J.P. Morgan discusses the barriers to insurance firms investing with hedge funds

Hedge funds have found insurance companies to be a tough nut to crack. There are a number of reasons for this, and a recent report from J.P.Morgan titled INVESTOR SERVICES: Barriers to Entry: Permeating the Insurance Company Investor Segment delves into the whys and wherefores of this situation.

Alessandra Tocco and the J.P. Morgan team begin the report by highlighting that “insurance companies historically have had lower allocations to alternatives in general and to hedge funds in particular. Traditionally, insurance company general accounts have been weighted heavily towards fixed income and credit with lower allocations to alternative investments.”

Risk-based capital (RBC) rules

Insurance Firms Hedge Funds

The JPM report notes that even though the “low for long” yield environment of recent years has made alternative investments a more realistic possibility for  insurance firms from a return perspective, the risk-based capital rules framework makes alternatives relatively expensive. For example, in the U.S., RBC rules are promulgated by the National Association of Insurance Commissioners, which oversees U.S.-domiciled insurance companies. The rules require insurance firms to hold mandated levels of regulatory capital based on several factors, including a prudential assessment of the risks of the investment holdings in insurers’ portfolios. Of note, property and casualty insurance firms can see RBC-related charges ranging from 10% to 15% in their alternatives investments. Capital charges for life insurance companies can reach 22.5% to 45%.

Insurance Firms Hedge Funds

In most cases, insurers hold higher levels of capital than required. In fact, RBC levels among U.S. insurance companies are up substantially over the last few years, mainly because of greater regulatory scrutiny and increased conservatism among insurance firms after the financial crisis. As can be seen from Figures 1 and 2 show, the RBC ratios for the largest U.S. life insurance firms are up notably since 2008. It should be noted that the upward trend actually begins before the financial crisis.

In the period from 2006-2013, the RBC ratios for the largest life insurers were up by an average of +19%, much higher than the specified requirements. It might seem likely that if insurance firms have more capital on balance sheet, they would be more likely to consider allocations to hedge funds to try and up their returns, but it turns out that isn’t the case.

Tocco and colleagues point out closer analysis of the data shows that “within the current RBC framework, the potential delta of additional capital for new hedge fund allocations among those companies totals only $1.2 billion.”

Return hurdles

Insurance Firms Hedge Funds

Insurance Firms Hedge Funds

The JPM analysts also note the RBC requirements in effect create constraints on insurers’ investments in alternatives. That means insurance company investment committees need to choose investments that justify the the capital charges. This situation dynamic explains why insurers have historically been larger buyers of private equity than hedge funds. Private equity is a higher-returning asset class over time. With a three-year horizon, private equity firms produced an aggregate IRR of 14.5% compared to a 4% annualized return for hedge funds; over a five-year horizon it was 17.7% for PE compared to 6.5% for hedge funds.

Insurance Firms Hedge Funds

Volatility

The relatively high volatility of hedge funds also represents a challenge for insurance firms. Give the fact that private equity investments are illiquid, insurers generally just hold them on their books at cost until realization. On the other hand, insurance companies usually mark hedge fund assets to market. This means that any substantial volatility in an insurance firm’s hedge fund holdings can create a drag on earnings.
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