Alternatives: A New Solution to a Familiar Challenge for Asia Insurers

Insurance companies in Asia ex Japan face an exciting opportunity and a familiar challenge. With premiums growing at 13% annually – almost threetimes faster than the global average – the opportunity to offer insurance products to an emerging middle class is clearly attractive. However, asgovernment bond yields in Taiwan, South Korea and elsewhere fall to multi-year lows, Asian insurers find themselves confronting the same investmentchallenge as their U.S. and European counterparts: how to preserve and grow returns in a world of low yields.

Insurers have adapted to this new environment in different ways. Many have increased allocations to overseas investments, with Taiwanese insurerspreferring U.S. and European corporate bonds and Chinese insurers targeting real estate (including the famous Waldorf Astoria in midtown Manhattan). Globalfixed income allocations differ across Asia ex Japan, with Taiwanese and Singaporean firms typically allocating more to the asset class than their Koreanand Chinese counterparts.

Several firms are also responding by increasing investments in alternatives, a relatively new asset class for many Asian insurers. Along with the lowinterest rate environment, permissive government policy and widespread adoption of private equity and hedge funds among U.S. and European insurers seem tobe enticing Asian insurers to take a closer look. In January 2015, a group of Chinese insurers won regulatory approval to launch a private equity fundfocused on small- and medium-sized enterprises. And since January 2014, one of the largest life insurance companies in Taiwan has invested nearly $1billion in alternatives, net of redemptions.

While alternatives still represent a small portion of most Asian insurance investment portfolios, outside of Asia, where yields have remained low for thelast several years, insurance companies have grown increasingly comfortable with private equity and hedge fund investments. In fact, between 2008 and 2014,the book/adjusted carrying value (BACV) of private equity investments held by American insurers more than doubled. Indeed, at the end of 2014, the top 25alternative asset managers were managing nearly $290 billion for insurance companies globally.

Alternatives: Looking at risk and returns

To assess the drivers of this evolution, let’s examine the result of adding alternatives to a typical insurer’s investment portfolio in terms of return andvolatility.

In the analysis in Figure 1, we calculate the effect of reallocating a portion of a typical insurer’s equity exposure to alternatives. Because insurerstend to hold most of their assets in high-quality fixed income and equities, one might expect alternatives to enhance the return potential anddiversification properties of the average portfolio. Indeed, as our analysis shows, even small allocations to hedge funds and private equity funds can leadto a meaningful improvement in the Sharpe Ratio (which measures risk-adjusted return), thanks to higher expected returns and typically low correlationswith traditional asset classes.

Another factor driving higher allocations to alternative investments is the widely held belief that returns on traditional asset classes will be belowtheir historical averages over the next several years. Figure 2 summarizes PIMCO’s 10-year capital market assumptions, illustrating our expectation thatreturns on mainstream asset classes will be lower going forward than they have been in the past. In this scenario, insurance companies could benefit fromadding alternative asset classes to improve return potential.

While many insurance investment teams recognize the benefits of alternatives, it is often not feasible for firms to manage these strategies themselves. Wetherefore see a growing number of insurance companies partnering with asset managers to implement alternative strategies. Between 2009 and 2014, outsourcedassets under management (AUM) from U.S. and European insurance companies grew from $1.05 trillion to $1.6 trillion, with a significant proportion of theseinvestments going into hedge funds and private equity funds managed by third-party asset managers. We expect this trend to continue.

We see some interesting patterns in terms of the strategies that insurance companies prefer. In general, insurers tend to allocate more to private equitythan to hedge funds, reflecting the higher expected returns available through longer lock-up vehicles. Within the industry, the trade-off between privateequity and hedge funds is heavily influenced by the type of insurance each company underwrites (and the corresponding need for liquidity). Property andcasualty insurers are more apt to invest in hedge funds than life insurers, given different liquidity needs and liability profiles. Life insurers, bycontrast, tend to invest more heavily in private equity funds.

One common concern that insurance companies have with alternatives is their impact on capital ratios. Because alternatives are relatively capitalintensive, insurance companies must be thoughtful and strategic in adding them to their portfolios. While these investments may require increased capitalunder risk-based capital (RBC), Solvency II and other risk-oriented capital frameworks, the value proposition has increasingly made this trade-offworthwhile for insurers. PIMCO’s Investment Solutions Group has worked with a number of insurance companies to navigate these trade-offs by modeling theimpact of adding alternatives on an insurer’s profitability and capital ratios under a variety of economic scenarios.

The environment facing insurers in Asia continues to demand thoughtful, innovative investment solutions, which in many cases will include allocations toalternatives. As a global investment manager with more than $23 billion in alternative investments under management at the end of 2015 (including more than$700 million of global insurance company assets), we stand ready to support and partner with investors in the region as they explore these challenges andopportunities.

The authors are grateful to account managers Matthew Schwarz and Justin Tang for their valuable contributions to this article.

The Author

Robert Young

Head of Financial Institutions Group

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Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Alternative strategies(including hedge funds and private equity) may involve a high degree of risk and prospective investors are advised that these strategies are suitable onlyfor persons of adequate financial means who have no need for liquidity with respect to their investment and who can bear the economic risk, including thepossible complete loss, of their investment. The strategies will not be subject to the same regulatory requirements as registered investment vehicles. Thestrategies may be leveraged and may engage in speculative investment practices that may increase the risk of investment loss. Investors should consulttheir investment professional prior to making an investment decision.

No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not representactual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance resultsand the actual results subsequently achieved by any particular account, product or strategy. In addition, since trades have not actually been executed,simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the marketsin general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and allof which can adversely affect actual results. Return assumptions are for illustrative purposes only and are not a prediction or a projection of return.Return assumption is an estimate of what investments may earn on average over the long term. Actual returns may be higher or lower than those shown and mayvary substantially over shorter time periods.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor shouldevaluate their ability to invest long-term, especially during periods of downturn in the market. It is not possible to investment directly in an unmanagedindex.

This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This materialis distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategyor investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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