Like in life, there are no guarantees in financial markets. We say that to clients all the time, particularly to ground them after we explain a high-conviction trade. A prospective client recently remarked, “Well, there are no guarantees except birth, death, taxes, and my 6% guaranteed annuity.” That ain’t right, and it’s led me to investigate.
As in all boom/bust markets, the mortgage crisis reminds us to merely look for the misincentive, and you’ll find the agitant that’ll ultimately chafe the market. Guarantees, leverage, asset-liability mismatch, eroding bond yields, and a flattening yield curve. All the devils are there, so are certain insurance & annuity companies toast?
Warren Buffett has latched onto insurance, touting it as a value business brimming with cash flow and free leverage. Where the goldmine lay, the goldbugs congregate. Natural disasters happen (although they’re often the liability of reinsurers), but that’s a business risk which insurers have managed to quash with their probability models and large sample sizes. What’s not supposed to happen is an outbreak of products offering 6% guaranteed with a high-water-mark provision. Such gimmickry exhibits a nasty brand of financial innovation, a kind of short-termism that ignores consequences a la the subprime mortgage outbreak. When it’s all about that paycheck, that bonus, or that growth-at-all-costs, it’s all about to collapse.
With prevailing 10-year benchmarks drawn to 2% even, 6% sounds unattainable without undue risk or leverage. At best, the profitability of insurers is headed deeper into cyclical decline until rates start to rise. At worst, institutional capital (hedge funds & private equity) will troll the industry, looking for cheap leverage to juice returns in a ZIRP regime.
I’d like to discuss this more in the future, but I wanted to relate the notion now.