Life insurers have historically invested their portfolios in the relative safety of mortgages and bonds, but economic volatility, sticky inflation, and other headwinds have spurred many insurance companies to diversify into alternatives, a trend explored in a recent Milliman paper. On this episode of Critical Point, three of the paper’s authors discuss two alternative asset classes that are particularly attractive to insurers in today’s market: private equity and real estate. They talk about unexpected assets like student housing and storage facilities, the synergy of private equity firms investing in insurers and vice versa, and why many insurance companies continue to hold commercial real estate despite post-pandemic office vacancies.
Transcript
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Valea Coyne: Hello and welcome to Critical Point, brought to you by Milliman. I’m Valea Coyne, an asset specialist in the life technology solution professional service division, and I’ll be your host today. In this episode of Critical Point, we’re going to talk about alternative asset classes, particularly private equity and commercial real estate, and how they’re used in strategic asset allocations within the insurance industry.
Milliman has been helping many of our clients design strategic asset allocations, and I have two experts that have done this here with me today: Lucy Ouyang, a consulting actuary from our Philadelphia office.
Lucy Ouyang: Hello.
Valea Coyne: As well as Erica Wilson, a consulting actuary from our life technology solution division.
Erica Wilson: Hello.
Valea Coyne: Erica and Lucy were two of the principal writers of a paper that we recently published, which looked at 11 alternative assets in the insurance landscape. Thank you both for joining me today.
So to kick us off, let me provide some background on the topic. As competition in the life insurance industry intensifies, the focus on these alternative assets is gaining prominence, so life insurers are expanding beyond traditional bond and mortgage holdings and venturing into these nonstandard assets. Along with that, the identification and understanding of these alternative assets is critical as the market dynamics evolve, and modeling considerations of these alternative assets is much more intricate than standard assets. Traditional investors are diversifying into these assets for various reasons, including reducing portfolio volatility, securing reliable income streams, hedging against inflation, and seeking high risk-adjustable returns. Energy transition infrastructure assets, for instance, play a unique role and have unique characteristics that make them attractive in this current economic environment. Let’s hand it over to Lucy to provide information on historical trends in alternative asset use in the insurance industry.
Historical trends in alternative investments among insurers
Lucy Ouyang: Yeah, I’m happy to. I would just keep in mind that alternative asset classes will vary by insurance companies depending on their region, regulatory environment, and also by company size, and I can provide some general insights and the trend.
In general, we do see that insurance companies have been steadily increasing their asset allocation to alternative assets over the past decade. If we look at the Schedule BA asset in the company’s financial statement, where they report both private equity and the real estate fund, we have seen that has doubled over the past decade. For private equity specifically, that’s one of the most popular alternative asset classes among life insurance companies. If we look at the share for private equity in the Schedule BA, we can see that exposure to private equity has increased to 30% by year-end 2022. And according to an industry survey, we see more than half of the insurance companies globally had exposure to private equity.
And then the same thing for real estate equity and the real estate funds. That’s another significant alternative asset class for insurance companies, and they have been investing a lot of their assets in the real estate investments, including direct property ownership, real estate investment trusts, and also real estate equity and funds. Today we will focus on the real estate equity and funds, where the share has grown to approximately 20% of their total Schedule BA reporting.
Valea Coyne: Let’s dive into the specifics of those two particular alternative assets, private equity and commercial real estate. Erica, can you provide an overview of the five-part profile that we developed for private equity in our paper?
Five characteristics of private equity for life insurers to consider
Erica Wilson: Sure. So in the private equity, or PE, section of the research paper, we first profiled the security structure and characteristics of these funds. In this part, we detailed different targeted investment strategies, how they’re typically structured, and types of fund management strategies employed.
Secondly, we looked at the cash flow profile. PE funds are closed-end funds with a typical life cycle of seven to 10 years, and the distribution timing is not certain, and the funds are relatively illiquid during the lifetime.
In the third part, we looked at the economic risks to consider. With PE funds there is a high potential return, but with this return there are various risks, including liquidity and market risks. The paper looked at some mitigating strategies as well.
Next we looked at the asset-liability management (ALM) consideration. A big consideration is to determine the private equity allocation in the strategic asset allocation of a company that aligns with the company’s risk appetite and risk profile.
Lastly, we looked at the modeling consideration and simplifications. The key modeling consideration is to determine and model the equity risk premium due to the liquidity and asset risk inherent in the PE investments.
Valea Coyne: Okay, so now that we understand the profile of private equity, can you say how those private equity instruments are used in the asset allocation strategies, Lucy?
How are life insurers using private equity instruments?
Lucy Ouyang: Yeah. So we see life insurance companies investing in private equity for different reasons. As I mentioned earlier, investment in private equity has been growing significantly over the past 10 years, and one of the main drivers for this would be the low interest rate environment. Historically, we see companies trying to enhance their return on assets in a low interest rate environment. Just about two years ago, the interest rate was still close to zero. And now, even though interest rates are up, we also see companies continue to enhance their return on assets to stay competitive in the market, and private equity has historically generated higher returns compared to public markets over the long term. For private equities, we typically see an unlevered return range from the 10% to 14% range compared to an average return of 4 to 5% for a public corporate bond, so life insurance companies often utilize the private equity investment as part of their strategic asset allocation to enhance their returns.
And second, I would say private equity also offers diversification benefits beyond the traditional asset classes like stocks or bonds. For private equity, they are less volatile compared to the other public market assets. And private equity tends to have lower volatility compared to common stocks. Some studies suggest that the volatility of private equity is about 60 to 70% of the public markets’, so this would help the company to mitigate their risk associated with the public market volatility.
And third, private equity typically has a longer investment horizon. That can serve as a tool to help life insurance companies to better manage their asset-liability duration mismatch. Some companies, they would target their private equity investment in order to match the liability duration after 30 years, because it’s really hard to find other fixed-income assets with years to maturity longer than 30 years, so they will typically use private equity to hedge the tail risk for their liability portfolio.
Valea Coyne: Sure. So that gives a great understanding of the return and cash flow profile of those assets. In addition to that, what are the risks that insurers are seeing in the PE investments?
What risks should life insurers consider when investing in private equity?
Lucy Ouyang: Because of the longer investment horizon for private equities, which will make them less liquid compared to other public assets, this will pose a challenge to companies, especially for companies with liquidity concerns. And the return for private equities typically follow the J curve, which is that the initial returns are typically negative due to the initial capital investment and the upfront management fees. Then it is followed by gains over time as the investment matures. If the company has a liquidity issue where they will need cash immediately, they will need to liquidate this private equity in their portfolio, and it would potentially result in a substantial haircut to their value, so a company typically wouldn’t liquidate a private equity portfolio if it’s unnecessary.
And there are also risks associated with the returns of the private equities as well, because the private equities are managed by third-party fund managers and the performance of these managers can vary. If someone has very poor investment decisions and underperforms, that can adversely affect the return for this total private equity fund. So, of course, the returns of the private equity fund are not guaranteed either, and this could potentially lead even to the loss of their initial investment.
Valea Coyne: Right. So when they’re selling in the J curve that’s really going to impact the returns. If they’ve made it past that initial outlay they’re seeing a much higher return, but if they liquidate during that first period that’s really going to impact the return.
Lucy Ouyang: Exactly, and then there’s another risk associated with that, which is the risk-based capital (RBC) charge, because for private equity that has a much higher RBC charge after taxes—like 23.7%—so for companies it’s always a tradeoff between the risk charge and the return. So yeah, basically, by investing in private equities, companies will need to find the balancing point for their investment.
Valea Coyne: Okay, perfect.
Erica Wilson: I can also add that companies that borrow capital to invest in private equity, they can have much greater risks due to the leverage combined with the possibility of losing this capital.
Lucy Ouyang: Yeah, absolutely agree.
Private equity investment trends among life insurers
Valea Coyne: Lucy, you’ve already talked about how they’re using private equity currently. What are the trends that you’re seeing among life insurance companies?
Lucy Ouyang: There are variations. In general, we still see a growing appetite for the private equity fund, especially for companies who never had invested in any of the private equities in the past. One of the main reasons is they would like to diversify their portfolio a little bit, so private equity would be one of the better options in order to diversify their portfolio.
We also see some other companies who already have a substantial private equity investment, so for those companies, some of them are dialing back a little bit, because right now, given the environment where the interest rates are much higher now than a few years ago, companies do get higher risk-adjusted returns for other fixed-income assets compared to private equity. So from the private equity standpoint it’s not as favorable as maybe a few years ago when companies are doing their risk-adjusted return analysis.
And also, for some Bermuda companies, they are dialing back down on their private equity investment because of the regulatory restrictions on the private equities.
Because of those reasons we do see some companies are dialing back down a little bit, but we also see companies who have a longer-term plan. They are trying to kind of ramp up their private equity allocations over time to a certain level, like over the next five years or so, so we do see the variations in the market.
Valea Coyne: Okay. So the regulatory environment really is becoming unfriendly to these instruments?
Lucy Ouyang: Yes.
Valea Coyne: Right. Anything else either one of you would like to add about private equity?
Life insurers invest in PE—and vice versa
Erica Wilson: So we spoke about the private equity investment in insurance companies, but an interesting fact also is that PE firms are also investing in insurance companies, so there’s a two-way relationship between insurance companies and private equity.
Valea Coyne: Yeah, it’s very interesting how it has that two-way dynamic where insurance companies are doing private equity and private equity is doing insurance companies.
Lucy Ouyang: Yeah. I think one of the reasons is because that for the PE firm, if they get the assets under management then they gain the management fees. And then from the insurance company standpoint, because they have the expertise from the private equity firm, then they can generate the private equities, which would have a higher return, which would benefit the insurance company, so it’s kind of like a mutual benefit.
An overview of commercial real estate investing
Valea Coyne: Yeah, it’s really cool synergy between the two. Okay. So moving on to commercial real estate. Erica, can you provide an overview of how we profiled commercial real estate in the paper?
Erica Wilson: Sure. For the commercial real estate, which I’ll refer to as CRE, we looked at the same five-part profile as overviewed for private equity. For the structure and characteristics of CRE, we identified different types of commercial real estate investments. Popular options for institutional investors to gain exposure to CRE include ground leases and direct investment in commercial real estate, as well as investing in bonds issued by a real estate investment trust, or REITs for short.
Next, the cash flow profile depends on the type of commercial real estate investment. In the case of ground leases, there is a large upfront capital commitment that is required for direct investment to acquire the property. In return, investors can expect to receive stable and predictable cash flows from ground leases. REIT investments produce cash flows primarily through dividends and provide a steady income over longer term.
The next part of the profile was the economic risks to consider, and these include the main identified risks of market and interest rate risks. The performance of the CRE is intricately linked to economic conditions.
The next part of the profile was the ALM consideration, where the paper speaks to the predictability of cash flows depending on the type of CRE. REITs produce cash flows that are less predictable than ground leases but more predictable than traditional market securities. The paper identified modeling considerations and simplifications that can be applied when modeling REITs and ground leases.
How to simplify commercial real estate models
Valea Coyne: Modeling commercial real estate can be super complex, so what are those suggested modeling simplifications?
Erica Wilson: Depending on the composition of the REIT portfolio, it can be modeled as bond or common stock for simplification. Some adjustments would be needed for spreads and distribution rates in the model. For direct investments in commercial real estate, the cash flows from the CRE can be combined into two streams of payments. The first stream is the net rental income, which comprises a stable predetermined cash flow less expenses but adjusted for inflation. This can be modeled as coupon payments of bond assets. And the second stream of payment includes the amount for financing the property purchase. This can be modeled as a stream of mortgage payments. In the model, one can also project the mortgage refinancing amounts based on an amortization schedule. Prepayments are not common due to provisions in the commercial mortgage that discourages this.
Valea Coyne: Okay. So how can commercial real estate be used to mitigate ALM risk and immunize portfolios? Do you have some exposure to how that’s being done?
Erica Wilson: Yes. So first and foremost, asset allocation and diversification are the most effective strategies to minimize financial risks, right? Commercial real estate fits into a strategic asset allocation model by diversifying the portfolio and also potentially offering high returns. Payments across an entire pre-direct investment can be combined to achieve a good match with liability cash flow needs. Generally, given the relatively long duration of these investments, they can be employed in a duration-matching strategy to improve the duration matching of an insurer’s liability, especially if there’s a shortage of publicly traded long-duration fixed-income assets to back these long-term liabilities. Ground leases also provide an inflation hedge, as rents can be adjusted for inflation every 10 to 15 years based on the CPI, and therefore they can be allocated or matched against liabilities that are adjusted for inflation.
Valea Coyne: Okay. That’s really interesting, because I know a lot of insurers have traditionally used TIPS—Treasury Inflation-Protected Securities—and I wonder if they’re going more away from TIPS towards these ground leases that have that inflation adjustment in them.
And then, Lucy, similar to PE, what you did previously to profile how private equity is being used, can you detail how commercial real estate is used in the asset allocation strategies of various insurance companies?
Why and how life insurers are investing in commercial real estate
Lucy Ouyang: One of the key questions insurers always think about is how to meet all of those policyholder obligations and their long-term liabilities, especially during a low interest rate environment. They’ve been constantly looking for ways to enhance their return as well as to diversify their investment portfolios beyond just stocks and public bonds. That’s where the commercial real estate comes in. If you just picture those office buildings, shopping malls, and apartment complexes you see around town, those are the properties that insurance companies are snapping up because they offer a bunch of advantages.
And first off I would say, commercial real estate, it does provide a steady income through the rental payment. It’s kind of like having tenants paying the rent, and that serves as a reliable source of cash flow for the insurers to cover their policyholder payouts, and of course there are other operational costs.
Additionally, like Erica mentioned, commercial real estate offers diversification. Commercial real estate doesn’t always follow the ups and downs of the stock market, and so by adding commercial real estate to their investment mix insurers can spread out the risk and potentially lower the overall volatility of their asset portfolio.
Additionally—I think Erica touched on this as well—is that commercial real estate can also act as a hedge against inflation. You see the price rise over time with the rental and property values. That means commercial real estate can really help the insurance company to preserve the purchasing power of their investment portfolios in the inflationary environment, especially now. And another neat thing is that the commercial property tends to appreciate over time, so as the economy grows and the demand for the space increases, the value of these properties goes up. So not just only the insurers will get the rental income, but they will also get the potential returns or potential growth of those commercial real estate assets.
Valea Coyne: I think the diversification aspect of commercial real estate is really interesting. There’s properties that you don’t typically think of, like student housing and storage facilities, that are now being used as commercial real estate investors in this alternative asset space, so just thinking about the broad range of products that are out there. Anything else to add?
Erica Wilson: Most of what we spoke about before was insurance companies owning properties and renting or leasing them, but there’s also another aspect, which is insurance companies are directly invested through offering commercial mortgage loans.
Valea Coyne: Right, so not just the properties but the loans behind them are being invested in.
Erica Wilson: Yes.
Risks for insurers investing in commercial real estate
Valea Coyne: Okay. So those are kind of the profiles of the instruments. What are the risks we’re seeing in a commercial real estate investment?
Lucy Ouyang: There are risks involved as well too, right? So, for instance, the commercial real estate market, it can be volatile. During the economic downturns or if there’s oversupply in a certain area, that can also lead to the drop in the property value as well as the rental income, which could dent the return for the insurers. And especially, like with the pandemic, because there are some companies that are moving to 100% remote, we’re seeing increased vacancy rates in office buildings.
Then there’s also the issue of liquidity. Unlike stocks or public bonds, where you can sell in a snap, for a commercial property it can take time to sell. So if insurance companies need quick access to their cash to meet their obligations for policyholders, they will probably run into some hurdles of holding those commercial real estate equities.
But there’s also property management headaches, tenant turnover, and all of those facts that will affect the commercial real estate values, and it will change in the interest rate environment as well.
So overall, commercial real estate equity can be a smart move for insurance companies if they’re looking to balance their investment portfolio, because it provides a stable income, diversification, potential for the capital appreciations, and also a hedge against inflation. The key is diversification and balancing this into their strategic asset allocation.
Valea Coyne: Yeah, it sounds like a really powerful instrument, that it has all those different aspects, diversification and a stable income, but certainly a downside there with the pandemic and the vacancy rates and the illiquidity. So it’s a big tradeoff between stable income and illiquidity. So, interesting perspective. Anything else?
Erica Wilson: Yeah, for insurers that offer the commercial mortgage loans, there’s also the risk that during an increased interest rate environment borrowers may not be able to refinance, so that’s a risk that they face, borrowers not refinancing. However, they typically mitigate this risk by commanding a very low or one of the lowest loan-to-value (LTV) ratios and high debt service coverage ratios.
Are insurers avoiding commercial real estate amid high office vacancies?
Valea Coyne: That makes a lot of sense that they would command, that you have to have a low LTV and a high debt service ratio. And so we talked a little bit about vacancy rates, and so what are the trends that we’re seeing because of those vacancy rates and concerns about illiquidity?
Lucy Ouyang: We do see that some insurance companies have raised concerns about commercial real estate given the high vacancy rate in office buildings, and some companies, they already stopped investing in commercial real estate, including commercial mortgage loans, in their tactical investment strategy. But then they do still envision to maintain their commercial real estate equity in their long-term strategic asset allocation just due to the benefits we have mentioned earlier.
And in addition to the traditional commercial real estate properties, life insurance companies are also showing interest in the real assets like Valea, you mentioned earlier, like infrastructure, renewable energy, and those natural resources. So these investments typically offer long-term inflation-length cash flows and can serve as diversifiers within the insurance company’s portfolio. Infrastructure assets are particularly attractive because of their stable returns and their essential role in supporting economic growth and development.
Post-pandemic real estate trends spur residential mortgage investments
Lucy Ouyang: Another trend we see is actually that some insurance companies are also moving into more residential mortgage loans. Even during the pandemic, we saw the residential mortgage was pretty resilient because more and more people were staying home working. It’s more the habit after the pandemic. And then with the high interest rates right now, it’s just more expensive to finance for both the homeowners, like the homebuyers, as well as the home builders. So right now in the market you will see a very low supply for housing, and at the same time the housing affordability has also come down because of the high financing cost for the homebuyers. So what we will see in the market is that potentially the rental income will go up because just more and more people will prefer to rent instead of buying a house, but then in the meantime the supply in the market’s still low, so I think we are probably potentially going to see an increase in the rental income, which would benefit the investors who are investing in those residential mortgages.
Valea Coyne: Yeah, that certainly makes sense because it’s becoming so unaffordable to buy a house directly, so a lot more people are renting, and then that even contributes to the stability of that rental income for the life insurer investor in those properties.
Erica Wilson: Yes, I agree. And rental income—rents are going up. Rents have increased since COVID, yes.
Valea Coyne: All this discussion reminds me of a joke I recently heard at an investment conference, and that was: What did the alternative asset say to the regular asset? And that is, “Don’t be so traditional, mate! I’m here to shake things up and add some spice and flavor to your investment stew.”
So I’d really like to thank Lucy and Erica for joining me today. You can read our full paper exploring the 11 alternative assets. We highlighted two today, but the full set of 11 is in the paper on milliman.com, and you can find it by searching for “profiles of alternative assets.”
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