Why Should Insurance firm Invest in Private Equity?

Key Points:

  • Investment strategy and strategic asset allocation for Insurance Company largely depends on the cash flow requirements to meet expected future claims
  • The basic principles of strategic asset allocation for an Insurance firm need to intelligently balance the long-term investment returns and cash flow requirement to meet claims in near future
  • The cash flow requirements and hence investment objective differs for the life insurance business, property & casualty business and health insurance business, this demands to adopt different approaches for asset allocation in private equity by an Insurance firm
  • Asset allocation to private equity can help Insurance companies generate long-term superior risk-adjusted returns than compared to traditional investment avenues
  • A lower correlation of Private equity with other traditional investments can help generate a good diversification strategy for Insurance investments
  • A portfolio mix of small to medium buyouts, secondaries, mezzanine and distressed debt can help mitigate the J-curve effect and generate cash flows in relatively shorter period
  • Different restrictive regulations like Solvency II, Basel III, external ratings, internal risk capital requirements and other local country laws restrict investment in PEs by Insurance firms

Background & Introduction

An Insurance company can be classified on the basis of nature of the insurance business it falls in, which can be either life insurance, Property and Casualty (P&C) or Health insurance business. The cash flow requirements to meet their future expected claims varies depending upon what business segment they are catering to, and hence their investment objectives and strategies.

An assortment of United States coins, includin...

An assortment of United States coins, including quarters, dimes, nickels and pennies. (Photo credit: Wikipedia)

 A typical insurance company is been investing with certain overall strategies in mind, such as matching assets to liabilities in terms of maturity and interest rate risk, including managing duration; liquidity requirements; and overall risk appetite/volatility tolerance.

In addition, in order to stay competitive compared to its peers, an insurance company must also achieve a satisfying return on its investments. Furthermore, these returns should not vary too much from year to year since both policyholders and shareholders prefer stable and predictable investment profits and returns. All these requirements mean that insurance companies have to constantly look for ways to  improve  the  risk-return  profile  of  their  investment  portfolios,  which  becomes  particularly important in a volatile interest rate environment.

The risk return profile can be managed by strategic asset allocation across four major assets classes: Fixed Income, Stocks, Real Estate and Alternative Vehicles. The portfolio mix of the insurance companies varies over time and is based on certain macroeconomic and industry specific factors, also taking into account the general state of the global economy, industry trends, market and political events.

Historical Asset Allocation Snapshot

Looking at the historical asset allocation mix, in year 2010 the majority of insurance companies’ investments were in bonds or 73.2% of total cash and invested assets (Bonds include categories such as corporate debt, municipal bonds, structured securities, U.S. government bonds and foreign government bonds), this followed by investment in common stock (10.3% of total assets), Mortgages, First Liens and Real Estate (7.1%), Cash and Short Investments(4.3%), Others(3.86%) and the remaining 1.24% in private equity and hedge fund. The private equity and hedge fund investment taken together accounted for $61.6 billion (or 1.24%) of the total invested capital by insurance companies[1].

Asset Allocation of Insurance Industry in 2010


The inclusion of private equity in an insurance company’s asset allocation demands different approaches for different product segments ((i.e. Life, Property & Causality, Health etc.). As of year-end 2010 Life companies accounted for the majority of industry Private Equity Investment in terms of book adjusted carrying value, at 71.9%[2]. Property/casualty companies represented the second-largest, at 23.6%. Life insurance companies do more to integrate the asset and liability sides of the balance sheet than other financial institutions. Longer time horizon products require asset/liability management risks to be managed on an ongoing basis

As per recent survey by Preqin the Insurance companies represent one of the largest investor types by total assets under management, managing an aggregate $16.2 of which close to 2.7% is allocated for investment in PE. This is indicative of the relatively low-risk investment approach that insurance companies take in order to maintain the necessary levels of liquidity required as a result of the variable nature of their liability payments.

Insurance investment in PE

Private equity funds and hedge funds are generally illiquid with significant restrictions on transferability. In addition, private equity funds can only distribute cash when the underlying illiquid investment can be sold. Private Equity Investment by insurance companies increases when the need to hold cash and liquid securities is overshadowed by the need for stronger returns. Currently 322 of the 4,455 U.S. insurance companies are active in the private equity asset class[3]. The insurers’ $61.6 billion investment in 2010 is compared with estimates of total private equity and hedge funds’ capital of approximately $4 trillion[4].

Issues faced by insurance companies in investing private equity

  • Liquidity requirement: Insurance companies typically seek out investments as part of their overall investment strategies which can provide them with significant current income streams and require the ability to opt out of investments they wish to avoid. The liquidity requirement varies across different business segments; Life companies have a lesser cash requirement to meet the claim as compared to P&C companies.
  • Risk Appetite: Risk appetite of insurance companies is different from other institution such as pension funds and endowments. Having a different risk appetite endowments and pension funds invest heavily in private equity.
  • Negative J-Curve: Capital outflows to fund investments during the commitment period, combined with fund organizational expenses, due diligence expenses, transaction fees, management fees and other costs borne by investors, produces what is termed as the “J-Curve” effect of private equity, leaving investors with initial negative returns. Insurance companies with current income needs in particular, mitigating the “J-Curve” can be of significant importance.
  • Regulations: A recent survey conducted by Preqin shows that 79 %[5] of the insurance companies have not changed their level of exposure to the asset class as a result of new restrictive regulations. But a number of investors believe that they may be affected in future as result of impending Solvency II regulation.

How Private Equity Investment can help to improve risk-return profile.

Investment of insurance companies in private equity funds help in obtain higher returns, increase diversification (there by reducing risk), and increased access to emerging asset classes. These investments fit within an overall framework of asset-liability management that balances risk and return while providing for the overall liquidity needs of the insurer. The long-term nature of insurers’ liabilities, especially compared to those of banks and broker-dealers, lends itself ideally to longer-dated or illiquid investments such as private equity and hedge funds. Detailed reporting and valuation guidelines provide state insurance regulators the necessary tools to examine these investments for appropriateness at a given insurer.

Other benefit of investing in private equity over the traditional asset classes can be illustrated as follows:

Higher Returns:  Private equity investments generate higher returns in the long run as compared to other asset class. The US State pension funds 10 year asset class returns for 69 funds for the fiscal year ending June 30, 2011 shows that the private equity has outperformed the other asset classes.

                              10th to 90th Percentile Distribution of State Fund Returns

Source: NACUBO (“National Association of College and University Business Officers”)

The capacity to earn excess returns in traditional asset classes has been a challenge for many years. The excess returns for 10 years ending June 30, 2011 is shown in the chart below:

Distribution of Excess Return for 10 Years ending June 30, 2011[6]


  • Unfunded Commitments One important aspect unique to private equity investing is unfunded commitment. When investors subscribe to a private equity fund, their commitment is typically not fully or immediately paid-in; instead, capital is “called” or “drawn-down” over time as investment opportunities arise. This unfunded capital can be invested in short term liquid securities which can generate additional nominal returns.

  • Tax Benefits:  There is no established research available on this, but the way limited partnerships are structured and the tax-heaven geographies where these are registered are can provide various tax benefits in long run which adds upon to the expected return from investment.

Solution to the problem faced by the Insurance companies

The problem of negative J-curve and the current income requirement faced by the insurance companies while investing in private equity funds can be mitigated by inclusion of secondary/seasoned investments along with the primary investments.

Secondaries/ seasoned primaries can help smooth the “J-Curve” effect and provide for earlier draw downs of capital and earlier returns of capital.  In addition, secondaries/ seasoned primaries offer more asset visibility (i.e., is not investing in a blind pool of assets) and reduced manager risk and have the ability to achieve additional vintage year diversification in a shorter commitment period.

Second method to mitigate the “J-Curve” effect for investors is the inclusion of mezzanine and distressed debt funds in client portfolios.  The current income paid out by mezzanine funds and the relatively shorter holding periods exhibited by distressed debt funds relative to buyout investments, both help to mitigate an overall portfolio’s “J-Curve”. Distressed debt funds exhibit return profiles similar to those of buyout funds, but tend to provide investors with unique diversification benefits during downturns in the economic cycle.

Third method to mitigate the “J-Curve” effect on client portfolios is the inclusion of direct co-investments. Co-investments enable investors to put capital to work quickly and have historically tended to return capital within a few years of making the investment, thus serving to further mitigate the “J-Curve”.  Additional benefits of co-investments include:

  • Co-investments enable investors to capitalize on their relationships with premier private equity funds to generate high-quality deal flow;
    • Co-investments allow investors to invest alongside private equity investors who have deep domain expertise;
    • Co-investments provide investors with the ability to closely manage a portfolio by determining the investment pace and portfolio composition on a portfolio company level; and
    • Co-investments allow investors to invest in selective high quality deals at substantially reduced fees thereby potentially enhancing the overall portfolio returns.

Overall, Insurance industry is working in very tight regulatory regime and the very nature of their business demands a lot of money to be kept in near liquid investments. However, a multi-step strategic asset allocation and a small percentage of the total asset investment in alternatives viz., private equity can help these companies generate higher risk-adjusted returns, reduced risk through diversification and access to additional and emerging markets. Further, from private equity offering perspective a multi-layered portfolio mix spreading out to two-three vintage years  topped with secondaries and mezzanine investment can help mitigate the “J-curve” effect and can address the liquidity requirements in mid to long term. Private equity investing is a long-term engagement, which promises strong returns with a favorable risk-return relationship.

[1] Source: NAIC Capital Market Special Report-Analysis of Insurance Industry Investment Portfolio Asset Mixes

[2] Source: NAIC Capital Market Special Report-Schedule BA – Private Equity and Hedge Funds

[3] Source: Preqin Special Report: Insurance Companies Investing in Private Equity

[4] Source: NAIC Capital Market Special Report-Schedule BA – Private Equity and Hedge Funds

[5] Source: Preqin Special Report: Insurance Companies Investing in Private Equity

[6] Source: Cliffwater LLC-Trends in State Pension Asset Allocation and Performance

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