The 2015 Preqin Global Hedge Fund Report shows that insurance companies represent only 4% of the hedge fund investor universe. Insurance companies show a conservative approach to hedge funds, allocating, on average, just 3.3% of their total portfolio to the asset class as of Q1 2015. This compares unfavourably to the 14.4% average allocation to hedge funds demonstrated by the rest of the institutional investor universe. It could be argued that hedge funds more generally have become less attractive to insurance companies because of Solvency II, a European directive that dictates how much capital insurance companies must keep liquid on their balance sheets to reduce the risk of insolvency. The biggest impact of this regulation is a 49% capital charge on hedge fund investments. The low number of insurance companies active in the asset class and their low average allocation can, therefore, be attributed to the Solvency II directive.
Nevertheless, insurance companies continue to have high expectations for their hedge fund investments. The chart below is taken from the 2015 Preqin Global Hedge Fund Report and shows that insurance companies investing in hedge funds have the third highest hedge fund return expectation of all institutional investors at 6.7%. In order to achieve these high expectations, insurance companies tend to put their money directly into hedge fund strategies; 78% of insurance companies that invest in hedge funds have exposure to direct hedge fund investments.
Insurance companies have shown a willingness to take on risk in order to meet their relatively high return expectations, despite keeping their allocations to the asset class low. The most likely explanation for the aggressive approach taken by insurance companies towards hedge funds is the inclination towards higher rewards. The 49% capital charge that will be imposed in January 2016 will cut into hedge fund returns for insurance companies and, consequently, seeking higher returns will be necessary to help negate some of that charge.