Insurance portfolio construction for alternatives

Insurers’ complex liability profiles and regulatory and accounting constraints create additional portfolio construction considerations. We explore these below.

Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

The case for private market allocations

Insurers are embracing private market assets. The reasons are by now well known: a search for higher returns given persistently low yields, a need to diversify for greater portfolio resilience, and, in certain cases, attractive regulatory capital treatment.

As allocations increase, the ability to incorporate private market assets into insurers’ portfolio construction processes takes on ever more importance. This includes addressing challenges such as forming robust views on expected return assumptions, accounting for the wide dispersion of outcomes between different private market managers and considering the role of liquidity.

But insurers’ complex liability profiles and regulatory and accounting constraints create additional portfolio construction considerations. We describe some of these here.

Regulatory capital

One key consideration is the regulatory capital charge for any given asset class. Higher capital requirements ultimately diminish shareholder returns and may hamper asset allocation due to insufficient solvency ratios. This is true for both public and private market exposures. This principle broadly applies across the various regulatory capital regimes but comes with a number of nuances for private markets. The European Solvency II regulatory regime is illustrative in this regard. Since its introduction in 2016, we have seen how changes in the standard capital charges (applicable to insurers without their own internal capital model) have increased the attractiveness of private market investment. Figure 1 summarizes most of the key changes.

Figure 1: A more favorable environment

Portfolio construction implications

First, while lower capital charges ultimately result in more attractive return on capital, the need to meet often prescriptive and detailed conditions to qualify for such beneficial treatment imposes additional governance requirements on both the insurer and their asset manager. Second, whilst Solvency II is a European regulatory regime, it is still relevant for insurers domiciled elsewhere. For example, many of the evolving regulatory capital regimes in Asia-Pacific are conceptually similar to Solvency II and often apply comparable capital charges, while many US insurers and Bermudan reinsurers have significant European operations. Finally, as these changes are partially motivated by regulators’ desire to foster greater financing of the ‘real economy’ by insurers, we could see further modifications.

Deployment profile

Beyond regulatory capital requirements, the differences in sourcing of private and public market exposures, also matter:

• Rather than buying assets immediately, as would typically be the case in public markets, purchasing private assets usually involves making upfront capital commitments to managers (or internal management teams). They then seek investment opportunities consistent with their mandate.
• When suitable opportunities arise, the committed capital is then drawn, often at relatively short notice. The extent to which it is possible to predict capital calls will vary by manager and asset class, but even with internal teams, complete certainty on timing is unlikely.
• Once deployed, capital typically cannot be withdrawn until the investment is realized, for example a loan being repaid or a privately held company being sold to another investor. Capital would then be returned to the insurer.

Insurers therefore need to consider the funding of any capital calls

• If they fund private market allocations from an existing public market portfolio, the most natural choice may be to leave assets invested as they are. However, if asset values were to fall, there is a risk of missing capital calls, particularly if the ability to sell other parts of the liquid asset portfolio is constrained by regulatory or accounting considerations.
• At the other end of the spectrum, committed capital could be invested in cash. That removes the risk of missing capital calls but is likely to result in a return drag. A secondary consideration is the asset liability management (ALM) impact of holding significant allocations in cash.

It is also worth noting that investments may start to be realized and capital returned before all committed capital is fully deployed. As a result, not only will the net asset value (i.e. the amount of capital invested, ignoring any investment returns) vary over time, but it may also never reach the full level of the initial capital commitment. Some investors, therefore, make additional commitments, potentially funded by any returned capital, to target a stable level of exposure to the underlying asset class. It is also the main reason why private market managers launch additional funds.

Figure 2 illustrates this dynamic for direct lending and private equity, using sample data from BlackRock’s portfolio management teams. We have sought to find a pattern of ongoing commitments that broadly maintains constant exposure over time, for the horizon of the original investment. Different approaches would be possible, but it is worth noting the absolute size of these numbers: for example, an insurer wanting to maintain a constant exposure of US$1bn to direct lending would need to make additional commitments of US$1.43bn over the next seven years, on top of the original US$1bn investment.

Figure 2: The commitment dynamic

Portfolio construction implications

While adding private market allocations should help deliver more efficient portfolios, results may differ materially depending on how committed capital is treated. Whether or not an insurer seeks to maintain a constant exposure also has major implications. To illustrate this, we first perform an optimization across public assets only (we use cash, government bonds, credit and equities), relative to a simple liability benchmark. We then introduce private market assets (private equity, infrastructure equity and direct lending), ignoring practical considerations and assuming that capital is deployed immediately, and stable exposures can be maintained over time. Single period portfolio construction frameworks used by many insurers implicitly make this assumption. Finally, we introduce a multi-period approach which explicitly captures the deployment profile of each private market asset. We do not re-run the optimization, but instead use the composition of each original efficient portfolio to explore the impact of the choices described above. The results are shown in Figure 3.

Figure 3: Adopting a more nuanced approach.