Insurers Flock to Private Debt and Alternatives: Diversification or Risk?

The traditional world of insurance is undergoing a shift. A recent report by Mercer and Marsh McLennan reveals a surge in insurers looking beyond traditional fixed-income investments. The key takeaway? 73% of insurers have or plan to make private markets investments in 2024, with a particular focus on private debt and alternative assets.

Why the Change?

There are a few key reasons driving this move:

• Low Yields: Rock-bottom interest rates have made it challenging for insurers to generate sufficient returns on traditional government bonds. Private debt, with its higher yields, offers an attractive alternative.

• Diversification: By venturing into private markets, insurers can spread their risk across different asset classes. This diversification can help mitigate volatility in their overall portfolios.

• Tailored Risk-Return Profiles: Private debt allows insurers to invest in specific debt instruments with varying risk-return profiles, potentially aligning them better with their long-term liabilities.

Types of Private Debt:

The private debt market encompasses a variety of investments, including:

• Corporate Loans: Direct loans to companies that may not have access to public bond markets.

• Infrastructure Debt: Financing for infrastructure projects like toll roads or wind farms.

• Real Estate Debt: Loans secured by real estate properties.

Up by 19%, why Asset Owners continuing to pour money into Alternatives in 2023? They keep private equity and venture capital as their top category by size, even though these two alts are lagging on investment returns, per a study. 

This news highlights a seemingly contradictory trend in the world of asset allocation. Here's a breakdown:

The Trend:

• Asset owners (e.g., pension funds, insurance companies) are significantly increasing their investments in alternative assets ("alternatives").

• A 2024 study shows a 19% rise in capital flowing into alternatives in 2023 compared to 2022.

The Conundrum:

• Despite this surge, two of the largest alternative investment categories, private equity and venture capital, are reportedly lagging in terms of returns.

Why Invest in Underperforming Alternatives?

There are a few reasons why asset owners might continue investing heavily in alternatives, even with potentially lower returns from private equity and venture capital:

• Diversification: Alternatives offer a way to diversify portfolios beyond traditional stocks and bonds. This diversification can help reduce overall portfolio risk.

• Potential for Higher Long-Term Returns: Although some alternative investments might underperform in the short term, they can potentially offer higher returns over a longer investment horizon compared to traditional asset classes.

• Illiquidity Hedge: Some alternative investments are less liquid (difficult to sell quickly) than stocks and bonds. This can be a benefit for long-term investors like pension funds, as it discourages frequent trading and aligns with their long-term investment goals.

• Access to Unique Assets: Alternatives can provide access to investment opportunities not readily available in public markets, such as infrastructure projects or early-stage startups.

Private Equity and Venture Capital:

While the study mentions these two categories lagging in returns, it's important to consider a few nuances:

• J-Curve Effect: Private equity and venture capital investments can follow a J-curve pattern, where returns are negative or low in the initial stages and then rise significantly later. So, the underperformance might be a short-term phenomenon.

• Focus on Long-Term Value Creation: These investments often focus on companies with high growth potential, and their returns might not be immediately reflected in the valuation.

Overall, the continued high investment in alternatives despite potentially lower returns from some categories suggests that asset owners value the diversification and potential long-term benefits these investments offer. However, it's crucial for them to carefully assess the risks and choose alternative investments aligned with their specific investment goals and risk tolerance.

The Rise of Alternatives:

The report also highlights a growing interest in alternative investments beyond private debt. This could include:

• Private Equity: Investments in companies that are not publicly traded.

• Hedge Funds: Actively managed funds that use various strategies to generate returns.

• Real Estate Investment Trusts (REITs): Investments in income-producing real estate.

Potential Challenges:

While private debt and alternatives offer intriguing possibilities, they also come with potential challenges:

• Complexity: These investments can be complex and require specialized expertise to manage.

• Illiquidity: Unlike publicly traded stocks and bonds, private debt and alternative investments can be less liquid, making it difficult to sell them quickly if needed.

• Higher Fees: Investing in private markets often involves higher fees compared to traditional investments.

While the Mercer & Marsh McLennan report doesn't mention specific insurers by name, here are some examples that illustrate the trend of insurers entering the private debt and alternatives space:

• Legal & General Investment Management (LGIM): They recently proposed a hybrid property investment approach for their UK Property Fund, combining direct property ownership with investments in Real Estate Investment Trusts (REITs). This strategy falls under the "alternatives" category, aiming to provide diversification and potentially higher liquidity.

• Prudential Financial: This large U.S. insurer has been increasing its allocations to private debt and real estate investments in recent years. They see these asset classes as a way to generate better returns and manage risk within their portfolio.

• Aviva plc: This British multinational insurance company has also been exploring alternative investments, including infrastructure debt and private equity. These investments offer the potential for higher returns and diversification compared to traditional bond holdings.

• Sun Life Financial: This Canadian life insurance company has been actively investing in private debt, particularly in North America. They view private debt as a way to achieve their long-term investment goals and match their liabilities.

It's important to note that these are just a few examples, and many other insurers are likely exploring private debt and alternative investments. The specific strategies and asset classes each insurer invests in will vary depending on their risk tolerance, investment goals, and regulatory environment.

The Verdict: A Calculated Move?

The increasing involvement of insurers in private debt and alternatives reflects a search for yield and diversification in a challenging investment environment. However, careful due diligence and a clear understanding of the associated risks are crucial before diving into these markets.

The future remains to be seen, but one thing is clear: the insurance industry is evolving. Whether this shift towards private markets proves to be a masterstroke or a risky gamble, it's a trend worth watching closely.