Should P&C insurers change investment mix after new tax law?

A coach may have an ideal game plan for success, but if the rules change, the strategy must evolve as well. Property & casualty insurers can expect to see the rules of the game change this year: New tax laws will likely require them to make significant changes in how they play the game, including a fresh look at their long-time investment strategies.

The changes in federal tax laws offer some clear homerun opportunities for growth: They will likely improve the bottom line for most P&C insurers. The reduction of the federal corporate tax rate to 21% from 35% will generally be a positive for insurers’ net income.

The change in tax rates, however, also lowers the appeal of tax-exempt municipal bonds, a heretofore staple of P&C investment portfolios. How should insurers respond? Conning expects many to replace at least a portion of their municipal bond allocations with more attractive taxable assets.

Increased exposure to corporate credit is certainly one possible change, but those insurers seeking to maintain fixed-income portfolio quality and diversification may also want to consider other strategies in their playbook, such as higher quality structured securities, taxable municipal bonds, commercial mortgage loans and private placements.

Related: Insurers’ good fortune may need more than a capital idea

Less roster space for tax-exempt munis?

In addition to the lower corporate tax rates, the new law also increases the proration rate, which is the portion of tax-exempt income insurers must add back to taxable income, to 25% from 15%. This maintains the effective tax rate on municipal-bond income of 5.25%, which doesn’t help municipal bonds’ appeal.

Moving away from tax-exempt municipal bonds would be a significant change because the asset class comprises on average one-third of P&C investment portfolios, with some insurers far exceeding that ratio.

However, the yield environment has now changed. The yield curve for tax-exempt municipal bonds at the new tax rate is less appealing than that for an A-rated corporate bond, at least until we reach maturities of 15 years or greater. As a result, Conning expects P&C insurers will reduce their portfolio allocations to tax-exempt municipal bonds to between 10% and 25% from 33%. (Ironically, the elimination of the Alternative Minimum Tax [AMT] makes it easier to invest in municipals, as insurers no longer need to compare portfolio allocations with and without tax-advantaged municipal bonds with regard to potential AMT impact.)

This should not drive major changes in the dynamics of the municipal bond market, as retail investors make up 86% of the $3.8 trillion market. Retail demand is expected to remain strong, as individual tax rates have changed little while state and local tax deductions were capped.

Related: Calif. issues first ever stress test to evaluate climate risks to insurers

Substitutes for corporate bonds

Corporate bonds seem the most likely candidate to gain in this allocation shift. Government bonds don’t offer enough spread, and P&C portfolios are already heavily invested in commercial mortgage-backed securities and asset-backed securities. Corporate bonds, currently comprising about one-third of all P&C portfolios, may rise to nearly one-half.

This too poses risks, however. P&C portfolios’ overall credit quality may suffer as the average corporate bond credit rating is four notches below the average municipal bond rating. Adding to the corporate bond allocation also will make it harder to underweight BBB rated bonds, as half the corporate market is rated BBB.

Alternatives to higher corporate bond allocations include:

• Commercial mortgage loans — Although not a common allocation in P&C portfolios, mortgage loans are 12% of the average life insurance company portfolio. They can carry high credit ratings, offer attractive income and can be an inflation hedge.
• Collateralized loan obligations (CLOs) — These asset-backed securities have floating interest rates, a valuable feature should interest rates rise, and offer investment-grade-rated opportunities with relatively attractive income.
• Taxable municipal bonds — These are now more attractive due to lower tax rates.
• Private placements — Privately issued corporate bonds yielding a premium to similarly rated public corporate bonds, these securities may include covenants for enhanced investor protection. Issuers may not participate in public bond markets, providing investors with potentially greater diversification.

Related: Swiss Re ‘open’ to anchor investor as SoftBank talks fail

A steady hand for playing under the new rules

The end game for P&C insurers hasn’t changed; they seek investment strategies that will support their business objectives within a reasonable risk profile. However, some of the rules have changed, affecting the relative attractiveness of securities within the fixed income market. As a result, insurers will need to modify their investment strategies to continue to be successful. Conning suggests insurers seek highly experienced advice in navigating the new laws and work closely with a partner who has a deep understanding of the nuances of their highly complex businesses.

Related: Hey InsurTechs: Here’s why you will likely fail

Scott E. Daniels, CFA, CPA, is a managing director at Conning, where he heads the insurance advisory team responsible for developing strategic asset allocations. He can be reached at Scott.daniels@conning.com.