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We explain how SMAs have led to a wide dispersion in results, large deviations from standard benchmark returns, and in many cases underperformance.


For U.S. property and casualty (P&C) insurers, public equity investments diversify risk in income-oriented portfolios, typically offer higher expected returns than fixed income securities and provide a ready source of liquidity. They have regularly made up the second-largest allocation in P&C portfolios after fixed income and currently account for nearly 10% of total non-affiliated investments.* P&C insurers hold most of their equity investments in separately managed accounts (SMAs). The low-turnover, buy-and-hold strategies of many SMAs, while allowing for precise control of the timing of realized gains and losses for tax purposes, have led to a wide dispersion in results and large deviations from standard benchmark returns—with substantial under performance in many cases, as our analysis shows.

P&C companies have allocated a much smaller portion of equity investments to funds and exchange-traded funds (ETFs). These allocations trade the ability to manage tax outcomes for the SMA’s ability to track a benchmark at low cost or gain access to skilled managers who can potentially outperform a benchmark. We believe insurers should give this trade-off serious consideration, weighing the advantages of a buy-and-hold strategy against the drag it can impose on returns that chronically lag an established benchmark.

*These figures exclude Berkshire Hathaway and State Farm, whose large equity allocations skew the industry totals upward.

Watch your taxes, but mind the GAAP

The fundamental appeal of a buy-and-hold approach to equity investing is its capacity to defer taxes indefinitely by not realizing gains. We believe that conventional wisdom can overestimate these benefits. Realizing gains (or losses) on equities is neutral from both a statutory surplus and a GAAP equity perspective, since unrealized gains on common stock in non-controlled investees generate deferred tax liabilities (DTLs) under both statutory and GAAP accounting. When P&C investors take a gain on an equity investment, it is true that cash goes out the door to pay taxes. From an accounting perspective, however, the offsetting reduction in DTL neutralizes the effect on statutory surplus of taxes paid on the realized gain. The realized gain on equity is neutral on the GAAP balance sheet as well, because the reduction in the associated DTL offsets the tax paid.
A few stocks outperform the index over their lifetime—by a substantial margin—but most lag

Exhibit 1: Distribution of excess lifetime returns on individual stocks vs. Russell 3000, 1980-2014

This is not to say that realizing gains on equities has no financial-statement downside whatsoever. Public P&C insurers can categorize their holdings as available for sale (AFS) under GAAP provisions. The realized gain from the liquidation of an AFS holding shows up as a single-period increase in GAAP income from continuing operations—and thus increases GAAP-income volatility.

Concentration and its consequences

Obviously, not every P&C separately managed account consists of concentrated stock positions. (SMAs can avoid concentration risk by adequately diversifying, even if an easier way to avoid it would be simply to invest in diversified funds or ETFs.) Nevertheless, sizing up the historical costs of concentration may illustrate the value of avoiding it. We measured the price returns of each of the constituents of the Russell 3000 Index against that of the index as a whole over a 34-year period, from the beginning of 1980 through 2014 (EXHIBIT 1). The median stock underperformed the Russell 3000 by 54% during the period, and two-thirds of all the stocks lagged the index’s price return. That still left room for substantial outperformance in fact, about 7% of the index universe achieved returns two standard deviations or more above the mean but the findings clearly imply that a concentrated portfolio is likely to underperform the broad market.
This broad divergence in outcomes implies that deviations from benchmark indexes that result in concentrated portfolios can lead to extreme investment outcomes, either underperformance or outperformance, relative to broad benchmarks. Underperforming the market could lead to difficulty in matching the insurance pricing of competitors. And although extreme outperformance could provide a windfall to shareholders, this is not the purpose of an insurance company. We suspect a typical shareholder would not expect an insurance company to generate value through concentrated equity positions.

The who and how of P&C stock ownership

Since 2005, publicly traded equities have constituted between 5% and 9% of P&C unaffiliated assets (EXHIBIT 2A). The range reflects the volatility of the equity market itself, falling off from a peak over the course of the financial crisis and resuming a more normal trajectory in the ensuing recovery. In all, publicly traded equities have regularly constituted the largest component of P&C investment portfolios, after the traditional heavy allocation to investment grade fixed income. The 5% to 9% portfolio average masks a wide disparity of equity holdings within the P&C sector, however (EXHIBIT 2B). Of 1,229 reporting companies in 2013 statutory filings, two-thirds had holdings of less than 10%. In fact, more P&C insurers had holdings of 1% or less (437) than had at least 10% of their assets invested in public equities (411).
P&C sector’s allocation to equities has varied with overall market performance

Exhibit 2a: Aggregate investments for U.S. P&C insurers*

Only about one-third of the P&C sector holds significant equity portfolios

Exhibit 2b: Number of P&C insurers vs. equity holdings as a percentage of unaffiliated assets

Analyzing P&C portfolios over the 10 years ended in 2013, we found that P&C companies with Schedule D equity investments valued at or above $50 million held between 80% and 85% in SMAs. Mutual funds and ETFs grew from just under 6% of aggregate P&C equity portfolios in 2004 to 10% by 2013 (EXHIBIT 3) . Fund holdings surged in particular during the crisis year of 2008, going from just under 6% to nearly 10.5% of the equity total.
Fund and ETF share of P&C equity portfolios jumped during the financial crisis and has remained steady

Exhibit 3: Investment vehicles used by P&C insurers with equity investments greater than $50 million

Happy mediums

Asset turnover has been minimal since 2008, as changes in unrealized gains have dominated the total equity returns for P&C investors (EXHIBIT 4). Indeed, the small contribution to return from realized gains indicates how minimal asset turnover has been. Even in 2013’s monumental rally, which would have occasioned sizable rebalancing in a gain-oriented portfolio, realized gains contributed only about one-fifth of total P&C equity return.
P&C insurers have not “realized” most equity performance going back to the financial crisis

Exhibit 4: Components of P&C equity returns

Since 2008, notwithstanding the wide dispersion, the P&C sector’s median pre-tax returns have largely matched the S&P 500 index’s, with somewhat less volatility (EXHIBIT 5). That means, of course, returns of approximately flaf the sector ahve lagged. Simply performing in line with the index would have enabled policyholders and private company shareholders at half the companies surveyed to participate to a greater extent in the stock market’s subsequent rebound, which would have led to increases in GAAP equity and statutory capital generation. Put another way, half of the 118 companies whose returns are plotted in Exhibit 5 endured the period’s exceptional volatility and still ended up trailing the index. The group of underperformers includes 19 companies that trailed the S&P by more than 300 basis points per annum over seven years.
Median P&C equity investment performance has matched the S&P 500 and Russell 1000

Exhibit 5: Annualized equity return and volatility
The long-term dispersion, as significant as it is, doesn’t really reflect the year-to-year variance. In the crash of 2008, the spread between the top-performing equity portfolios in the 90th percentile and the back of the pack in the 10th percentile amounted to 31 percentage points (EXHIBIT 6). In the subsequent rebound year of 2009, it came to 25 percentage points. Dispersion this wide, with its impact on statutory surplus, can undermine the pricing flexibility of the laggards, placing them at a serious disadvantage in the notorious swings of the P&C business cycle. As Exhibits 4 and 5 have both shown, median P&C equity portfolio returns tend to track the S&P 500. In other words, if a 10th percentile insurer had invested in a low-cost, low-tracking-error index fund, it might have narrowed the downside dispersion, resulting in a “median-like” return and therefor fairing better in that year.
Median P&C equity investment performance has matched the S&P 500 and Russell 1000

Exhibit 6: Comparison of 10th and 90th percentile returns
among P&C insurer equity performance

Fund appeal

The case for fund investing has evidently gained the greatest traction among insurers with smaller equity holdings, as a non-dollar-weighted look at P&C equity investments reveals (EXHIBIT 7). The lines on the scatter chart below show a doubling in the use of mutual funds and ETFs in the decade following 2004, from 13% to 25%. The points on the chart demonstrate that most of the trend derived from insurers with smaller equity holdings. This relatively broad adoption leads us to infer that funds have afforded smaller portfolios access not only to global markets and specialized equity investments, such as those with an income focus, but to low-cost, index-like returns as well.
Smaller portfolios are driving the sector trend to mutual funds

Exhibit 7: Allocation to mutual funds by equity portfolio size

Conclusion: avoiding the downside

Equity investment portfolios have served P&C insurers well. Aggregate industry performance has tracked broad benchmarks like the S&P 500, and equity holdings diversify predominantly fixed income holdings. But equity portfolios have underperformed for many insurers in no small part because in focusing on low turnover insurers have drifted away from benchmarks.
Our findings indicate that P&C insurers should question whether they have over-emphasized tax efficiency at the expense of performance, especially at the risk of dramatic underperformance relative to the industry and broader benchmarks. We believe that fund strategies that provide automatic diversification and performance in line with benchmarks, such as ETFs, index funds and low-tracking-error active funds, could better serve many insurers. Beyond these standard solutions, the marketplace today offers SMAs designed to consistently outperform benchmark equity indices by exploiting small risk budgets and SMAs that closely track a benchmark while allowing for customization related to investment strategy or realized gains and losses.
In our view, the wider adoption of benchmark-like strategies, whether in fund or SMA formats, will ultimately lead to more consistent P&C equity portfolio returns and greater stability in the insurance industry.

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The material was prepared without regard to specific objectives, financial situation or needs of any particular receiver. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. The results of such research are being made available as additional information and do not necessarily reflect the views of J.P. Morgan Asset Management.
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Take stock: Equity investing for P&C insurers
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