Insurers & hedge funds: the pullback continues

Hedge fund performance has been volatile in 2018. The year started off favourably, according to Preqin, up 1.92 percent in January before posting negative returns in both February and March, leading to a 0.35 percent return for first quarter 2018. Insurers’ top two strategies—multi-strategy and long/short equity—both posted negative, albeit marginally, returns for that quarter.

The insurance industry as a whole continues to pull back from hedge fund investments for a second straight year, down 8.5 percent to $16.4 billion from $17.9 billion in 2016, based on a review of year-end 2017 data from the National Association of Insurance Commissioners’ (NAIC) statutory financial statements. This occurred even as total hedge fund asset flows were once again positive in 2017, after consistent quarterly outflows dating back to fourth quarter 2015.

The life/annuity (L/A) segment reported the largest decrease in investments, cutting its hedge fund holdings from $8.3 billion in 2016 to $7.0 billion in 2017—half the $14.2 billion reported in 2015. The property/casualty (P/C) segment’s hedge fund investments declined by 4 percent, from $9.1 billion in 2016 to $8.8 billion in 2017. The health segment’s holdings have been flat at around $600 million for the past three years; however, holdings are concentrated in 10 health insurers who invest in this asset class.

Given the larger scale of its investment portfolios, the L/A segment typically has more dollars invested in non-traditional assets, but the P/C segment has held more hedge fund investments than its L/A counterparts in each of the past two years.

Annuity insurers are the driving force behind the pullback

From a ratings unit composite view, individual annuity insurers have been the driving force behind the pullback, with their hedge fund holdings declining by nearly three-quarters over the past two years—60 percent in 2016 and 34 percent in 2017.

Multi-line L/A insurers have reported a 39 percent decline since 2015, but these rating units actually increased holdings 3 percent in 2017, after a decline of 41 percent in 2016, and now have more hedge fund investments than AM Best’s individual annuity rating units. Despite three years of declines by commercial lines rating units, they now have more exposure to hedge funds.

Despite pulling more than $4 billion out of hedge fund investments in 2016, accounting for more than half the insurance industry’s reduction, American International Group (AIG) has further reduced its exposure $1.2 billion out in 2017, accounting for nearly half of the industry’s decrease. AIG still holds the most hedge funds in the insurance industry, 18 percent, but that is down from 34 percent just two years ago.

Athene, Aegon, and Metlife had the next most significant decreases in exposure, accounting for another 25 percent of the industry’s drop. Roughly the same number of insurance organisations increased their holdings as those that decreased, although additional investments were much more incremental. Prudential reported the largest dollar increase in hedge fund investments, 20 percent, followed by Principal Financial, 13 percent.

Small number of insurers account for a large majority of hedge fund holdings

The top 20 insurers account for roughly 84 percent of industry holdings, up from about 77 percent in 2015. Thirteen of the top 20 did report increases in hedge fund holdings in 2017, although all were marginal. Schedule BA, which is the investment schedule containing hedge funds as reported by the insurer, is somewhat of a catch-all schedule for non-traditional asset classes with less reporting guidance in terms of investment characteristic specifications, but the large majority of the declining investment holdings in hedge funds looks to be due to strategic investment decisions as opposed to reclassification nuances.

Investment strategies are changing

Hedge fund category allocations continue to shift, as insurers modify their strategies and increase or decrease their allocations. Multi-strategy and long/short equity hedge funds remain the two most popular strategies for all three insurance segments, albeit to varying degrees. The two strategies combined account for more than two-thirds of hedge fund holdings for each of the three segments.

Sector investing also remains an attractive option for insurers, as the P/C segment has increased dollars flowing into this strategy for at least the past four years, and it remains the third largest allocation for both the L/A and the health segments. The L/A segment pulled money out of every strategy in 2017 except for global macro and emerging markets—both of which have a focus on foreign investments—and to a much lesser extent, merger arbitrage. However, that strategy has an allocation of less than 0.5 percent. According to Preqin, emerging markets reported the highest returns in first quarter 2018.

Insurers have pulled money out of the distressed securities strategy, but it still represents 9.2 percent of L/A hedge fund holdings and 8.1 percent for P/C. AM Best believes this strategy might attract more attention if the credit markets turn. The sector is focused on investment opportunities that involve any credit instrument trading at a significant discount and with a greater than average spread for its industry.

A substantial number of these opportunities represent securities that are in outright default; as a result, these investments take the form of loans or bonds intended to aid companies facing significant challenges. Several types of strategies are used for the distressed securities, and even though each one is distinct, many funds use a hybrid of strategies in some combination, as the marketplace and opportunities dictate. AM Best views distressed securities warily, given that the underlying organisations are usually in or near bankruptcy and are considered below investment grade.

Exposures remain minimal, as a percentage of capital & surplus

Overall, hedge fund exposures, as a percentage of capital & surplus for each of the three industry segments, are minimal (Figure 5). Although the L/A segment still holds the largest exposure, it has declined from a high of 3.7 percent in 2015 over the last five years to 1.8 percent in 2017. Similarly, P/C exposure has declined from 1.4 percent to 1.1 percent over the same period.

AM Best views modest allocations to hedge funds as it would many other traditional asset classes. Our analysts expect companies to be able to discuss these investments in detail, including their strategic use, performance, liquidity, and how fair value is measured, regardless of whether an outside manager is used. There should not be significant concentrations (similarly to other asset classes), whether by manager or investment strategy.

Most of the alternative risk is borne by the higher-rated insurers that have the capital and expertise to better absorb the risk. Other mid-sized or smaller insurers without in-house investment expertise in this asset class are more comfortable utilising an outside investment manager. Nevertheless, AM Best closely monitors trends in alternative investments and regularly reviews capital charges to ensure appropriate treatment of this asset class.

The asset/liability aspect of these securities is also important. Historically, these assets were primarily used as “surplus” investments. More recently, they have been increasingly used in liability portfolios—which is less attractive from our viewpoint, given that the potentially higher risk-adjusted return, which has not materialised recently, is offset by the lack of liquidity to be used as a cash flow or duration-matched tool.

AM Best expects that most managers will reallocate hedge fund portfolios back into more traditional investments, such as investment-grade corporate bonds or commercial mortgage loans and common stock—even though this reallocation further squeezes an already tight investment market and insurer returns.

After a few years of sub-par returns, particularly against a broader S&P indexed return, AM Best would not be surprised to see a continued pullback from direct investments in hedge funds, as companies try to ride out the volatility on the sidelines. Although most hedge fund investors in the insurance industry are disappointed in performance, attractive alternatives in which to invest in this current low-return environment are limited.

Jason Hopper is an associate director–industry research & analytics. He can be reached at jason.hopper@ambest.com