector, which provides an attractive opportunity today at the most common tax rates. Strategies Insurance Companies Continue to Contemplate in the Current Low Interest-Rate Environment 3

Chart 3: Yield Comparison As of September 3, 2014 5.50 5.00 AAA Muni AAA Muni After Tax US Treasury AA Corp A Muni A Muni After Tax 10Y 25Y Source: Bloomberg LP. After tax rate assumes 28% AMT tax rate. This increased demand for the muni sector by insurance companies is a natural rotation for them as the asset class has several positive attributes insurance companies are focused on for their general account investments. First, it is generally a very high-quality asset class. A vast majority of the market is investment-grade rated with issuers primarily focused on providing essential services to the municipalities they serve. This high-quality characteristic is advantageous for insurance companies as it means a lower capital charge versus riskier asset classes. Second, historic municipal default rates have been lower than their corporate counterparts, even for investment-grade issuers. These lower default rates can give the asset class an advantage when it comes to cash flow testing as they should be superior for cash flow testing scenarios. Finally, the underlying fundamentals of this asset class as a whole have remained strong throughout the recent periods of volatility. We believe this strength should give insurance companies confidence in making allocations as the relative value becomes attractive or their operating situations change. In terms of allocating to the asset class, we have worked with insurance companies on a variety of potential solutions to meet varied needs. Many solutions include more traditional high-quality, intermediate allocations, while others have included more customized approaches that may focus on more credit-driven issues down the credit spectrum. We have also seen an increased enthusiasm for cross-over mandates. As the relative value in the market can change very quickly, a cross-over approach may prove beneficial as it allows the manager the ability to quickly allocate across the various sectors of fixed income in a more efficient way, focusing on after-tax relative value. At Franklin Templeton, we have the luxury of leveraging our 30-plus years of both tax-exempt and insurance experience and our $70+ billion municipal bond platform to work with insurance clients in developing customized solutions to meet their needs. A WORD ABOUT RISKS High-yield debt securities (including loans) and unrated securities of similar credit quality ( high-yield debt instruments or junk bonds ) involve greater risk of a complete loss of an investment, or delays of interest and principal payments, than higher-quality debt securities. Issuers of high-yield debt instruments are not as strong financially as those issuing securities of higher credit quality. High-yield debt instruments are generally considered predominantly speculative by the applicable rating agencies as these issuers are more likely to encounter financial difficulties and are more vulnerable to changes in the relevant economy, such as a recession or a sustained period of rising interest rates, that could affect their ability to make interest and principal payments when due. If an issuer stops making interest and/or principal payments, payments on the securities may never resume. These instruments may be worthless and an investor could lose its entire investment. The prices of high-yield debt instruments fluctuate more than higher-quality securities. Prices are especially sensitive to developments affecting the issuer s business or operations and to changes in the ratings assigned by rating agencies. In addition, the entire high-yield debt market can experience sudden and sharp price swings due to changes in economic conditions, stock market activity, large sustained sales by major investors, a highprofile default, or other factors. Prices of corporate high-yield debt instruments often are closely linked with the company s stock prices and typically rise and fall in response to factors that affect stock prices. High-yield debt instruments are generally less liquid than higher-quality securities. Many of these securities are not registered for sale under the federal securities laws and/or do not trade frequently. When they do trade, their prices may be significantly higher or lower than expected. At times, it may be difficult to sell these securities promptly at an acceptable price, which may limit an investor s ability to sell securities in response to specific economic events or to meet redemption requests. As a result, high-yield debt instruments generally pose greater illiquidity and valuation risks. Substantial declines in the prices of high-yield debt instruments can dramatically increase the yield of such bonds or loans. The decline in market prices generally reflects an expectation that the issuer(s) may be at greater risk of defaulting on the obligation to pay interest and principal when due. Therefore, substantial increases in yield may reflect a greater risk by an investor of losing some or part of its investment rather than any increase in income from the higher yield that the debt security or loan may pay to an investor on the investment. Strategies Insurance Companies Continue to Contemplate in the Current Low Interest-Rate Environment 4

IMPORTANT LEGAL INFORMATION This article reflects the analysis and opinions of the authors as of September 23, 2014, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. This information is intended solely for institutional investment management consultants interested in Franklin Templeton institutional investment advisory services. Various account minimums or other eligibility qualifications apply depending on the investment strategy. This document has been prepared for circulation to persons reasonably believed to be within one of the professional or qualified investor exemptions contained in the applicable regulations of their jurisdiction or to whom this document may otherwise lawfully be communicated to give preliminary information about the investment advisory services described herein. It is a confidential communication to, and solely for the use of, such persons and is not intended for public or financial advisor distribution. Because market and economic conditions are subject to rapid change, the analysis and opinions provided are valid only as of September 23, 2014. The commentary does not provide a complete analysis of every material fact regarding any country, market, strategy, industry or security. An assessment of a particular country, market, security, investment or strategy may change without notice and is not intended as an investment recommendation nor does it constitute investment advice. Statements about holdings are subject to change. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. This material is not an offer to buy or sell securities or an offer of investment advisory services and is not intended to be, nor should it be used as, investment advice; it may not be copied or distributed without the prior written consent of Franklin Templeton Investments. The services described herein would be provided to insurance companies or accounts of, or affiliated with, insurance companies; such services would not provide any insurance or guarantee for the subject assets principal value will fluctuate and may be lost. All investments are subject to risks and investment strategies may not achieve the desired results. CFA and Chartered Financial Analyst are trademarks owned by CFA Institute. Franklin Advisers, Inc. One Franklin Parkway San Mateo, California 94403 www.ftinstitutional.com/iam franklintempletoninstitutonal.com Copyright 2014 Franklin Templeton Investments. All rights reserved. 9/14