Alternatives: In search of alpha
Alternatives: In search of alpha
As markets and perspectives evolve, Alison Dyer, Managing Director - Bermuda explains how capital can be used and structured to address different investment strategies.*
There is an unwavering desire for alpha, for returns, for uncorrelated returns and for new ways of deploying capital. As markets and perspectives evolve, there are different ways to think about how capital can be deployed, is now the right time, are there actual opportunities in the market? These questions have long plagued investors and in this piece, we will look to explore some of these questions by providing focused commentary on the alternative space – looking at their usefulness not just at the moment, but for a long-term outlook.
What do we mean by alternative investments in this context? Simply put, alternatives are those investments and assets that don’t otherwise fall into the traditional, or more conventional categories of bonds, equities and cash. Examples include real estate, infrastructure, transportation and renewable energy.
Alternative investments are nothing new, diversification of allocation has ebbed and flowed as risk tolerances evolve and differing influences affect the appetite of institutional investors, whether in the insurance market or in the broader Bermuda landscape. Those influences do, of course, very much depend on the type of industry player looking to deploy capital, and at a more granular level the legislative and regulatory requirements which necessarily inform what, how, when and in what a licensed entity should or, probably more importantly, what it can invest in.
Not all alternative investment has to be exotic of course. Given the breadth of both possible assets and diversification of available structuring, there are various principle advantages to deploying capital in this asset class. These tend to be:
- Low or uncorrelated returns
- Optimisation of returns
- Ease of structuring – asset class and entry point
- Reduced downside risk
- Healthy returns
It is certainly a time of development and innovative thinking in Bermuda's most prevalent markets, by which I am primarily referring to insurance and related industries. One theme emerging, particularly in the captive space, is a considered review of the governance and investment strategy. Is the current investment strategy delivering what it was supposed to be delivering, should the board or investment committee be looking to re-balance and re-allocate capital between investments, and if so, in what? What should a board be looking at?
- A focus on the investment manager – clearly, you need one with a proven track record that is of sufficient size and scale to be able to source the right type and price of deals and investment opportunities.
- A focus on the asset, product and ability to get into the investment – this is highly dependent on the type of insurer and the peril that it insures or is otherwise involved with. This will start to frame out what the balance sheet of the insurer can support. For example, many insurers, particularly with perils of high frequency occurrence, are going to need to be able to liquidate an investment position quicker than one with longer tail risk. Longer tails risk being able to tolerate more flex in the duration. Ultimately, the risk appetite, duration, liquidity, reserves and tiering of capital of the insurer will inform the type of investment or corresponding asset that any capital can be deployed into.
By way of an initial example, let’s take a commercial insurer - what are their typical broad-brush commercial considerations? Normally, commercially, this would centre around:
- the need for alpha on returns (which among other value adds, would help with solvency requirements);
- the ability for flexible redemptions for access to cash for claims payments; and
- the need to keep control over credit and market risk.
Compare this then to the regulatory considerations, which again, on a broad-brush basis would be the need for Tier 1 Capital; the tailored restrictions imposed by the regulations; and the need for robust observable valuations for statutory accounting and audit purposes.
Let’s look at a captive. Commercially a board would be looking for:
- better returns;
- flexible redemption to allow access for cash for claims payments (that is duration matching); and
- a focus on low frequency, to limit the need for short-term, continuous payments.
Again, on the regulatory side, the captive would need to make sure that the asset class counts as a relevant asset to ensure it qualifies for liquidity ratios and solvency ratios. As with other insurers, the board would need to be cognisant of tailored restrictions imposed by the relevant regulator and the need, as with others, for observable valuations for accounting and audit purposes.
How can an alternative asset class allocation be structured to address these types of considerations?
Broadly speaking, from a structuring perspective, the choices are obviously quite wide. These could range from:
- a relatively straightforward investment as a limited partner in a fund which then invests in the asset class, whatever that asset or basket of asset may be;
- the direct holding of infrastructure, transportation assets or other real property; or
- direct holdings in holding companies of those real property asset.
It is of course possible to rate certain types of assets, list (on a recognised exchange) the limited partnership interests in the fund by way of increased “enhancement” of the asset and how it would be treated and/or rated from a solvency or liquidity perspective. Structuring is clearly critical to how the asset can be recognised on the balance sheet, as clearly capital charges are to be avoided. Structuring is also of fundamental importance to be able to duration match as far as readiness of reserves for the payment of claims incurred.
The more conservative an investment strategy, the relatively lower tolerance for risk there will be institutionally. Generally speaking though, a more conservative strategy will necessarily have lower returns, but of course as a balance, often provide easier access to immediate cash. A propensity, in the more conservative strategy, for money market products or sovereign debt, is largely understandable. However, if an insurer is sufficiently capitalised or otherwise supported, to be able to diversify, the relative increase in returns for, on balance, a relatively small amount of additional risk (if structured properly with the right match of alternative asset), is something we are starting to see boards consider more fully. This is particularly the case in the current environment, where the search for alpha has certainly not diminished.
A key challenge in a lot of more traditional asset classes is a direct correlation to the market, which although can be bull or bear, are not straight-line on a forward-looking basis. Large swings in indices, confidence, and right now, ability for consumer spending in key areas, are making the markets particularly challenging. Alternative investments typically have a low correlation to traditional asset classes, resulting in them moving counter to the stock and bond markets. This provides a very useful tool for portfolio diversification and provides an effective hedge against inflation.
It is clear that there is no slow-down in the search for alpha. As economies begin to recover, viable alternatives to the traditional investment become more palatable. This is particularly compelling for the more sophisticated investor base, who look for innovative and interesting solutions.
Expert, tailored solutions: how and where they are needed
Our Bermuda based ILS team has been involved in a significant share of ILS transactions in the market, and we are an important provider of corporate services to the captive industry, with one of the largest market shares. We work seamlessly with all the major insurance managers and intermediaries to provide a complete solution to large, multinational enterprises and smaller companies. For more information contact Alison via her profile below or view our full range of insurance-linked securities and captive insurance services here.