Carl Terzer, CapVisor
Carl Terzer of CapVisor Associates explains how alternative investments are becoming more popular for all kinds of insurance companies, including captives.
When alternative investments (ALTs) are mentioned to insurance company investment committees, boards and senior management, certain things probably come to mind.
Specifically, private equity, hedge funds, real estate, collectables, commodities and structured products are the most commonly known asset types belonging in the ALTs category. Large insurers, pensions, endowments and foundations, public funds and high net worth individuals, or their family offices, have been the primary consumers of such ALTs.
Other institutional investors, such as small to mid-sized insurers have historically shied away from such investments as they possessed unfavourable characteristics for most insurance company investors. For example, the investments typically required long investment periods during which liquidation was impossible or heavily penalised.
In addition, regulatory limitations and accounting treatment were unfavourable for insurers, RBC charges were high and rating agencies were not kind to such investments. These ALTs typically required large initial capital deposits which constituted a significant barrier to entry particularly for small to mid-sized insurers. Finally, and perhaps most importantly, while promised returns were often very attractive, significant risk was involved in attaining those returns.
That was then, and this is now. Many of today’s new ALTs strategies are becoming less “alternative” and accordingly, they are being adopted into insurance companies’ portfolios at higher rates than ever before (Figure 1).
These newer strategies generally offer greater returns than those available in the traditional, publicly traded securities markets without necessitating great risk-taking. In fact, due to low or negative correlations to some of the commonly held core asset classes, these new alternative strategies can be used to reduce overall insurance company’s investment programme risk exposure. These newer ALTs have strategies that are more clearly defined, have better transparency, are more easily understood and some have features specifically designed for an insurer’s benefit.
Figure 1: Outsourced asset category trends
Specifically, features that insurers may find attractive and make ALTs less like the ALTs of yesteryear include:
- Higher returns with low correlation to core bond and core stock allocations
- Improved returns and better portfolio diversification
- Investment-grade rated structures
- Lower credit risk and better capital treatment
- Simplified accounting requirements
- Less headaches for regulatory reporting
- Limited lock-up periods
- Better liquidity than ALTs of the past
- Low minimum investment requirements
- Access now available and appropriate for smaller to mid-sized insurers
Careful and thorough vetting of ALTs managers is essential. In addition to possessing the characteristics desired, insurers need to be satisfied that the ALTs managers have the expertise and experience required to fulfil their contribution goals to the insurer’s portfolio.
Fancy pitchbooks and/or slick presentations are not the answer. Even after completing a quantitative risk-adjusted analysis of the track record of any of the manager’s past or similar strategies, some old-fashioned shoe leather inquiry is required. For example, physically meeting the management in their offices to assess their resources, their expertise, and see supporting systems and technology, etc, are all required to complete appropriate due diligence. This qualitative assessment can sometime uncover things that are not visible in the numbers or slide decks.
The final step in determining if an ALTs strategy is desired and/or which ALTs strategy best suits the insurer’s risk profile, requires that some asset allocation work be done.
Figure 2 gives is an example of how ALTs can complement an insurer’s current investment programme. The lower curve represents the efficient frontier* of a typical portfolio; one using publicly traded securities in an investment programme consisting of 80 percent core bonds and 20 percent “core” stocks. By adding 5 percent (Portfolio 1) and 10 percent (Portfolio 2) of an ALTs** strategy, the new efficient frontier for the insurer’s overall investment programme shifts upward to the left.
The addition of the ALTS provides incremental return at a slightly lower overall risk level. This demonstrates how appropriately introducing low to negatively correlated ALTs in a portfolio can provide a great diversification benefit.
Figure 2: Asset allocation optimisation
*Investopedia definition: The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.
**This particular sampled strategy comprises private debt of which 75 percent has attained a credit rating of “A” (SVO-1) and the remainder is expected to be an SVO-6, all with an expected annualised return of 11 percent, a 3-year lock-up and a $1 million minimum investment.
The alternative investment industry has undergone significant change over recent years. With current markets for stocks and bonds producing negative real returns, and the high probability of continued choppy markets, it behoves insurers to explore new asset classes for possible incremental investment allocations. Some ALTs managers have structured investments specifically for insurers with more accommodative features.
Understanding how various strategies may benefit the risk/return characteristics of an insurer’s investment programme and pursuing proper quantitative and qualitative methodologies for manager vetting could therefore be a timely and worthwhile effort.
CapVisor Associates is an SEC registered investment advisor. We offer non-discretionary investment advice, as a fiduciary, specifically for insurance companies. We do not sell any investment products/strategies and we do not manage insurance client assets or money.
Carl Terzer is principal and founder of CapVisor Associates. He can be contacted at: firstname.lastname@example.org
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