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(Re)insurers' hedge fund allocations to rise as barriers come down

P&C investment allocations to hedge funds are expected to increase as barriers to accessing the asset class continue to come down, according to a report by Deutsche Asset & Wealth Management.

The firm noted last week that currently most insurance companies have minimal hedge fund investments, despite the struggles they face in meeting portfolio return targets amid a chronic low interest rate environment.

This is in contrast to many institutional investors, which have responded by becoming active investors in hedge funds and other alternatives.

For these investors, the asset class "can provide low correlation and superior risk-adjusted returns to those available in the fixed income markets".

Indeed, the report notes that 58 percent of institutional investors polled in a survey earlier this year achieved 5-10 percent returns in their hedge fund portfolios in 2012.

A similar percentage reported portfolio volatility of 5-10 percent while the weighted average return for the group was 6.34 percent - a level that would have been difficult to find in the fixed income markets.

While 65 percent of large insurance carriers surveyed by the bank grew the asset class in their portfolios in 2012, overall the sector trails behind other institutional investors in its hedge fund allocations.

At the end of 2010 the industry had just 1.24 percent of its $5tn general account investments in hedge funds, compared to allocations of 25 percent by endowments and foundations last year and an average of 5 percent by pension funds.

The chief factors holding insurers back from the asset class include the limited partnership (LP) structure of the traditional hedge fund investment vehicle, which "is illiquid and offers little portfolio transparency".

"Also, insurers often must hold prohibitively large amounts of risk-based capital against their limited partnership interests in hedge funds," it continued.

For P&C insurers, risk-based capital charges run at 10-15 percent, while for life insurers they are higher still at 22.5 percent to 45 percent.

However, control, liquidity and transparency concerns can be partially addressed by accessing the asset class through separately managed accounts - albeit this approach comes with the cost of setting up internal operations and committing capital upfront.

Another alternative for insurers is to utilise managed account platforms, thus leveraging the infrastructure and controls of financial institutions that maintain relationships with leading hedge funds.

This approach could include obtaining a specific level of exposure to a hedge fund through a structured note. The capital charges are closer to fixed income instruments than LPs and it benefits from cost efficiencies the financial institution can achieve that are not available to insurance companies.

"With increased options to access the space, we believe it should only be a matter of time before more insurers allocate to hedge funds," the report concluded.

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