Risk Management

Hedge Funds Remain An Option For Some Insurers

Attractive for risk diversification and low correlation to other asset classes

New market analysis from AM Best. To access the full copy of this special report, please visit here.

OLDWICK, N.J., June 15, 2021—In 2020, the life/annuity and property/casualty insurance segments increased their exposures to hedge funds, leading to an overall 6% increase in insurance industry investments, according to the latest AM Best report.

The new Best’s Special Report, “Hedge Funds Remain an Option for Some Insurers,” notes that during 2020 the hedge fund market did not fall as far as the public markets and recovered more quickly and efficiently. Several qualities made hedge funds attractive to investors during the pandemic, including risk diversification and a low correlation to other asset classes. The hedge fund industry still lost approximately $44.5 billion in asset flows in 2020, according to the report, but that is nearly half the amount pulled out in 2019.

Asset flows were positive under multi-strategy, with an addition of $9.5 billion, and a $2.9 billion increase in equity strategy allocations—the two strategies most popular among insurers. Although the number of insurers’ hedge fund holdings continued to decline in 2020, the book-adjusted/carrying value (BACV) increased for the first time since 2015, to $12.3 billion in 2020 from $11.6 billion in 2019.

Life/Annuity Segment Up To 5.8%

The life/annuity segment raised its dollar exposure in hedge funds 5.8%, to $5.4 billion, and the property/casualty segment, 5.5%, to $6.6 billion. However, the health segment continued to pull back on its modest concentration in these investments, leaving with approximately $320 million in holdings, compared with $490 million in 2019.

Twenty rating units accounted for 87.7% of the industry’s hedge fund exposure in terms of BACV. A majority of those rating units have expanded their holdings since 2019, while seven have continued to pull back. Nevertheless, investments in hedge funds are not that prevalent in the insurance industry as a whole—fewer than 80 U.S. rating units have hedge fund investments.

Just over 95% of the rating units that invest in hedge funds have either an A-level Best’s financial strength rating with the superior (60.6%) or excellent (34.5%) rating descriptor. The remainder fall in the lower-rated categories. Higher-rated companies are better equipped to manage the elevated risk inherent in hedge fund investments and have substantial capital and expertise to manage the risk. Moreover, the hedge fund holdings are significantly concentrated in large organizations, with 86.5% of these rating units having over $2 billion in capital and surplus.

The lingering effects of the pandemic and ongoing market uncertainty in 2021 will determine if the hedge fund market will continue to see renewed interest and greater exposures or revert to being viewed more unfavorably relative to other asset classes.

Excerpts from the Report:

Industry Exposure Highly Concentrated

Twenty rating units account for 87.7% of the industry’s hedge fund exposure in terms of book adjusted/carrying value. A majority of those rating units have expanded their holdings since 2019, while seven have continued to pull back. Prudential of America remains the industry’s largest holder of hedge funds, accounting for almost 17% of the industry’s exposure after its BACV increased by $243 million—the third-largest dollar increase, after Nationwide Group and FM Global. AIG’s P/C rating unit, which had been pulling back from the hedge fund industry consistently the past few years, increased its BACV more than 15% year over year, though it is still less than a third the size of portfolio in 2016. Other rating units with significant growth include Globe Life Group, up 107.2%, followed by Nationwide Group, 51.9% and FM Global Group, 49.6%. Nevertheless, investments in hedge funds are not that prevalent in the insurance industry as a whole—fewer than 80 US rating units have hedge fund investments. Notably, less than a handful are sponsored by private equity firms.

The lingering effects of the pandemic and ongoing market uncertainty in 2021 will determine if the hedge fund market will continue to see renewed interest and greater exposures or revert to being viewed more unfavorably relative to other asset classes...

Minor Shifts in Investment Strategies

Both the P/C and L/A segments expanded their multi-strategy allocations throughout 2020, but all three segments have significant exposures, which is not surprising given the greater diversification benefits. Sector investing became a more favorable option for both P/C (up 14%, following a sharp decline of 19% in 2019) and L/A (9%). The uptick is a concern worth monitoring, given that sectors such as the hospitality, travel, and service industries suffered a greater economic impact than others—businesses that were already in rougher financial shape at the start of the pandemic were likely to feel an even greater squeeze as a decline in revenue hindered their ability to pay off debt. However, overall exposure to sector investing is a fairly minimal percentage of capital & surplus.

Both the P/C and L/A segments expanded their multi-strategy allocations throughout 2020, but all three segments have significant exposures, which is not surprising given the greater diversification benefits. Sectors such as the hospitality, travel, and service industries suffered a greater economic impact than others—businesses that were already in rougher financial shape at the start of the pandemic were likely to feel an even greater squeeze as a decline in revenue hindered their ability to pay off debt. Sector investing became a more favorable option for both the P/C segment (up 14%, following a sharp decline of 19% in 2019) and the L/A segment (9%). Overall exposure to sector investing is a fairly minimal percentage of capital, but the uptick is a concern worth monitoring.

Long/short equity strategies were less favored by the P/C and health segments, with reductions by both. An equity long/short investment is a combination strategy in which a manager buys equities expected to rise in value and sells equities expected to fall in value. Long/short managers tend to have longer holding periods (three to five years) than market-neutral or statistical arbitrage managers, and more concentrated portfolios consisting of three to ten core positions, with perhaps an additional 20-40 smaller positions. Further diversification strategies can be implemented in long/short equity holdings through investments in value, growth, blend, or bottom-up funds.

 

 

 

AM Best is a global credit rating agency, news publisher and data analytics provider specializing in the insurance industry. Headquartered in the United States, the company does business in over 100 countries with regional offices in London, Amsterdam, Dubai, Hong Kong, Singapore and Mexico City. For more information, visit www.ambest.com.