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The road less traveled: An insurer’s path to investing in alternatives

Tim Antonelli, CFA, FRM, SCR, Multi-Asset Strategist
2023-09-30
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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

Key points

  • Many investors have historically taken a cautious stance on alternative investments, but that has begun to change in recent years — an encouraging development, in our view.
  • Before investing in alternatives, insurers should attempt to define the universe and understand the roles these investments can play in a strategic asset allocation.
  • From an insurance standpoint, we believe there are four main types of investments that should be classified as “alternatives”: real assets, private credit, private equity, and hedge funds.
  • It’s also important for insurers to determine the optimal sizing of an alternatives allocation and to assess ESG considerations and opportunities.
  • In the years ahead, we fully expect alternative investments to continue to find their way toward the mainstream of insurance portfolio construction.

The investable asset universe for global insurers has evolved and proliferated rapidly and continues to do so. From new asset classes and security types to numerous implementation vehicles, keeping track of it all could easily be a full-time job. Within this vast universe resides a “galaxy” that is pretty large and eclectic in its own right: alternative investments. It’s an area that many investors (including some insurance companies) have historically taken a cautious stance on, but that has begun to change in recent years — an encouraging development, in our view.

One reason for the past skepticism was widespread confusion around the alternatives space. While traditional asset classes like equities and fixed income are familiar to and well understood by most investors, the alternatives bucket has chronically lacked a clear consensus, both in terms of the scope of the universe and what purpose it should serve in an investor’s strategic asset allocation. With that in mind, this paper aims to provide global insurers with a robust framework for how they might approach and navigate the alternative investments landscape. As prerequisites to using this framework, insurers should of course identify their own overall portfolio risk/return objectives and at least be open to the possibility that alternative investments can aid in the pursuit of those goals.

So how might insurers go about creating, implementing, and managing an effective alternative investments allocation? From where we sit, there should be four steps:

  1. Establish the contents and boundaries of the alternatives asset class universe
  2. Understand the roles these investments can play in a strategic asset allocation
  3. Determine the optimal sizing of an alternatives allocation within the portfolio
  4. Assess environmental, social, and governance (ESG) considerations and opportunities 

Defining the alternatives universe for insurers

It’s safe to say that the umbrella overarching what constitutes an alternative investment is very broad and not of a “one-size-fits-all” variety. Even among insurers, there is little to no agreement or consistency. Some choose to include anything that is not public fixed income or public equity. Others opt to fold investment-grade-equivalent private fixed income and commercial mortgage loans into their fixed income bucket and not as alternatives, while others still may classify 144a bonds like securitized assets as alternatives. Simply put: The asset class has long been in dire need of a more uniform definition that insurers can latch onto. So, let’s address that first.

From an insurance standpoint, we believe there are four main types of investments that can/should be categorized as “alternatives” to public-market asset equivalents of core equities and fixed income (Figure 1).

Figure 1
the-road-less-traveled-an-insurers-path-to-investing-in-alternatives-fig1

1. Real assets

The assets in this category share the fact that they are largely tangible investments with an intrinsic value tied to their substance and/or physical properties. In essence, investors acquire the underlying assets themselves as opposed to investing in financial contracts for ownership of the assets. The assets are incredibly diverse as shown in Figure 2, but there is significant overlap among them when it comes to how they might fit in an insurer’s overall asset allocation strategy. If properly integrated into such a strategy, real assets can potentially confer the following portfolio benefits:

Figure 2
the-road-less-traveled-an-insurers-path-to-investing-in-alternatives-fig2
  • Diversification versus traditional asset classes: Generally speaking, real-asset values and behavior have historically exhibited relatively low correlations with those of public-market equity and fixed income investments (Figure 3). Thus, an appropriate allocation to real assets may provide greater strategic diversification, perhaps including a much-needed cushion for portfolio returns during periods of severe market sell-offs.
Figure 3
the-road-less-traveled-an-insurers-path-to-investing-in-alternatives-fig3
  • Possible hedge against inflation: Investments in physical assets such as commodities (e.g., oil) are key parts of the overall inflation “basket” and, as we have seen firsthand over the past year or so, tend to display high correlations with rising consumer prices throughout the economy. As such, real assets may help to offset weakening performance in other asset classes.
  • Income generation potential: Many types of real assets can generate steady income streams over time, particularly physical infrastructure assets, real estate investment trusts (REITs), and agricultural commodity products. Most REITs, for example, pay regular dividends and can be an attractive source of investment income.  
  • Total-return potential: While the elevated level of expected volatility in the real-assets space can at times heighten a portfolio’s risk exposure, the flip side of that coin is that it may also translate to enhanced portfolio growth and total returns at other times.

2. Private credit

This asset class has swiftly evolved from a niche allocation idea adopted by the largest life insurers, or a surplus investment idea for longer-duration non-life insurers, to a core portfolio holding for global insurers of all stripes. With more insurers now investing in or seriously considering the private-credit asset class, an understanding of exactly what investments it comprises is critical to how insurers should think about structuring their portfolios.

A little background: As most banks worldwide reduced lending activity post the 2008 financial crisis, private investment capital stepped in to fill the void. In 2000, total private-credit assets under management (AUM) were only around US$50 billion, but that figure had soared to over US$1 trillion by the end of 2020 — a roughly 20x increase! Global insurers have helped to fuel the rapid growth of this asset class and remain major participants in it, continuing to invest across the private-credit risk spectrum. For example, private placements as a percentage of total bonds outstanding have reached 40% for US life insurance companies and nearly 20% for both US health and P&C insurers (Figure 4).

Figure 4
the-road-less-traveled-an-insurers-path-to-investing-in-alternatives-fig4

In general, most insurers’ private-credit positions tend to skew toward the less risky side of the spectrum and, in the investment-grade bond sector, are similar in many ways to traditional public fixed income. However, it’s important to note that global insurers can (and some do) utilize private-credit assets not just for capital preservation and income generation, but also to boost their portfolios’ total-return potential if they are willing to accept the attendant risks of such assets (Figure 5).

Figure 5
the-road-less-traveled-an-insurers-path-to-investing-in-alternatives-fig5

If we break down the private-credit investment universe by anticipated levels of risk, you can begin to make portfolio allocation decisions based on some common characteristics:

1) Lowest potential risk (capital preservation focus):

  • Includes investment-grade private credit, senior commercial real estate debt, and (even though it is also a real asset) infrastructure debt
  • Offers a yield advantage over investment-grade public-market equivalents 
  • Can serve as an intermediate- or long-duration liability hedge  
  • May receive favorable risk capital treatment by industry regulators and ratings agencies
  • Can be a core portfolio allocation for many insurers

2) Moderate potential risk (both capital preservation and total-return potential):

  • Includes middle-market direct lending and asset-based lending 
  • Offers a yield advantage over high-yield-rated public-market equivalents
  • Can provide downside risk-mitigation potential due to underlying contractual elements
  • Typically best suited to being a surplus portfolio allocation for insurers

3) Higher potential risk (total-return potential):

  • Includes distressed and special-situation debt, mezzanine debt, and venture-capital debt
  • Opportunistic and higher risk, with a focus on maximizing total-return potential
  • Can be an equity replacement or exist alongside private equity (see below)
  • Will typically be a surplus portfolio allocation for insurers

3. Private equity

Similar to private credit, private equity has also found a place in the invested assets of many global insurers. This should not come as a surprise, as the very nature of how companies approach going public versus staying private has changed considerably in recent years. Over the past two decades, there has been a growing trend of many companies remaining private for longer. Stepped-up industry regulation, favorable market dynamics for large-cap equities, and a recent history of strong post-initial public offering (IPO) performance for mature businesses have all contributed to this phenomenon of companies going public later in their life cycles and at larger sizes than in the past.

By way of further illustration, a quick look at the small-cap equity universe highlights the structural market shift toward the private-equity sphere. In 2001, the proportion of companies in the publicly traded small-cap Russell 2000 Index with market capitalizations of less than US$1 billion was 55%. By 2011, this number had fallen to 44%. As of year-end 2021, it was down to a mere 12%. The takeaway? While public-market opportunities have shrunk, the opportunity set in the private-equity market has expanded meaningfully and now consists of…

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Please refer to the investment risks page for information about each of the following risks:

  • Alternatives risks
  • Asset/Mortgage-backed securities risk
  • Below investment grade risks
  • Capital risk
  • Commodities risk
  • Common stock risk
  • Concentration risk
  • Credit risk
  • Currency risk
  • Emerging markets risks
  • Equity market risks 
  • Fixed income securities market risks 
  • Foreign and emerging markets risk
  • Hedging risk
  • Interest-rate risk 
  • Issuer-specific risk
  • Leverage risk
  • Long-short strategy
  • Real estate securities risk
  • Repo and reverse-repo risk
  • Risks of derivative instruments
  • Risks of investments in other pools 
  • Short selling
  • Smaller capitalization stock risks
  • Sustainability

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