Research Summary

  • Insurance

Tax-Aware Investing for the P&C Insurance Industry

December 15, 2003

Our research shows that an integrated approach to portfolio construction, in which opportunities across both the taxable and tax-exempt markets are compared on a tax-equivalent and risk-adjusted basis, provides higher after-tax returns over time than separate taxable-bond and municipal portfolios, without additional risk. This approach is also suitable for investors seeking to maximize after-tax book yield.

Insurance companies traditionally view tax-exempt bonds in isolation rather than as one of the many sectors that may be used to maximize after-tax results. This approach does not allow for relative-value plays between the taxable and tax-exempt markets.

No single sector is always best for any investor (display), regardless of tax rate. Sometimes municipals are the top performer, sometimes corporates or another taxable sector. By the same token, no single mix of sectors always represents the optimal portfolio. The right combination varies as opportunities change, even when tax circumstances remain static.

The Top-Performing Sector Varies over Time
  Annual Fixed-Income Sector Returns* at 35% Tax Bracket
  Municipals Treasuries Agencies Credit Mortgages
1996 4.7% 2.0% 2.6% 2.6% 2.5%
1997 6.1 5.6 6.3 5.4 6.5
1998 5.6 6.3 6.0 5.3 5.7
1999 2.3 (0.9) (0.4) 0.1 (0.1)
2000 6.8 7.6 7.9 6.1 7.1
2001 5.8 5.3 5.8 6.3 4.9
2002 7.9 7.9 8.5 6.5 9.0
*Annual returns were created by compounding monthly returns, assuming the investment is liquidated at the end of each month. Capital gains and income are taxed at the same rate. In the case of municipals, only the capital-gains component of total return is taxed. All returns assume a four-year duration. Mortgage returns were created by adding the excess return of the Lehman Mortgage Index to the interpolated return on a Treasury portfolio with a four-year duration. Source: Lehman Brothers and AllianceBernstein

The different term structures of the taxable and municipal markets also argue for a holistic approach to portfolio construction. Maturity selection tends to be more meaningful in the municipal market than in the taxable market; there is frequently an opportunity to add value by adding long-maturity municipals to a broad-market portfolio, while keeping the overall portfolio duration the same. This ability to exploit the differences between the markets’ maturity structures—which continually change—is unique to an integrated approach to portfolio construction.

To evaluate the potential added value of an integrated portfolio-management approach, we ran several sets of simulations for three portfolios—integrated, corporate-only and municipal-only—using historical yields and return. In our study, the portfolios optimized from a shared universe consistently outperformed any combination of the independent sector portfolios. We conducted simulations using both after-tax total-return and after-tax book-yield mandates, with favorable results in both cases. We have thus concluded that optimizing a portfolio from a shared investment universe should be the preferred approach to portfolio construction for P&C insurance clients.

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