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The Bid 174. “What can insurance premiums tell us about inflation?

Episode description:

You might not think of insurance as such a key input to their overall consumption basket, but the impact of the insurance industry is felt far beyond what individual consumers pay for individual policies and extends broadly throughout the supply chain as a necessary input for many industries in the production process.

Mike Pensky, portfolio manager within BlackRock's Multi-Asset Group joins Oscar to help us understand the connection between insurance and inflation, the possibility for rising insurance premiums to persist, and how investors can position their portfolios in a new market regime.

Sources: Insurance, Inflation, Issuance, BlackRock Insights, Dec 4^th 2023; Bureau of Labor Statistics, March 2024

Written Disclosures in Episode Description:

This content is for informational purposes only and is not an offer or a solicitation. Reliance upon information in this material is at the sole discretion of the listener.

For full disclosures go to Blackrock.com/corporate/compliance/bid-disclosures

TRANSCRIPT:

<<THEME MUSIC>>

Oscar Pulido: Welcome to The Bid, where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host Oscar Pulido.

Amidst the backdrop of unprecedented inflationary pressures. Most people might not think of insurance as such a key input to their overall consumption basket, but the impact of the insurance industry is felt far beyond what individual consumers pay for individual policies and extends broadly throughout the supply chain as a necessary input for many industries in the production process. So, what can this link between inflation and insurance tell us about the future path of inflation and how can investors use this learning in their own portfolios?

Today I'm pleased to welcome back Mike Pensky, portfolio manager within BlackRock's Multi-Asset Group. Mike will help us understand the connection between insurance and inflation, the possibility for rising insurance premiums to persist, and how investors can position their portfolios in a new market regime.

Mike, thank you for joining us on The Bid.

Mike Pensky: Thanks for having me, Oscar.

Oscar Pulido: And I should say, Mike, welcome back. It's been about a year since we had you on, and we're going to talk about inflation and insurance and how the two are interrelated. But perhaps let's start with inflation, which is a word that we hear a lot about, but we spend less time talking about how it's measured. So maybe you can tell us a little bit there as a starting point.

Mike Pensky: So, Oscar in one sentence, determining inflation levels it involves systematically tracking and analyzing changes in the prices of a representative basket of goods and services over time to really understand how those prices are changing at the overall economy level.

So, think about a basket of goods, you go to the grocery store, you have a shopping cart, and you put a bunch of items into that shopping cart that you regularly consume. So today you go, and it costs a hundred dollars. Next year, you go, and you buy the exact same basket of goods and suddenly that basket of goods cost $102.

So that represents a 2% increase in the value of that representative basket of goods. Of course, within your shopping cart, you can look under the hood and you can see, some items maybe went up by 5%, maybe some items dropped in price, and you can really get a sense for how prices are changing and what's driving them.

Economists do that at an economy wide level, they look at a representative basket of what overall consumers buy, whether it's a good or a service, and they try to evaluate how the cost of that basket of goods and services is actually changing at the overall economy level.

Oscar Pulido: What you described sounds like a pretty straightforward process, but in a big economy, I imagine there's a lot of goods to try and keep track of and one of those goods is insurance or maybe it's a service or it's kind of a combination of both. How does insurance interrelate with inflation? I know there's been a lot of headlines about rising insurance premium, so maybe that's part of it.

Mike Pensky: Insurance has made national headlines in the last year or so for a couple of reasons. So, first of all, we've seen insurance prices or what we call premiums come up meaningfully just in the last couple of years. So, if you look at the property insurance component of the CPI basket, it's actually running now at about 4% year over year increase at the highest level of roughly the last 10 years.

And this is at the same time as we've actually seen overall inflation levels come down in the last two years. The second reason why we've seen it in the national headlines is that especially in places like where I live in California, there have been many news stories of major insurers pulling out from renewing policies in particular for property insurance. Of course, we're not the first ones to be talking about this, but the story really started with insurers pulling out from natural disaster-prone areas, especially those that have recently encountered increased wildfire and flood risk.

Lately, we're seeing insurers actually pull out of other areas where those risks are lower, but really where there's just higher density of populations living close to each other because of the concentration of their exposures.

One thing that has been common in all these situations is that there have been elevated asset valuations, rebuilding costs a bit much higher, and quite frankly, natural disasters have become a bit more frequent and as a result, have lowered the insurer's profitability when they encounter these, when they encounter these events.

I'll give you a personal example. My family and I, we live in San Francisco in about a central part of the city as possible, so we're not the most natural disaster-prone area of even San Francisco very far from floods and quite far from wildfires. Arguably, we do have some density in our neighborhood, but like most homeowners and actually drivers of cars as well. When we saw our insurance prices reset this year, they went up. They went up by about a hundred dollars or more. That's a bit painful, but there's one thing that I really should clear up as a direct part of the inflation basket, that grocery cart that I talked about earlier, property and car insurance don't actually make up a very big component of the overall consumption basket. It actually only makes up about 3.3% for an individual consumer on average in the United States.

One thing that is underappreciated by many people is that insurance is actually a very central component of the production process for goods and services in the United States. This is really because it's a necessary input for every component in the production process, and this is because it's a very central component of the production process, whether you're a goods manufacturer or a service producer.

Take the example of a restaurant owner. You provide a service, you provide food, you provide hospitality, entertainment, and you charge customers for this. Essentially, that comes into the form of revenue. Of course, you have costs on the other side. You have food costs, employee wages, equipment, rent, and of course insurance. So ultimately, your profit that you earn is the difference between those revenues that you get and those costs that you pay. Now, as your prices go up, that means that your profit starts to decline. So, we actually saw this recently the pandemic where labor costs were a major component of rising cost pressures for producers of goods and services. So, what typically happens is that if you see your profitability go down because of price increases, you'll start to think about passing those costs onto your customers through higher prices. And what's amazing is that we actually see this effect economy-wide, and we study this regularly to help us position our portfolios.

So going back to insurance, it's one of those inputs costs as well. So, if your property insurance prices start to go up, you're likely to pass that out on through the production process through the form of higher output prices as well.

Oscar Pulido: So, Mike, the restaurant example actually resonates. It was, pretty vivid. I'm picturing myself going into one of these places and they have all these costs. you said employees rent insurance. I've always thought employees and labor were the biggest cost for any business, including a restaurant. So how important is insurance then, as an input cost? How impactful is it and how do you measure that at an economy-wide basis?

Mike Pensky: To answer your question, in short, Oscar, insurance is a very central component of the United States production process for goods and services.

To get a better sense for this, we use something called input-output tables, which really tell us how the inputs and outputs of various industries relate to each other. And really, it's something that the US government publishes through their economic statistics frameworks. Within these input output tables, within one of the more granular formats, we can look at something like 380 different industries and understand what inputs of one industry are related to the outputs of another.

So let me give you an example of a traditional car manufacturer. The data might tell us that 15% of the value of the production of that car might come from engine manufacturing. Another big component might come from transmission manufacturing and so forth. each of those inputs has its own sub inputs as well. So, this really goes down the chain.

Oscar Pulido: And Mike, just to clarify there, you said. 15% of the value of the car comes from the engine. is that 15% of the cost of producing it is from the engine or does it mean something else actually?

Mike Pensky: Oscar, ultimately what that 15% relates to is how much of the value of the car on average economy wide can be attributed to the 15% input of that transmission manufacturing. One thing that is really interesting, and this is much more of an important point, is that when we look across those 380 or so industries at the economy level, we find that insurance carriers rank at just about number 15. That puts them at roughly 3% of the share of the relative importance at the overall economy level. That's on par with really critical industries that we typically think of like banking goods, transportation, petrochemical, manufacturing.

And what's really interesting is that if you play that input output game of trying to understand how much that pass through might ultimately mean for the importance of insurance overall, it retains its importance in its relative ranking even as other industries shift around. So, this tells you that even as individual consumers insurance might be a really small part of our basket of consumption at the overall economy, it has very central importance. And one thing that is also really interesting, and we found this and highlighted it in a blog post that I co-authored with my colleague Tom Becker, is that property insurance innovations tend to foreshadow future service inflation.

And this is because of what we've just been talking about, premium changes they transmit through the production process and ultimately result in higher output prices. So, when you put this all together, this means that large impending property insurance price increases are likely to be passed down the chain and you might see higher upward increases in prices in overall services within the United States.

So, we talked about insurance being a central part of the US production process. You might be wondering what is not that important. And these are things like amusement parks and breakfast cereals, while they make me very happy, not really that important at the service and goods production in the United States.

Oscar Pulido: So, Mike, you've made a compelling case about why insurance is so central to the inflation story in the economy. And I guess my question then is, how quickly do we see these rises in insurance premiums when oil prices go up and down. I feel like that kind of, affects our gasoline prices pretty quickly. Or sometimes you hear about, droughts and that causes commodity prices to move around pretty quickly. Is it the same for insurance or does it happen a little bit more slowly?

Mike Pensky: So, insurance is a little bit different from other industries, and mainly that's because it's a very regulated market. So, this means that in many areas, insurers are actually statutorily limited in how much they can increase their premium. Despite the high rates that we've already seen, so give you an example of California where I live here.

Insurers must get approval for increasing their premiums beyond certain levels, even though there are some rules now in the works to try to amend that. There are processes by which these increases might also be contested, and so as a result, it might take time for those increases to actually happen. So even when you thought some of the insurance price premium rises might already be done, you might continue to see them filter through because of the limits on those step changes that could actually happen.

So why this is really important is that in effect, gradual changes can take a longer time to impact inflationary pressures in the United States. So as a result, not only might we see a slower burn of persistent increases insurance premiums, but also given those lagged pass through effects to other services and goods that might also increase inflation over a longer period that many might expect.

Oscar Pulido: And Mike, I mentioned that it's been about a year since you joined us on the podcast. When you joined us last year, you were talking about geospatial data, and how you're using big data to help, investors in their portfolios. How are you applying that to the insurance space and just some of the insights that you're trying to derive.

Mike Pensky: That's a great question, Oscar, and just to remind everybody about what we mean by the term big data, my colleague Josh Kazdin, said this very eloquently in the last discussion, but we use all sorts of generate, but we use all sorts of data to generate insights in alpha, and it can come in different forms, traditional, big and alternative. So traditional data is something that we've used in finance research for decades. This is things like financial statements, macroeconomic releases, industry reports. They can fit neatly into a spreadsheet and are fairly easy to understand and interpret. Big data refers to both the size of the dataset and the computing resources needed to process it.

So, moving from the megabytes of A PDF that you might download in a few seconds to terabytes or petabytes of data that require a lot of computing resources to be able to understand. And then finally, alternative data. It can be big or small, usually strange, unstructured, harder to map to really understand how to use it.

Just to give you an example, newspaper articles or broker reports that are just a collection of sentences that somebody wrote is a traditional form of alternative data. Of course, our geospatial data that we talked about where we pull satellite images is another example of both alternative and big data.

It needs to be processed, transformed, mapped to be useful, to interpret and actually make investment decisions. So, since we're talking about insurance. Geospatial is actually again, a data lens that we can help us to gain some, since we're talking about insurance, geospatial data is again, a lens through which we can gain some insights about the space.

So, one thing that we have recognized is that lower availability of private insurance could actually make certain regions of the country more vulnerable to the negative economic impacts of future disaster events. Traditionally, the federal government has really backstop the largest US natural disasters, and so we can actually use historical disaster relief data to explain some of the recent pressures that we've seen within the private insurance markets.

So, if you look at spending by the Federal Emergency Management Agency, we call. FEMA The regions where private insurance have been pulling out the most, so these are places like California, Florida, Louisiana, in some cases, Texas.

They're the exact same parts of the country that have had the highest historical funding, that have had the highest historical federal spending on disaster relief. Of course that's not an accident.

These are areas that have seen many more large national disasters and also lower private sector insurance availability has led to the federal government needing to backstop some of these areas. So, we also talked about really the need to understand the macro fundamentals, but from an investment perspective, we also really need to understand what the market is already appreciating.

And so, we spend a lot of time trying to understand how much of the market has already priced some of these insights that we have. For that we use some other tools, for example, natural language processing and in, in one sentence, natural language processing is another example of alternative data, where we use computers to read thousands of documents, whether it's newspaper articles, broker reports, to understand what the collection of market participants represented within those documents. Think about a particular topic. So, in this case, relating to insurance. What we are finding is that the potential for the persistence of inflationary pressures, especially relating to some of these issues relating to insurance premiums, are really not well understood by common market participants, and that gives us a lot of confidence that it's not yet priced by markets.

Oscar Pulido: As you started to use some of that terminology, natural Language Processing and alternative data. You've reminded me of some of the conversations we've had about artificial intelligence over the course of the last year with people like Brad Betts, who I know also is based in San Francisco, like you, Mike. So, what does artificial intelligence, or how are you applying that, in the big data that you're analyzing, or are you? Is that something that's on the horizon?

Mike Pensky: So, AI is definitely a tool that can provide very rich interpretations from large sets of documents, and it's something that we are starting to leverage as well. Really moving beyond the traditional way of counting words and looking at the pers, the. Accounting words and looking at their frequency to, in a much more romantic way, actually having conversations with the market as represented by a set of documents.

So, in this way, what we can do is we can upload a large group of newspaper articles of broke reports and start to ask that collection of reports in an aggregated way. What does the market believe is going to be driving inflation going forward? What are the causes, what is appreciated, and what the market may not yet know.

Oscar Pulido: Mike, you've made this compelling case of how insurance is such an important input to the economy and how, it is prognosticating, higher levels of inflation going forward. So, what does this mean for investors and particularly in their portfolios?

Mike Pensky: So ultimately one thing to recognize is that the issues in the insurance industry are likely to move beyond just insurance itself. So, we talked about how increases in prices for insurance are likely to continue for some time, but also that they might pass through the economy through the input cost channel. This is going to lead to inflation staying stickier at higher levels for a longer period of time. Already in the world where inflation doesn't appear to be heading down to the 2% target rapidly, it becomes an even bigger challenge to overcome, yet an additional pressure that might keep inflation at a higher level.

So, from a portfolio perspective, the way that we tend to think about this is that higher inflation for longer likely means that you need more compensation, more return for holding bonds over longer maturities. So said in a simpler way. Higher interest rates for longer maturity bonds.

 So as a result in portfolios, we're underweighting those longer duration bonds to benefit from the notion that yields will likely rise for some time on the backend of the US treasury curve.

Oscar Pulido: And what you're saying is consistent with actually some of the comments that we've heard from our colleagues in the BlackRock Investment Institute of we're in a new market regime, that means higher interest rates and higher inflation than what we've been accustomed to. Mike, thank you for once again providing this interesting lens on the economy that it seems like only you can provide. And thank you for joining us on The Bid.

Mike Pensky: Thank you, Oscar.

Oscar Pulido: Thanks for listening to this episode of The Bid. If you've enjoyed this episode, check out how geospatial data can inform investing where Mike Pensky and Josh Kazdin explain big data and how investors can use it in their decision-making process.

<<SPOKEN DISCLOSURES>>

This content is for informational purposes only and is not an offer or a solicitation. Reliance upon information in this material is at the sole discretion of the listener.

For full disclosures go to Blackrock.com/corporate/compliance/bid-disclosures

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