In Search of Better Returns, Insurance Companies Dial Up the Risk

When Breege Farrell wants to boost returns, she can’t stray too far from investment-grade bonds. As chief investment officer of life insurer Unum in Chattanooga, Tennessee, Farrell is handcuffed by state insurance regulators, who levy stiff penalties for equity investments in Unum’s $40 billion portfolio. Things are quite different up at the Northbrook, Illinois, headquarters of Allstate Insurance Co., a subsidiary of Allstate Corp. There, CIO Judy Greffin has more leeway with equities for the firm’s $36 billion property/casualty portfolio because state regulators assign less onerous equity indemnities to p/c investors. But with Allstate’s $57 billion life and retirement portfolio, Greffin must, like Farrell, put aside cash to balance the risk of any equity investments she makes. Victims of the same low yields that are plaguing other investors, insurance companies of all stripes have had to move further out of their comfort zone. Besides chasing the higher returns that come with riskier assets, many of them are outsourcing their alternative investment portfolios. “The issue is, these organizations have commitments to make to shareholders and policyholders, and traditional asset classes are struggling to deliver the yields required to meet their obligations,” says David Lomas, New York–based head of BlackRock’s global financial institutions group, which has $278 billion in insurance assets under management. U.S. insurance companies must adhere to complex cash requirement formulas based on the riskiness of the products they offer. For example, a p/c insurer can take on more equity than a life insurer. But regardless of their specialty, most insurance companies are looking beyond investment-grade bonds. “When you’re an insurance business and counting on those yields, it starts to have a big impact,” Unum’s Farrell says. As insurers step into new territory, don’t expect them to make any daring moves. What might look timid to a pension or endowment CIO can be a big alternative-investment play to an insurance company asset manager. Globally, insurance general accounts hold $22.5 trillion in assets, most of it in fixed-income securities, reports BlackRock’s Lomas, who saw an additional $5 billion in outsourced insurance assets flow into the financial institutions group last year. As the proportion of alternative investments — commodities, hedge funds, infrastructure, private equity, real estate and timberland — has risen in insurance portfolios, it’s meant brisk business for third parties like BlackRock and Deutsche Bank Asset Management, two of the biggest players in this niche. Fussier than many investors because they have to be, insurance company CIOs won’t stand for underperforming managers. Allstate’s p/c general account, which holds $4.3 billion in public equity and $4.7 billion in alternatives, first waded into venture capital and private equity investments more than 20 years ago and hedge funds a decade later. “We’ve seen the good, the bad and the ugly,” Allstate’s Greffin says of hedge funds. She’s cutting down the firm’s hedge fund allocation. “We’re pretty disappointed,” Greffin explains. “Right now they’re not pulling their own weight.” At the same time, Unum’s Farrell is favoring alternatives that she thinks will add more value, such as direct ownership of real estate, infrastructure and other cash-generating assets. Insurance investors have gotten creative in their search for higher returns to offset the capital charges that come with equity risk. This quest includes seeking more benefits from alternative investments than a pension or endowment fund would. For instance, Unum’s private equity investments are part of what Farrell dubs a “combo strategy”: Before committing, she looks to forge relationships with firms that need loans to buy their portfolio companies. “We might make loans where we can make them outside the public markets,” Farrell says of her private equity limited partnerships. But, she adds, “unless you’re willing to significantly increase your risk, it won’t move the needle. Regulators won’t let you.” Scott Sleyster, chief investment officer of Prudential Financial’s $278.5 billion U.S. business, based in Newark, New Jersey, estimates that state regulation limits most of his peers to holding between 3.5 and 6 percent in below-investment-grade bonds and between 2 and 5 percent in alternatives. Prudential outsources a small portion of assets to hedge fund and private equity managers.

Although alternative allocations in insurance portfolios are increasing, they’ll probably stay in the single digits, at least for now. That doesn’t mean they’re small, says BlackRock’s Lomas: “Taking 1 percent up to 2 percent is not large in percentage terms but is enormous in absolute terms.”  •  •