For more than a decade, insurance companies have sought greater yields than the near-zero interest rates offered by traditional fixed-income strategies. Many have found opportunities in alternative strategies, or “alts.” Is this an approach other insurers should consider?
What, actually, is an alt? There are many definitions, and for some it’s as simple as “what we are not doing right now.” There are many forms of alts spread across the investment landscape. Some fit the perception of alts as being further out on the risk curve, but several alts can help reduce portfolio risk.
Are alts an appropriate investment? The key, as usual, is whether an alt fits an insurer’s needs. What are the investment goals? What portfolio issue must be addressed? How much risk is the insurer comfortable with? And if an insurer ventures into new investment territory, does its staff have the asset management skills, knowledge of the regulatory framework, accounting skills and more to include alts in the portfolio successfully?
Conning believes alts may offer insurers a greater menu of investment choices to help further diversify a portfolio, generate greater yield and return, and improve downside protection. We also think that, as with any investment selection, an alt must align with an insurer’s investment strategy. However, if insurers can learn how to expand the array of suitable investment options, the education and experience gleaned in the process could pay greater dividends down the road.
A Rich And Varied Asset Class
What constitutes an alt?
We most commonly think of asset types, such as below-investment-grade fixed income (both developed and emerging markets), hedge funds, private equity, real estate, commodities, currencies and derivatives. Even further out on the risk spectrum are distressed assets, fine art, non-fungible tokens and cryptocurrencies. There are also alternative strategies, such as absolute return, multi-strat, factor-based and quantitative methods.
Just listing them demonstrates that, although we tend to group them together in portfolio asset allocations, alts comprise a rich and varied set of investment opportunities and challenges. They derive their value and performance characteristics from just about every corner of the global economy.
For Insurers, Additional Considerations
Varied as they are, alts have several common features that offer both advantages and drawbacks.
The main attraction is how alts expand the investible universe and thereby improve a portfolio’s risk-reward potential.
At the same time, a few features often concern investors. These traits are not universal, and not all alts exhibit them all the time, but generally:
Alts have limited liquidity.
Alt strategies often lack transparency.
They charge fees significantly higher than those for core assets.
Insurers often have additional considerations with respect to alts:
Alts typically are subject to regulatory limits and required disclosures.
Alts attract high capital charges.
Accounting and tax calculations may be unfamiliar.
Board approval may be required and investment guidelines may need to be amended.
Alts need specific risk-management techniques, data, and systems for monitoring and reporting positions and activity
Alts tend to trade in specialist markets, so outsourcing to appropriately skilled asset managers is often prudent.
The tug of war between the desire for better income and returns versus the operational friction of educational, regulatory, informational and procedural challenges has held the insurance industry back from diving headlong into the asset class. Alt allocations among U.S. insurers are currently in the low single digits, not surprising as it’s hard to place large bets on expensive assets.
The liquidity question is often the most important one since insurers are liability-driven and surplus-bound. Some alternative assets can take months or years to generate payouts. These assets may feed a portfolio’s need for diversification and long-term capital appreciation, but an insurer may need that liquidity on shorter notice to pay claims or manage solvency ratios.
The Learning Curve May Pay Dividends
The year thus far has seen many alt assets outperforming more traditional insurance portfolio fixed-income assets, such as cash and treasuries. However, insurers should also want to understand how an alt asset has performed historically during various market conditions. That will help illustrate how well an alt asset fits an insurer’s investment strategy.
For smaller and mid-size insurers who don’t have the capabilities or desire to manage an alt asset, there are many external managers ready to assist. However, due diligence in this step is crucial, as performance disparity is far greater among alt managers than in traditional asset classes. Insurers will want to know if a manager’s current return is a measure of alpha (manager outperformance) or beta (volatility) and ensure they are not paying alpha fees for beta performance. The portfolio exposures may be small, but a poor experience with an external manager could hamper the longer-term opportunities for portfolio growth if it makes an insurer hesitant to widen its investment universe.
For many insurers, the alts consideration is an attempt to improve yields. That begs the question of what may happen when and if interest rates return to “normal,” i.e., higher: Will the trend into alts subside if insurers’ goals can be met by more traditional means?
There might be some pullback if it becomes easier to cover margins again with high grade fixed income. However, having done the education with board members, established accounting, reporting, and risk management procedures, and experienced the benefits of diversification, I doubt they will toss it all to buy just core again. The potential diversification benefits of an expanded investible universe may be too good to pass up.
Richard Sega, FSA, is the global chief investment strategist at Conning, a leading global provider of investment management solutions with more than $200 billion of assets under management. He may be contacted at [email protected].