Insurers' alternative imperative

Alternative investments appear in many respects to constitute, for lack of a better term, the most plausible alternative for insurance portfolios today. They pursue idiosyncratic alpha in an environment where the outlook for yield in traditional fixed-income insurance investments seems increasingly problematic.

Notwithstanding alternatives' inherent risks, the diversification that comes from the pursuit of unconventional sources of return can enhance returns in insurance portfolios heavily concentrated in low-yielding fixed income with minimal incremental risk. Simultaneously, they can moderate portfolio volatility. The models used for pricing private equity and real assets, while reflecting public market inputs, exhibit lower volatility for equivalent returns as a rule. Moreover, many hedge funds that invest in publicly traded equities do so with strategies designed to mitigate public market volatility. Perhaps most crucially, alternative investments give insurers the means to capture a premium for both the excess liquidity in their investment portfolios and the relative predictability of their liabilities.

Across the insurance industry — and even, we suspect, within individual companies — the definition of alternative investments can vary widely. We define them as hedge funds, real assets (both real estate and infrastructure equity) and private equity, grouping them together on the basis of their regulatory treatment and their fundamentals. Insurers in the U.S. list these assets under Schedule BA. Of these alternatives, private equity and real assets tend to be very illiquid, while hedge funds vary in liquidity, but tend to be much more liquid.

Alternative investments share a risk factor and primary source of return that set them apart from asset classes such as equities and fixed income. The bulk of traditional assets' return and volatility derives from moves in the larger markets in which they participate — their market beta, in other words. Alternatives, by contrast, seek to add to return (or subtract from volatility) with idiosyncratic, often proprietary factors identified or developed by their managers — their unique alpha. They might realize their gains from the information asymmetries found in esoteric or undeveloped markets, or from trades that exploit transient anomalies in established markets.

Historically insurers have concentrated portfolios in fixed income because of its minimal impact on earnings and capital volatility. So while an incremental allocation to illiquid assets like alternatives might consume an outsized portion of an insurer's total adjusted capital — capital available to cover unexpected losses — it can also deliver comparably large diversification benefits.

Most alternative investments generate much of their alpha over lengthy holding periods. With their long-dated liabilities, life insurers in particular have an institutional capacity for the patience required for an investment of that nature to pay off. The long view gives them the flexibility to rebalance alternatives distributions according to market conditions.

They can use surplus premium income to invest consistently through rising and volatile markets, so that alternatives' good years can offset their bad. This institutional form of the retail investor's dollar cost averaging adds the diversifying dimension of time to diversification across asset classes and risk factors, so the higher returns can come in a smoother return stream.

Just as insurers have a longer time horizon to match alternatives' expected payouts, they also have the optimal liquidity profile. Liquidity is the public insurance company's proverbial double-edged sword. For the policyholder, the risk lies in not having enough; for the shareholder, it lies in having too much. The balance of liquidity typically favors policyholders. Life insurers and property and casualty companies held reserves in excess of the most extreme annuity redemptions and catastrophic losses in recent history. Even as they have maintained this liquidity cushion, however, a persistent low-yield environment challenges public companies to preserve their dividend, and a rallying stock market raises expectations that they will increase it.

Our research has found that an allocation to alternatives would have served to meet conflicting stakeholder demands by simultaneously smoothing and boosting the investment earnings trajectory. We modeled a small allocation to alternatives — 5% for property and casualty insurers and 3% for life insurers, which have larger balance sheets — on top of 10 years of actual investment results for a composite of insurance companies with little or no exposure to alternatives. Of the 40 quarters that began in 2004 and ended with the last quarter of 2013, the hypothetical alternatives allocation would have enhanced results in 83% of them.

Those extra returns demand an extra level of skill. Conventional investment results conform to readily identifiable cycles. They tend to converge on a benchmark mean as investors pile into a successful strategy and arbitrage away the competitive edge. By contrast, idiosyncratic, often proprietary alternative investment results tend to diverge. The tendency has a critical implication. Median returns in alternative investing don't mean much.

A recent study by McKinsey & Co. found that private equity returns in a given vintage year ranged from gains of 50% for the top managers to losses of 30% for those at the bottom. By comparison, top-quartile long-only equity funds outperformed the median manager by 0.7 percentage points to 2.3 percentage points per year over the past decade, according to Morningstar Inc.

Alternatives' dispersion stands to reason: Success in alternative investing feeds on itself. The top managers see the more promising deals. In private equity's earlier days, the majority of top-quartile funds sustained their top-quartile performance. Since 2000, the consistency of manager outperformance has declined, as it has among alternatives managers generally. More competition, better competition and, in private equity, subtler ways of creating value beyond cookie-cutter financial engineering all help explain the trend.

So does the accelerating pace of the global economy. Alpha today depends not only on managers' ability, but also on how their skills coincide with market opportunity and macroeconomic circumstance. Alternative investments don't lend themselves to “set it and forget it” management. They require exhaustive and ongoing due diligence. As essential as it is, a thorough understanding of what portions of manager performance to attribute to luck, to skill and to process is no longer enough. Effective due diligence in the current environment calls for a well-reasoned, exhaustively researched view of how a manager's process will fare in a constantly shifting dynamic of opportunity.

So the compelling potential of alternative investments for the insurance investor comes packaged with a warning label. The potential is compelling only for the top managers, combined with ongoing and rigorous investor oversight.

Once they obtain that oversight capability, insurance companies will have the attributes they need to realize the alpha inherent in alternatives. Insurers already possess the appropriate scale, the right time frame and credibility. They can make investments small enough for their risk budgets to accommodate yet big enough to move the dial on returns. They have a compatible time horizon with alternatives managers — insurers' ability to capitalize on liquidity premiums and invest consistently over time gives them a cash flow that parallels that of alternative investments. Not least important, insurers' reputation as long-term institutional investors can add to an alternatives manager's credibility and leverage in the deal-making universe.

Matt Malloy, managing director, is head of institutional solutions and advisory within J.P. Morgan Asset Management.