While other insurance companies watched their investment portfolios bleed losses during the financial crisis, The Guardian Life Insurance Company of America’s balance sheet came through the period very much intact. The New York-based mutual life insurer had less than 2% of invested assets in asset-backed instruments and no exposure to CDOs, CLOs, or structured investment vehicles.
That was no accident, says Robert Broatch, Guardian’s finance chief and executive vice president of finance, risk, and operational excellence. The insurer does its own fundamental credit analysis and uses models to understand its capital adequacy, and nine months before Lehman Brothers collapsed it had modeled a Great Depression-like scenario. (Guardian’s actual performance in 2008 and 2009 fell within $100 million of the model, says Broatch.)
Still, Broatch had plenty to do to steer the $31 billion (in assets) private company through the crisis. He diligently tracked Guardian’s capital position and policy withdrawals for any hint of market deterioration or panic, and used hedges to protect the insurer’s downside risk.
Today, Broatch has a new set of priorities. With Washington bearing down on financial-services companies, compliance risk is a growing threat. The state of the financial markets also poses a unique double-barreled challenge to the life-insurance industry. In a recent interview with CFO, Broatch discussed his concerns about regulatory reform and how his finance department is now modeling a new, perhaps scarier, economic scenario: a Japan-like cycle during which interest rates stay depressed for the better part of the next decade.
The following is an edited version of CFO’s interview with Broatch.
While Guardian didn’t invest in complex securities or pour money into derivatives, it did make a big change in its portfolio after the collapse of Lehman Brothers in September 2008. What was it?
We had quite a bit of common stock, and since it’s marked to market, it can bring your capital base down very quickly. One of our risk-management techniques is to be 100% out of stock if our capital is ever threatened. The chief investment officer, the CEO, and I met and asked, Are we going to pull the trigger on this and get out of the market? It was a tough decision. On September 16, when things really fell apart, we had well over $1 billion in stock; the next day we were effectively 100% out of [equities] as a result of our dynamic hedging program.
What saved you on the liability side?
We didn’t do anything crazy with products. Many insurers that experienced trouble had products with guarantees associated with them, like variable annuities. They promised guaranteed incomes, and the assets were invested in stocks, so there was a big earnings gap. We had a small variable-annuity business, with risk limits around it. Guarantees can produce a lot of growth in no time at all; we didn’t chase growth.
So much of risk management is good judgment and knowing where your risks are. The one thing we did was to stick to our limits. Companies failed not because their practices were wrong but because they didn’t adhere to them.
What areas of risk management are getting your attention now?
We’re very focused on compliance risk management. We have a new chief compliance risk officer at the corporate level, and we’re escalating the role of the chief compliance officer in our business units to be a senior member of the staff. We’re also conducting formal assessments on risk identification and mitigation to deal with any gaps.
Not that we ever had any serious compliance problems, but I think the tolerance for compliance infractions is less than it has ever been. It’s zero tolerance. We’re watching regulatory developments in Washington and the states closer than ever, and stepping up our involvement in the process. I think regulatory bodies are looking to raise money through fines and to make examples of companies. The whole regulatory environment is getting tougher.
While the Dodd-Frank bill doesn’t have much effect on Guardian, are there other regulatory reforms to worry about?
At the state level there is one law that directly affects us, which involves agent-compensation disclosure on life insurance. We haven’t had to deal with it yet. They’ve had it in the U.K. for a while. It’s related to current efforts to provide even more consumer transparency to financial-services transactions.
There are also proposals to tax the insurance industry that are not particularly threatening. But in the end we will have to pay more state and federal taxes as an industry. I see that as indirect fallout from this whole financial mess.
Small-business owners are a big slice of your customer base. How have their woes affected your business?
People ask me if the recession has impacted the ability to sell into this market; in life insurance it has not. Small-business owners buy life insurance for key-man and succession planning. Our agents produce the highest average premium in the industry because they target the wealthiest small-business owners. Even in disability insurance our sales have held up. Our loss experience is running opposite to what you’d think, too. Everyone says people [are more likely] to go on short- or long-term disability in a down economy. But we’ve found people are fearful of leaving the workplace and never getting their jobs back.
What on the economic front concerns you?
We see the slow economic recovery most clearly in the returns on the investment portfolio. We’re now predicting new money going into bonds going to work at less than 5% — that’s down 100 basis points in the past 9 to 12 months. To the extent that our investment income is lower, we earn less money. We’re modeling all sorts of scenarios out five or six years to understand what [happens] if this is a protracted environment with cyclically long low interest rates.
How do you mitigate the impact of low interest rates?
We’re being careful not to lock in 30-year bonds. We also bought some very out-of-the-money hedges a year ago, before the rates dropped for our
interest-rate-dependent products. So if interest rates go down we get some big payoffs on these hedges. We have guaranteed products, but the minimum interest rates are well below what we’re earning right now. They’d have to stay down for five or six years for this to emerge as a problem.
But on the [liability] side, lower interest rates mean higher reserves, because we carry our reserves at the present value of future benefits. [Low interest rates] get you on both sides of the balance sheet. Ultimately, if rates stay down, some products will have to be repriced, like a disability product, which provides income for life if you’re disabled. It has a certain interest-rate assumption in it. Everyone in the industry will have to reprice, so it ripples not just through [a company's] reported results but also through the pricing and economics of these products.
Does the sustained lull in the economy also present opportunities?
This economy offers opportunities to go into asset classes where we were underweighted in the past. We recently partnered with Lowe, a well-known real estate organization that syndicates real estate investments in things like hotels and resorts and other real estate ventures. We’ll be looking opportunistically for investments where we may be underweighted and which offer good upside in this economy.