As traditional fixed income strategies have generated declining returns in the low-yield environment, insurance companies have been spurred to search for new investment opportunities, including alternative asset classes. For many firms, these investments constitute a fundamental change to their insurance general account investment practices, to be harnessed not only to enhance returns, but also to better manage risk through portfolio diversification.

This diversification is happening in an evolutionary, not revolutionary, fashion. For all, fixed income remains the primary driver of yield. However, many insurers who had previously focused efforts exclusively on selecting investment grade, domestic fixed income (i.e., core bond strategies) are now beginning to experiment with both higher-yielding investments and equity-type investments. In the face of current economic challenges, insurers have found they need to fundamentally change their approaches to portfolio construction. Leaders are now deploying multi-asset portfolio optimization to harness the benefits of diversification to achieve superior risk-adjusted yields, without taking on outsized loss potential. Of course, this also necessitates that firms improve their market risk monitoring solutions.

 
Diversified investment strategies
Of course, insurers’ general account portfolios remain driven largely by income-oriented assets. These bond, commercial mortgage, and short-term holdings are well suited to addressing the cash flow needs and stable values necessary to back insurance liabilities. Regulatory treatment, insurance ratings agency methodologies, and statutory & GAAP accounting principles have all been aligned to favour these core portfolio components, locking them into their primary role in most insurers’ portfolios.

However, the insurance industry’s long-term trend towards higher-returning, capital appreciation-oriented asset classes is unmistakable, especially when one views the evolution of the industry’s portfolio distribution over the past five years. Although allocations to bonds have remained relatively stable since 2008 (approximately 72% of the portfolio), insurers have redeployed some of their cash & short-term bond positions that had built up following the financial crisis, decreasing as a proportion of the overall portfolio from 6.5% in 2008 to 4.1% in 2013. At the same time, allocations to equities and Schedule BA assets increased from 9.2% and 3.8%, respectively, in 2008 to 10.5% and 5.3% in 2013.

Increasing investments in alternative asset classes
As they attempt to maximize returns in a low-yield environment, many insurers have particularly increased their allocations to a variety of alternative asset classes, including hedge funds and private equity, as well as other specialty investments, such as infrastructure, mineral rights, aircraft leases, and debt & real estate limited partnerships. In statutory filings, these non-traditional investments are classified in the US as Schedule BA assets. This gradual evolution in strategy has been reflected in insurers’ portfolios. In fact, in 2013, Schedule BA assets accounted for 5.4% of insurers’ total invested assets, up from 3.8% in 2008.

This increase is reflected across the entire industry, as all business lines have grown their allocations to a material extent. P&C insurers implemented the largest increase in allocations to Schedule BA alternatives, from 4.6% of total invested assets in 2008 to 7.7% in 2013, capitalizing upon the relative flexibility of their constrained total return investment programs. Health insurers similarly increased their Schedule BA allocations from 2.7% in 2008 to 4.6% in 2013. L&A carriers made the most modest, though still significant, proportional increases to their Schedule BA alternative assets, from 3.5% in 2008 to 4.3% in 2013, due to the constraints of the book income investment approach and significant regulatory risk-based capital implications.

Achieving enhanced financial returns
Insurers are investing in Schedule BA alternative assets for a variety of reasons. Many are harnessing alternatives particularly to realize the diversification benefits of assets with returns that are less correlated to their core fixed income portfolios. A number also seek to tap enhanced return potentials through both yield generating (e.g., infrastructure, mezzanine finance, equity real estate funds) and capital appreciation (e.g., hedge funds, leveraged buyouts, distressed debt, venture capital, commodities) vehicles.

Unsurprisingly, yield on Schedule BA assets was typically higher than that on fixed income assets – around 7% for both L&A and P&C insurers. L&A insurers that focused more directly on yield-oriented strategies achieved a modest uplift from capital gains, producing a total return of 9.6%. P&C insurers, which made extensive use of appreciation-focused assets, benefited more significantly from capital gains, reaching 14.6% total returns. However, this was not universally the case. Health insurers’ Schedule BA investments yielded only 2.9%, failing to significantly outperform fixed income investments, with total returns that only reached 3.9%.

Unique tactics of insurance business lines
Life & annuity insurers
Because of their preference for income over capital appreciation, L&A insurers have been slower than those in other business lines to make large proportional allocations to more volatile assets, such as equities and Schedule BA. Unlike other insurers, their use of equities has decreased since 2008; however, Schedule BA allocations have grown by nearly one percentage point. These have been limited not only to limit price volatility, but also to avoid onerous risk-based capital requirements, which are more severe than those imposed on property & casualty and health firms.

Historically when life insurers have invested in alternatives, they have concentrated on less liquid private asset partnerships. These are more compatible with their traditional book income strategies, investing in products that bring significant income potential (e.g., from mezzanine financing interest or infrastructure use fees/real estate rents) or limited pricing volatility (e.g., illiquid private equity fund interests held at commitment values in initial years).

However, innovative life insurers are beginning to draw upon less correlated alternatives to mitigate overall portfolio risk. Firms have learned from the credit crisis that investing in fixed income does not automatically protect from value impairments. Therefore, many life insurers are now keeping greater attention on portfolio total returns, while still investing to maximize book yield. In that light, they are starting to grow modest exposures to less correlated hedge fund and commodity investments to reduce aggregate portfolio volatility and increase risk-adjusted total returns.

Property & casualty insurers
Due to the distinct nature of their liabilities, P&C insurers have greater latitude in selecting investment strategies than do their L&A peers. Unlike L&A insurers, most P&C companies’ liabilities are typically short-term and claims payments tend to be covered by current premiums. As a result, their general account reserve portfolios are generally significantly smaller relative to their premium flows when compared to those of life insurers, who need to save up for large, predicable future payments.

P&C insurers’ more modest investment portfolios are relied upon primarily to cover these unanticipated cash flow needs resulting from high claim events. This requires P&C insurers’ investment portfolios to maintain significant levels of liquidity, allowing asset sales to raise any necessary cash in these loss scenarios. P&C firms have reallocated funds from bond & cash positions into appreciation-oriented assets, such as private equity and hedge funds. This has resulted in P&C insurers having the largest allocation to Schedule BA assets of any business line (7.7%, vs. 4.3% for L&A and 4.6% for health).

Health insurers
In many ways, modern managed-care health insurance businesses represent an outlier in the marketplace, with business fundamentals and investment patterns that differ significantly from those of peer companies in the L&A and P&C business lines. Health insurers’ business models more closely parallel operating companies, financing healthcare networks for ongoing preventative as well as critical care, than they resemble the traditional indemnity insurance models of life and P&C firms. This limits the need for large, long-term investment portfolios.However, health insurers do maintain focused long-term investment portfolios to both protect against unanticipated claims incidence and boost corporate returns. Leading health insurers have been seeking to mitigate the effects of the low-yield environment by adjusting their portfolios in favor of higher returning assets, and have approximately doubled their allocation to Schedule BA assets (2.7% to 4.6%) since 2008.

Alternative asset class spotlight: private equity & hedge funds
Insurers have particularly focused on private equity and hedge funds. In 2013, US insurers’ total investments in private equity and hedge funds, including those made without a traditional asset manager as an intermediary, reached 1.5% of insurers’ total invested assets – a 5.9% CAGR from 2008. Private equity accounted for 73% of these investments, while hedge funds made up the remaining 27%. The remainder of Schedule BA assets were comprised of focused credit strategies, infrastructure & private real estate fund investments, and other commingled investment solutions.

Private equity has long been a component of many insurers’ portfolios. Insurers, particularly life carriers with long duration liabilities, have been attracted to private equity’s multi-year investment cycle and illiquidity premium. Many are also attracted to its lack of mark-to-market pricing, avoiding the earnings volatility generated by public equity investments.However, private equity’s illiquid nature and vintage-year dependency of returns are portfolio construction challenges for many insurers, particularly in property and casualty lines, where liquidity is prized. Even in the life segment, certain income-oriented strategies, such as mezzanine finance, have been preferred, and many insurers are reallocating their alternatives portfolios toward greater hedge fund exposure upon maximizing their illiquid equity-risk budgets.

Although subject to mark-to-market driven earnings volatility, hedge funds present a very attractive value proposition for many insurers, leading to strong recent growth. Particularly attractive is hedge funds’ ability to harness a diverse array of investment & trading strategies that may be combined to address nearly any risk-return spectrum. Furthermore, experienced portfolio strategists may assemble multiple investments into customized, liability-driven portfolios in a way that other alternatives cannot. Furthermore, certain delivery vehicles, such as hedge fund managed accounts, provide look-through transparency to underlying securities holdings, allowing for improved monitoring and, in certain circumstances, superior capital treatment.

Challenges to executing an effective alternatives strategy
Insurers are struggling with a number of issues as they strive to incorporate alternatives into their portfolios in a cost-effective and risk-managed fashion:

1. Educating investment team and management – lack of detailed knowledge and awareness of alternatives inhibiting investments.
2. Constrained portfolio management resources – Internal personnel lack time to properly research and oversee alternatives.
3. Ability to access and select top performing managers – Difficulties locating, attracting and conducting due diligence on managers.
4. Integration in general account asset allocation – Issues determining the role of alts in surplus and liability portfolios.
5. Ensuring the security of investments and validity of information – Critical to managing risk and avoiding unanticipated investment failures.
6. Achieving attractive returns after expenses and capital charges – Must generate sufficient net returns to merit use of alts relativeto other investments.
7. Demonstrating value vs. other asset classes – Must provide financial and diversification benefits to justify additional risk and effort.
8. Stringent risk reporting needs – Alts funds frequently have insufficient transparency and reporting for stat filings.
9. Limited communications with alternatives advisers – managers are often not “high touch” enough to support insurer needs.
10. Concerns about high fees – Standard fee structures can be challenging to justify use of alternatives.
11. Minimal insurance knowledge in the alternative space – many managers view insurers as identical to all other institutional investors.
12. Alternatives industry is product, and not solutions, focused.

Each presents a unique impact on both outsourced and internally managed alternative investment programs.

Insurance company implementation tactics
To address these challenges and grow their exposure to alternative asset classes, insurers are taking advantage of diverse hedge fund and private equity access points.

Historically, firms have relied primarily on the shelf fund-of-funds vehicles. However, along with the double layer of fees, these portfolios are rarely optimized for insurance companies objectives. Only recently have fund-of-funds providers begun to develop insurance-specific portfolios tailored to liquidity & volatility targets, and insurers broader investment strategies (e.g., fixed income replacement).

Insurers are also beginning to retain these firms to assemble fully custom portfolios optimized for their unique needs. By retaining managers of managers that have an actionable understanding of insurance investments and regulatory constraints, insurers may investment disciplined alternatives portfolios constructed to maximize diversification benefits within insurance company general accounts, in order to best capitalize on RBC or economic capital model covariance factors to reduce net capital charges under US statutory or Solvency II regimes.

Increasingly, insurers are turning to managed accounts providers, particularly for hedge funds and managed futures solutions. These managed account platforms provide the reduced fees, security, transparency, and liquidity of segregated investments, alongside the superior manager access and disciplined due diligence provided by multi-manager providers.

Larger insurers are also increasingly building out their own alternative investment teams to support direct placements into partnerships. In certain segments, particularly income-oriented private asset opportunities including equity real estate, infrastructure, and mezzanine finance, insurers are also coordinating co-investment programs alongside managers and creating their own domestic and international deal sourcing capacity.

This remains a struggle for many organizations, as only the largest insurers yet have sufficient allocations to justify large teams comparable to leading funds of funds advisers. This is leading several to employ multi-manager fund advisers on a consulting basis, to capitalize on their access to top managers and deep investment and operational due diligence resources.