1/28/2015
FundFire - Insurers Hike Alts Allocations to Chase Returns Print Issue
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Insurers Hike Alts Allocations to Chase
Returns
By Laura Suter January 28, 2015
More insurance companies are increasing their allocations to alternative
investments, as new research shows alternatives boost insurer general account
returns across all investment climates.
Through both favorable and adverse investment climates, hedge funds, real assets
and private equity have "consistently boosted insurers’ portfolio income and
portfolio yields," finds a whitepaper from J.P. Morgan Asset Management.
"Insurers are more and more aware that fixed income portfolios are yielding less
than they had been, particularly as bonds mature and are replaced with new issuance
at much lower levels of yield," says Gareth Haslip, executive director for global
insurance solutions at J.P. Morgan Asset Management. "Given that, insurers are
looking to have an improved level of returns in their portfolio without adding too
much risk."
J.P. Morgan compared three portfolios: a pure fixed income portfolio of cash,
Treasuries and investment-grade corporates; that basic portfolio with the addition of
5% in large-cap stocks; and a third portfolio building on the second but with fixed
income assets reduced and up to 6% in alternatives exposure to hedge funds, private
equity, private debt, real estate and infrastructure.
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It found that expected risk-adjusted returns improved significantly with the addition
of alternatives. "At a targeted return of about 4.5%, for example, the [third] portfolio
… would have a projected volatility of 2.3%. At 3.8%, the projected volatility of the
[second] portfolio would be almost three-quarters more. For the pure fixed income
portfolio, it comes to nearly three times more," the report found.
But what alternatives are insurers investing in? More mandates have been seen for
specialized non-core fixed income products, says David Holmes, partner at Eager,
Davis & Holmes, which runs the Insurance Asset Outsourcing Exchange.
"Included in that mix are private equity and hedge funds that address insurance
companies’ need for diversification and provide higher returns than are currently
found in the prolonged low interest rate environment," he says. "However, each
insurer’s appetite for alternative investments will vary according to a number of
factors, including their financial strength, investment guidelines, and risk tolerance.”
The capital charges that insurers incur for holding higher-risk assets such as
alternatives also has to be taken into account when assessing which alternatives to
invest in, says Haslip. Insurers look "for different types of alternatives, what the
returns is net of fees and net the cost of holding that capital. They then judge how
attractive that is compared to fixed income," he says. "Once they factor in the capital
costs they can get close to then choosing the right type of alternative investment and
upper quartile alternative manager to work with."
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Insurance companies are looking for diversification from their fixed income
holdings, alongside returns, rather than purely high returns, says Stewart Foley,
partner at insurance asset manager consultant Insurance AUM.
"Alternatives have … the ability to provide returns with relatively low volatility so I
think in terms of where the money is flowing, it is not a swing-for-the-fences hedge
fund allocation. It is much more low to intermediate volatility with correlation to
interest rates certainly a consideration," he says.
Previously, as rates moved lower insurance companies moved down the credit
spectrum, first to high-yield, then to bank loans, says Foley, but "now the trade is to
[move] down in liquidity. Insurers are almost always cashflow positive, so they can
afford liquidity risk," he says, but it depends on the specific insurer and its liability
needs.
But total allocations to alternatives by insurers, while increasing, are still low. For
life insurers it has increased from close to 1.6% of the total portfolio in 2009 to just
more than 2% in 2013, according to J.P. Morgan. For property and casualty insurers
the uplift has been greater, from around 1.5% in 2009 to almost 2.4% in 2013.
A large allocation to alternatives is not necessarily needed to move the needle on
returns, says J.P. Morgan. Due to the very fixed income-centric nature of insurance
company general accounts, even a small amount can "deliver comparably larger
diversification benefits and hefty premiums for liquidity," says the report.
And while the percentage allocations are currently relatively low in relation to other
institutional investors, the sums on hand are large. And this is attracting a lot of asset
manager interest.
"I think that we are going to see that allocation grow to somewhere between 5% and
7%," says Foley. "But the base of assets is so big even an incremental increase in
percentage rate is a substantial flow of funds."
Ares Management is among the firms that have ramped up staff and infrastructure to
serve more insurance investors. The $80 billion asset manager has seen particular
interest in corporate credit, real estate lending and structured credit, and has $6
billion in assets from insurance companies to the end of September 2014.
"We believe insurers are attracted to Ares’ risk origination and risk management
capabilities as well as our portfolio … oversight," says David Reilly, head of
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business development at Ares.
However, Reilly says dealing with insurance companies requires a different
approach to other institutional investors.
Insurance funds require more help in addressing the growing complexity of their
business and their regulatory requirements, he says. "We work closely with insurers
in accessing differentiated investments and assisting them with their asset-liability
management as well as risk-based capital optimization."
For this reason, the company has hired people who previously worked with
insurance companies, such as in the banking or investing world with experience in
insurance firms. They are more able to speak the insurance industry speak, says
Reilly.
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