Insurers Will Come Back to Hedge Funds in 2010

Insurance companies cut their hedge fund allocations in 2009, but the sting of the financial crisis will wear off next year. Look for more insurance money to flow into the hedge fund sector in 2010, as carriers seek to take advantage of an economic recovery.Insurers are known for investing their assets conservatively. Liquidity and consistency have always been priorities for an industry that puts risk management over outsized returns, and the investment losses that carriers sustained because of the financial crisis have led them to take an even more cautious stance. So, it comes as no surprise that insurers reduced their hedge fund allocations through 2009, but the move isn't permanent, especially given the returns posted by the sector this year.

The financial crisis wasn't as brutal among insurers as it was for the banking sector. Using the Guy Carpenter (MMC) Global Reinsurance Composite as a proxy, the industry's capital fell only around 18%. Yes, this is a pretty severe drop, but it doesn't compare to the carnage in the banks, which consumed hefty amounts of federal cash. American International Group (AIG) notwithstanding, the insurance industry survived the scare rather well.

A Small Part of the Total

Nonetheless, the insurance business reacted to the financial crisis swiftly, particularly in regards to higher-risk asset classes, such as hedge funds. According to alternative investment research firm Preqin, 55% of insurance companies invest in the hedge fund industry both directly and through funds of funds, with 17% only investing directly and another 28% using funds of funds exclusively.

Despite the wide adoption of hedge fund investing, the insurance industry never committed large amounts of its capital to the asset class. By the end of 2008, only 4.2% of the industry's assets under management, on average, were invested through hedge funds, Preqin reports. Even this small allocation was reduced in 2009, as concerns of risk management trumped efforts to gain returns, and the insurance industry's average hedge fund allocation dropped to 3.2%.

The effort to mitigate risk did cause insurers to miss the 2009 hedge fund rally, which Preqin says may be the best year for the asset class in at least a decade. Hedge Fund Research's Fund Weighted Composite Index posted a 7% jump this year, compared to a 13% drop for the S&P 500 Index. But returns aren't the top priority of insurance industry portfolio managers, so leaving a few extra bucks on the table is a small price to pay for smoother sailing in the year ahead.

Even this conservative posture will bend, however. Preqin expects insurer target allocations to reach 5.4% for the hedge fund asset class in 2010. There's a difference between gunning for big payouts and taking advantage of a rising tide, after all.

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