Permeating the Insurance Company Investor Segment

INVESTOR SERVICES

PRIME BROKERAGE PERSPECTIVES Barriers to Entry: Permeating the Insurance Company Investor Segment

February 2015 Introduction Constraints on Hedge Fund Investments Relative to other institutional investor segments, insurance In order to enhance relationships in the insurance investor companies historically have had lower allocations to segment, it is necessary to understand the strictures alternatives in general and to hedge funds in particular. within which these companies operate concerning hedge Traditionally, insurance company general accounts have been fund allocations. There are several hurdles that insurance weighted heavily towards fixed income and credit with lower companies face in terms of their ability to allocate capital to allocations to alternative investments. This heavy fixed income hedge funds, the most obvious of which is the RBC regime to bias stems largely from the stringent risk-based capital (RBC) which such firms are subject. frameworks to which insurance companies are subject. Those regulatory frameworks require insurance companies to hold Risk-Based Capital (RBC) Rules large amounts of capital against investments in certain asset Although the “low for long” yield environment of recent classes, including alternatives and equities. years has made alternative investments more attractive to insurance companies from a return perspective, the RBC The low interest rates and depressed bond yields that have framework renders alternatives very expensive – in some characterized the post-financial crisis period have created a instances prohibitively so. In the U.S., the RBC rules are under serious investment income problem for insurance companies, the jurisdiction of the National Association of Insurance which face difficulty in meeting their portfolio targets given Commissioners (NAIC), which regulates U.S.-domiciled their traditional allocation patterns. That difficulty has in insurance companies. These rules stipulate that insurance turn created challenges for insurers from an asset-liability companies must hold specified levels of regulatory capital perspective and, in many instances, has resulted in a squeeze and are based on several factors, including a prudential on earnings. Consequently, insurance companies have been assessment of the risks of the investment holdings in insurers’ steadily raising their allocations to alternatives in a search for portfolios.1 Property and Casualty (P&C) firms are subject to higher returns. Nonetheless, there remain real barriers that RBC charges ranging from 10% to 15% for alternatives. prevent insurance companies from increasing their hedge Life insurance companies are subject to an even stricter fund exposure beyond a certain level. RBC regime; capital charges for such firms range from In light of the constraints that insurers face with respect 22.5% to 45%. to alternatives, the purpose of this Perspectives piece is to provide hedge fund managers with additional insights into the 1 evolving allocation trends of such companies and to highlight According to the NAIC, RBC is a way of measuring the minimum capital appropriate for an insurance company to support its operations relative how managers might target and permeate this investor to its size and risk profile. RBC limits the amount of risk a company segment with greater effectiveness. This report is based on can take and requires a company with a higher amount of risk to hold a higher amount of capital. Capital provides a cushion for a company industry data along with interviews with numerous hedge against insolvency. fund allocators and CIOs at U.S.-based insurance companies. See http://www.naic.org/cipr_topics/topic_risk_based_capital.htm.

This material is provided by J.P. Morgan’s Prime Brokerage business for informational purposes only. It is not a product of J.P. Morgan’s Research Departments. For institutional and professional investors only. For the intended recipient only.

1 Insurance companies based in Europe will be subject to a As a safeguard against outflows, insurers typically hold higher similar and even stricter RBC framework pursuant to Solvency levels of capital than the regulations require. In fact, in recent II, which is scheduled to take effect in January 2016. Under years, RBC levels among U.S. insurance companies have Solvency II, hedge funds will be subject to a capital charge increased materially, largely as a result of greater regulatory of up to 49%. However, for “black box” strategies without scrutiny and heightened conservatism among insurers in a “look-through” to the underlying assets, an even steeper reaction to the financial crisis. For example, as Figures 1 capital charge shall apply. and 2 show, RBC ratios among the largest U.S. life insurance companies have increased noticeably since 2008, although the upward trend pre-dates the financial crisis.

FIG. 1 Historical NAIC Risk-Based Capital ratios

Based on statutory filings for life insurance companies in J.P. Morgan’s Large Company Composite as of year-end 2013 ACL Risk-Based Capital Ratio/2 (%) 900 800 700 600 500 400 RBC Ratios 300 200 100 0 1996Y 1997Y 1998Y 1999Y 2000Y 2001Y 2002Y 2003Y 2004Y 2005Y 2006Y 2007Y 2008Y 2009Y 2010Y 2011Y 2012Y 2013Y

 AEG  AFL  ALL  AIG  AXA  GNW  HIG  ING  LNC  MFC  MML  NFS  NYL  NML  PAC  PFG  PL  PRU  TIA Source: J.P. Morgan Insurance Investor Client Management, SNL Financial LC

FIG. 2 Historical NAIC Risk-Based Capital ratios (median)

Median for life insurance companies in J.P. Morgan’s Large Company Composite as of year-end 2013 ACL Risk-Based Capital Ratio/2 (%) 500

450

400

350

300 Median RBC Ratio

250

200 1996Y 1997Y 1998Y 1999Y 2000Y 2001Y 2002Y 2003Y 2004Y 2005Y 2006Y 2007Y 2008Y 2009Y 2010Y 2011Y 2012Y 2013Y Source: J.P. Morgan Insurance Investor Client Management, SNL Financial LC

2 From 2006 through 2013, the RBC ratios for the largest life Return Hurdles insurers (depicted in Figures 1 and 2) increased by an average The RBC requirements discussed above impose de facto of +19%, well in excess of the specified requirements. One return hurdles for insurers’ investments in alternatives. might think that, because those companies are now holding Consequently, insurance company investment committees substantially more capital on balance sheet, they would have face pressure to select investments that justify the attendant more capital for hedge fund allocations, which could help in capital charges. That dynamic helps to explain why insurers their search for yield. However, closer analysis reveals that, traditionally have been larger buyers of private equity than within the current RBC framework, the potential delta of hedge funds (see Figures 3-4). Historically, private equity is additional capital for new hedge fund allocations among those a higher-returning asset class. Over a three-year horizon, 2 companies totals only $1.2 billion. This example underscores private equity firms generated an aggregate IRR of 14.5% the fact that there is a finite amount of capital available versus a 4.0% annualized return for hedge funds; over a for hedge fund allocations among insurance companies. five-year horizon that spread was 17.7% versus 6.5% Understanding such limitations is paramount for managers (See Figure 5). seeking to grow their relationships in this segment.

FIG. 3 Life insurance alternative asset investments3

Investment ($billions) 20

0 2008Y 2009Y 2010Y 2011Y 2012Y 2013Y

 Hedge Fund  Private Equity  Real Estate  Sch BA Fixed Income/Loans  Other LPs Total Source: J.P. Morgan Asset Management Global Insurance Solutions, SNL Financial LC

2 This figure was derived by calculating the median RBC ratio of J.P. Morgan’s Large Company Composite and the average alternatives allocation of the same group. For companies with above-median RBC and below-average alternatives allocations, we calculated the amount of additional investment that would be needed for those firms’ alternatives allocations to equal the average. That number is approximately $12 billion in aggregate. The average percentage of alternatives that are allocated to hedge funds among those companies was then calculated: 5.38% or $700 million. Companies with little or no hedge fund exposure were then removed from the average. It was then assumed that the goal among companies in this analysis would be to match the average hedge fund allocation of insurers with existing hedge fund programs, or 10.76%, which yields $1.2 billion. 3 Whereas Figure 1 is drawn from J.P. Morgan’s Large Company Composite, the data sets for figures 3 and 4 are drawn from the broader universe of listed life and P&C insurance companies, respectively.

3 FIG. 4 P&C insurance alternative asset investments

Investment ($billions) 10

0 2008Y 2009Y 2010Y 2011Y 2012Y 2013Y

 Hedge Fund  Private Equity  Real Estate  Sch BA Fixed Income/Loans  Other LPs Total Source: J.P. Morgan Asset Management Global Insurance Solutions, SNL Financial LC

FIG. 5 Hedge fund and private equity returns

Based on HFRI Fund Weighted Composite Index and Cambridge Associates LLC U.S. Private Equity Index

Hedge Fund Annualized Returns Private Equity Net IRRs Jun-09 -10.1% -20.20% Jun-10 9.1% 19.10% Jun-11 11.5% 25.40% Jun-12 -4.3% 6.50% Jun-13 7.9% 16.80% Jun-14 9.1% 22.40% 1 Year (6/30) 9.1% 22.40% 3 Year (6/30) 4.0% 14.50% 5 Year (6/30) 6.5% 17.70%

Source: HFR, Cambridge Associates

Volatility Investment Weightings Hedge funds can also present a challenge for insurance Regulatory constraints aside, insurance companies invest to company allocators in terms of volatility. Because private meet their actuarially modeled future liabilities. Such firms equity investments are illiquid, insurers typically are able therefore seek investments that mature close to when their to hold them at cost until realization. By contrast, insurance liabilities are due and which are capable of earning at or in companies tend to mark hedge fund assets to market. excess of the discount rate used for premiums. Consequently, Consequently, any material volatility in an insurance insurance company general accounts tend to be weighted company’s hedge fund holdings can exert a drag on earnings. heavily to investment grade corporate credit and government

4 fixed income (see Figures 6 and 7). That pattern has an asset-liability matching perspective to invest in less liquid changed little over time. Because life insurers typically have asset classes such as hedge funds. Nonetheless, life company longer-dated liabilities than other insurance companies, they alternatives allocations tend to be lower than that of P&C tend to weight their portfolios towards assets with lengthier companies given the stricter RBC charges to which they are durations. Accordingly, life insurers are well positioned from subject (see Figure 6).

FIG. 6 P&C and life insurance company investment allocations (2013)

2013 P&C Insurance company allocations 2013 Life Insurance company allocations

 Credit - 18%  Equity - 27%  Credit - 46%  Equity - 2%  Structured Securities - 11%  Mortgage Loans - 1%  Structured Securities - 20%  Mortgage Loans - 13%  Treasuries & Agencies - 18%  Alternatives - 11%  Treasuries & Agencies - 8%  Alternatives - 6%  Munis - 9%  Cash & Other - 5%  Munis - 1%  Cash & Other - 4% Source: J.P. Morgan Insurance Investor Client Management, SNL Financial LC

FIG. 7 Fixed income as a percentage of select insurance company assets

100 89.0 90.4 88.7 88.5 90 86.6 85.3 85.3 84.7 83.6 82.6 82.4 81.1 80.2 80 78.9 73.5 74.2 72.8 71.3 68.9 70.0 70.3 69.8 69.6 70.0 70.1 70 64.5 66.3 65.2 64.4 60.4 59.1 58.7 60 55.1 56.2 49.5 50 47.6 40 30 20 10 0 TRV HIG CNA ZUR AIG PRO CHU ALL NFS LM SF USAA

 2008  2012  2013

Source: J.P. Morgan Insurance Investor Client Management, SNL Financial LC

5 “Low for Long” Headwinds for example, has fallen over 180 basis points since 2008 (through year-end 2014). In 2014, a year in which many Given their historic skew towards fixed income, insurance market participants anticipated a rise in rates, the yield on company portfolios have run into difficulty in recent years as the 10-Year declined by more than 80 basis points. For U.S. a result of falling interest rates, which have reached new lows Treasuries, this decline is part of a trend that has been under post-2008. Since the financial crisis, accommodative central way for some time (see Figure 8). This pattern has been fairly bank policies have driven down the yields on government consistent across developed markets. Accordingly, there has debt to historic troughs leading to tighter credit spreads been little opportunity for insurance companies to seek among other results. The yield on the U.S. 10-Year Treasury, yield abroad.

FIG. 8 Yield on the U.S. 10-Year Treasury (2000-2015)

8.0

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15

 US 10-Year Treasury Yield Source: Bloomberg

Income on invested assets is a key driver of earnings for Shifting Allocation Patterns insurance companies. The declining rate environment has Necessity begets action. Falling yields and tighter credit therefore presented a challenge for insurance company spreads have caused many insurance companies to increase profitability, especially since insurers tend to hold their their exposure to other asset classes in search of higher bonds until maturity. Moreover, in many of the asset classes returns. On the fixed income side, insurance companies have in which insurers (particularly life companies) invest, credit been taking on more interest rate and credit risk by increasing spreads are either flat or have compressed. Consequently, their exposure to higher-duration bonds along with allocations new money yields in many insurance company portfolios have to lower-rated corporate credits, including, in some cases, been declining in recent quarters as higher-yielding bonds roll high yield. off. Over the last year, for instance, new money yields in life company portfolios were down approximately 40 basis points Insurance companies also have been increasing their and are far below portfolio yields.4 That pattern has exposure to alternatives—which the NAIC classifies as presented another headwind for insurance companies’ “Schedule BA” assets—including hedge funds.6 From 2007 investment income.5 through year-end 2013, life insurers raised their Schedule BA

4 J.P. Morgan North America Equity Research, Life Insurance 2015 Outlook, January 5, 2015, available at https://jpmm.com/research/content/ GPS-1586411-0. J.P. Morgan estimates that the prolonged low interest rate environment will pressure annual life insurance ROEs by approximately 10-20 basis points in the coming years. 5 J.P. Morgan North America Equity Research, Life Insurance 2015 Outlook. 6 The NAIC classifies non-traditional asset classes, including, but not limited to, alternatives, as “Schedule BA” assets. Schedule BA assets encompass alternatives such as private equity and hedge funds along with assets such as surplus notes and secured and unsecured loans.

6 asset exposure by +23.3% while P&C companies increased With respect to hedge funds specifically, the carrying value of such exposure by +38.8% (see Figure 9).7 Among life insurers, such investments—including year-over-year allocations—for the most substantial increases in Schedule BA assets have U.S. domiciled life insurers rose from approximately $1.5 been through greater exposure to private equity and hedge billion in 2008 to over $2.6 billion in 2013, or +73%. Among funds.8 Such exposure has risen +79.5% in absolute dollar P&C insurance companies, there was a +71% increase, from terms since 2008 (see Figure 10). $5.2 billion in 2008 to $8.9 billion in 2013 (see Figure 11). The upward trend is unmistakable.

FIG. 9 Insurance company exposure to Schedule BA assets including alternatives As a percentage of total invested assets 8

2 2006 2007 2008 2009 2010 2011 2012 2013

 Life Companies  P&C Companies Source: A.M. Best, Schedule BA Investments – Behind Their Rising Trend, June 30, 2014

FIG. 10 Life insurance company Schedule BA allocations

Allocations reflect underlying investment holdings, not strategy of investment vehicle. 160

140

120

100

US $billions 60

0 2008 2009 2010 2011 2012 2013

 Common Stocks  Real Estate  Fixed Income  Miscellaneous Source: A.M. Best, Schedule BA Investments

7 Source: A.M. Best, Schedule BA Investments – Behind Their Rising Trend, June 30, 2014. Part of that uptick was attributable to Berkshire Hathaway’s purchase of Burlington Northern Santa Fe. 8 Private equity and hedge funds are classified as “Common Stocks” on Schedule BA.

7 FIG. 11 Carrying value of hedge fund investments among insurers

900 800 700 600 500 400 $millions 300 200 100 0 2008 2009 2010 2011 2012 2013

 Life Alated  P&C Aliated Source: J.P. Morgan

Importantly, alternatives exposure for both the life and doubling those investments within the next three to five P&C industries tends to be concentrated among the larger, years. At the same time, though, the regulatory constraints better-capitalized—i.e., highest rated—companies. On average, that insurance firms face in making such investments are 88.7% of life insurers rated “a-” or above hold alternatives considerable. Therefore, as hedge fund managers approach exposure, whereas only 37.0% of life companies with ratings this segment, they must be cognizant of the ways in which of “bb+” or below do so. Among P&C firms, 55% of the various strategies and structures can impact insurers’ companies with “a-” ratings or better have investments in portfolios and balance sheets. alternatives versus a mere 32.0% of firms with “bb+” ratings Insurer hedge fund portfolios tend to be highly idiosyncratic or lower (see Figure 12).9 relative to one another. Nonetheless, our conversations with insurance company investors and our analysis of various BA Asset exposure among Life and P&C Insurance industry data revealed several common patterns across this FIG. 12 companies by rating segment, which may be additive for hedge fund managers:

Rating Life & Health P&C Insurers Minimal Volatility and Correlation Insurers Among insurance firms, hedge fund allocation patterns vary aaa to aa- 94.4% 67.2% considerably from company to company. However, because a+ to a- 82.9% 42.8% insurers mark hedge fund investments to market, as a segment, they prefer strategies with lower volatility to avoid bbb+ to bbb- 36.7% 20.7% potentially negative balance sheet impact. bb+ and lower 37.0% 32.0% Generally speaking, therefore, funds with lower volatility Source: A.M. Best, Schedule BA Investments and less correlation are better suited to such investors. Further, because investment yield is a key driver of earnings, Considerations for Managers particularly for life insurers, managers with steadier return As the preceding discussion shows, there are significant profiles and track records of being able to mitigate acute tailwinds driving insurance company allocations to hedge drawdowns will find greater receptivity in this segment. funds. We anticipate that this trend will persist as insurers In sum, funds and strategies with the following volatility/ continue to increase their exposure to the asset class. correlation/return profile may be potentially well-suited to As an example, a major insurer with a large hedge fund such investors in the insurance segment: portfolio that was interviewed for this piece anticipates 9 A.M. Best, Schedule BA Investments.

8 Volatility 5% – 8% is therefore underpenetrated with respect to alternatives Insurance Company Correlation 0.4 or less generally and hedge funds in particular. Volatility & Equity Beta 0.4 or less However, hedge fund managers seeking to deepen their Correlation Matrix Sharpe Ratio 1.0 or higher relationships with insurance companies will find more receptivity among larger companies with existing programs This is not to say that managers that do not fit these than they will among middle market and smaller firms. parameters precisely will be unable to make inroads with Companies in the latter group tend to be unfamiliar with insurance company allocators. But, the more a fund deviates alternative assets and lack the in-house capability to analyze from the above-listed ranges, the higher the hurdle may be. them. Accordingly, any dialogue with such firms likely would entail a lengthy, high-touch education process with only Existing Alternatives Exposure modest prospects for any actual allocations. Companies Larger and highly rated insurance companies, both life and with existing alternatives portfolios—even those with only de P&C, tend to have well-established alternatives portfolios minimis hedge fund allocations—generally have the capability and sophisticated teams of varying sizes to manage them. to research and analyze non-traditional assets, are far more Among middle market and smaller insurance companies, by comfortable in the space and far likelier to allocate capital. contrast, alternatives portfolios typically are much smaller or Hence, hedge fund managers should target firms with existing non-existent. That subset of the insurance company segment alternatives allocations.

FIG. 13 Top insurance companies by Schedule BA holdings10

U.S. Life/Health U.S. Property/Casualty Total Ba Ba/ Ba/Total Total Ba Assets Invested Capital Assets Ba/Invested Ba/C&S company name (Usd 000) Assets (%) (%) Company Name (Usd 000) Assets (%) (%) Metropolitan Life Berkshire 20,957,676 6.7 77.9 54,154,330 25.0 41.6 & Affiliated Cos Hathaway Ins Gp TIAA Gp 20,168,641 8.9 56.9 Liberty Mutual 12,057,784 20.7 68.0 New York Life Gp 14,003,009 7.5 66.2 Ins Cos Northwestern American Int'l Gp 10,353,049 12.3 37.8 11,332,646 6.1 55.1 Mutual Gp Nationwide Gp 3,885,136 12.3 27.0 AIG Life & 11,103,554 5.9 60.4 Travelers Gp 3,524,069 5.5 17.3 Retirement Gp Allstate Ins Gp 3,522,292 8.7 19.4 Prudential of 8,887,395 4.6 66.4 CNA Ins Cos 2,747,981 6.8 24.7 America Gp Zurich Fin'l Svcs MassMutual 2,506,370 10.1 32.0 7,439,514 5.9 50.3 NA Gp Fin'l Gp John Hancock Life State Farm Gp 2,279,662 1.6 3.0 5,575,739 5.6 77.0 Ins Gp Principal Fin'l Gp 3,056,770 5.3 64.5 Queen City 1,968,523 99.9 107.1 Assurance Inc Aegon USA Gp 2,952,173 3.5 32.4

Source: A.M. Best, Schedule BA Investments

10 Not all insurance companies that are Schedule BA filers currently maintain active hedge fund portfolios. Please contact the Capital Introduction Group for more information.

9 Multi-Strategy Appetite Second, insurance companies tend to prefer the diversification Generally speaking, multi-strategy managers are well that multi-strategy offerings can provide. This preference is positioned with respect to the insurance segment for not only a function of portfolio theory but also because, by two reasons. First, interviews with CIOs and hedge fund holding a wider array of underlying investments including professionals at the larger P&C and life companies indicate fixed income and rates, multi-strategy offerings can mitigate that, while such companies do still invest in funds of hedge to some degree the RBC impact for insurance companies. funds (FoFs), their allocations to FoFs are stagnant or Consequently, the carrying value of insurers’ multi-strategy decreasing, as insurers prefer increasingly to invest directly. hedge fund investments, including year-over-year allocations, Multi-strategy managers have been and are likely to be have increased substantially in recent years, growing more beneficiaries of this pattern. than +58% from 2008 through year-end 2013 (see Figure 14).

FIG. 14 Carrying value of hedge fund investments among life insurers by strategy

1.6

1.4

1.2

1.0

0.8 $billions 0.6

0.4

0.2

0.0 2008 2009 2010 2011 2012 2013

 Distressed  Emerging Markets  Fixed Income Arbitrage  Global Macro  Equity Long/Short  Multi-Strategy  Equity: Sector-Speciﬁc

Source: J.P. Morgan

Parameters particularly fee sensitive, it is not uncommon for them to seek Perhaps unsurprisingly, given insurance companies’ size, a fee break in return for longer-term allocations. low tolerance for volatility and appetite for steady returns, With managers across the strategy spectrum coming to they typically prefer larger, more established managers market with longer duration structures as markets become with built-out track records. More specifically, this means increasingly illiquid and more volatile, life insurers may be a managers with AUM of $1 billion or more and a three-year potentially fruitful investor sub-set. track record. Again, these are not hard and fast parameters but new launches and emerging managers may find this Separately Managed Accounts (SMAs) segment challenging. As discussed, limited partner interests in hedge funds or other alternative vehicles entail capital charges for insurance firms Life Insurers and Longer Locks because of the RBC frameworks to which they are subject. Unlike a number of other investor segments, insurance Investing in hedge funds via SMAs may help to lessen those companies tend to have greater tolerance for illiquidity. charges. In contrast to limited partner interests in hedge This statement is especially true for life companies given funds or other alternative investment vehicles, SMAs are not their longer-dated liabilities. Accordingly, many life insurers always deemed to be Schedule BA Assets subject to varying will consider funds with lock-ups – hard or soft – of one to capital charges. Whether a hedge fund SMA will be subject three years. Although insurance companies tend not to be

10 to Schedule BA treatment depends largely on the underlying Conclusion strategy and whether that strategy relies heavily on leverage Despite the myriad constraints that insurance companies face and/or shorting. Because equities are subject to Schedule in making hedge fund investments, there are various tailwinds BA treatment, SMAs in equity-based hedge fund strategies driving an overall increase in allocations among this segment. also will be viewed as Schedule BA investments. By contrast, The current and forecasted rate environment has brought there may be more benefit for such strategies as macro and into question the sustainability of the traditional insurance fixed income relative value where the underlying holdings company overweight fixed income model. As a result, insurers include rates, futures and bonds, which typically do not entail are looking to alternatives, and hedge funds specifically, as a punitive capital charges. Once again, though, a fund’s use of prospective component of the solution. leverage and shorting may blunt such benefits so there are various nuances about which managers will need to be aware. Understanding the strategies, structures and other attributes But, as a general matter, SMAs may be additive for insurance of hedge funds that are palatable for insurers is paramount companies with respect to non-equity strategies with less for any manager seeking to permeate this segment. We leverage. Managers that are equipped to run SMAs for their welcome inquiries from managers interested in discussing clients may therefore have some advantage with insurance these issues in more detail. company allocators.

A special thanks to Bill Wallace and Jackie Krasne of J.P. Morgan’s Insurance Investor Client Management (ICM) team for their help and input on this report. Please feel fee to contact J.P. Morgan’s ICM insurance team (see below for details).

Kenny King, CFA Bill Wallace [email protected] [email protected] 212-622-5043 212-834-9339

Christopher M. Evans Jackie B. Krasne [email protected] [email protected] 212-622-5693 212-834-9478

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