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INVESTMENTINSIGHTS

December 2014

PORTFOLIO DISCUSSIONGLOBAL INSURANCE SOLUTIONS

Plausible AlternativesINVESTMENTINSIGHTS

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Matthew MalloyManaging Director Global Insurance Solutions

Mark SnyderManaging Director Global Insurance Solutions

Gareth Haslip Executive Director Global Insurance Solutions

Ping LiAssociate Global Insurance Solutions

Declan CanavanManaging Director Alternatives Investment Strategies

AUTHORS

IN BRIEFAlternative investments seem in many respects to constitute, for lack of a better term, the best alternative for insurance portfolios today. They pursue idiosyncratic alpha in an environment where the outlook for beta in traditional insurance investments seems increasingly problematic:

• Much of alternatives’ return derives from their liquidity premium. Insurancecompanies, with their relatively predictable cash flows and generally ampleliquid reserves, are well positioned to earn it.

• A small allocation to alternatives can deliver large diversification benefits toportfolios heavily concentrated in investment grade fixed income.

• Aside from directly contributing to capital surplus, an alternatives allocation cangive shareholders in publicly traded companies indirect access to cutting-edgeinvestment strategies and managers.

Capitalizing on alternatives’ potential, however, demands a recognition of alpha’s constantly evolving nature and disciplined due diligence that identifies those managers most skilled at capturing it. Consistently and patiently applied, such due diligence can drive returns well above a company’s cost of capital. Less rigorously executed, it can expose the insurance investor to the underperformance always implicit in the pursuit of high alpha.

Through favorable and adverse investment climates, alternative investments—hedge funds, real assets and private equity—have consistently boosted insurers’ portfolio income and portfolio yields (Exhibit 1).1

Source: J.P. Morgan, SNL Financial; data as of December 31, 2013.

Alternative investments have enhanced portfolio yieldsEXHIBIT 1: SCHEDULE BA YIELDS VS. PORTFOLIO AVERAGE

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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

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Life average yield P&C average yieldLife BA yield P&C BA yield

1 We define yield (income) here as statutory earned income divided by total assets, including both affiliated and unaffiliated assets in the numerator and denominator.

2 | Plausible Alternatives

PORTFOLIO DISCUSSION: Title Copy HereINVESTMENTINSIGHTS Plausible Alternatives

Such “alternatives” to more traditional asset classes have proven a reliable resource—and on occasion have provided a critical hedge. The 2005 spike in property and casualty (P&C) Schedule BA yields presumably helped offset record catastro-phe claims, so that the sector ended that year with an extraor-dinarily low financial impairment ratio (Exhibit 2).

Overall, from the depths of the financial crisis, alternatives have recovered rapidly, thanks to appreciation as well as additional allocations. (Exhibits 3A and 3B). Among both life and P&C insurers, they account for a greater proportion of unaffiliated assets today (Exhibit 3C).2

This paper seeks to begin the process of defining more precisely alternatives’ strategic function. It addresses four considerations that underpin the case for alternative investing:

• How much is enough? That is, how can insurers tap intoalternatives’ superior return potential without compromisingtheir risk budgets?

• Is it worth the trade-off? Can the returns that insurers gainfrom alternatives compensate for the liquidity they lose?

• Hunting alpha vs. gathering beta: How can insurers reliablytap into the idiosyncratic sources of return that setalternative investments apart?

• Overcoming the fee hurdle: How can the industry reconcilethe benefits of alpha with the high fees associated with it?

2 The reported numbers may understate total holdings, because many insurers invest in alternatives at the holding company level. Nor do they reflect the concentration of alternative investments among insurers. A.M. Best’s “Trend Review” of June 30, 2014, reported that the five largest life insurance investors accounted for 51.5% of the sector’s total investment in alternatives. P&C investments are even more concentrated: The top five companies in the sector hold 68.6% of the total. Even eliminating Berkshire Hathaway, the top five still accounted for 48.8%.


Alternative investments recovered after the financial crisis...

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2008 2009 2010 2011 2012 2013

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Other LPs Total

EXHIBIT 3A: LIFE INSURANCE—SCHEDULE BA UNAFFILIATED ALTERNATIVE ASSET INVESTMENTS


EXHIBIT 3B: P&C INSURANCE—SCHEDULE BA UNAFFILIATED ALTERNATIVE ASSET INVESTMENTS

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$bn)

Hedge fundPrivate equity

Real estateSch BA fixed income/loans

Other LPs Total

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2008 2009 2010 2011 2012 2013


...and account for a greater percentage of insurance investment than before the crisisEXHIBIT 3C: SCHEDULE BA UNAFFILIATED ALTERNATIVE ASSETS AS A PERCENTAGE OF TOTAL PORTFOLIO

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P&C FIF %Catastrophe points

2005hurricanesHugo

Andrew

Northridge

9/11

Source: A.M. Best data and research, BestLink—Best’s Statement File—P/C US; data as of December 31, 2012. (Losses prior to 2008 from ISO’s Property Claims Services.)

Yield spike in 2005 likely helped P&C insurers overcome year’s record catastrophe points

EXHIBIT 2: U.S. PROPERTY & CASUALTY—FINANCIAL IMPAIRMENTFREQUENCY VS. CATASTROPHE POINTS IN COMBINED RATIO (1977–2012)

J.P. Morgan Asset Management | 3

By way of definitionAcross the insurance industry—and even, we suspect, within individual companies—no common standard defines alterna-tive investments. In this paper we define them as hedge funds, real assets—both real estate and infrastructure—and private equity. The investments themselves span traditional asset clas-sifications, but we have grouped them together on the basis of their regulatory treatment and their fundamentals. Insurers classify them as illiquid Schedule BA assets. More fundamen-tally, they share a risk factor and primary source of return that set them apart from their traditional peers.

The bulk of traditional return and volatility derives from moves in the larger markets in which the investments participate—their market beta, in other words. Alternatives, by contrast, seek to add to return (or subtract from volatility) with idiosyncratic, often proprietary factors identified or developed by their managers—known as their unique alpha. They might realize their gain from the information asymmetries found in esoteric or undeveloped markets or from trades that exploit transient anomalies in established markets.

How much is enough?Historically, a relatively small investment in alternatives has had a disproportionate effect on insurance portfolio returns. Regulation and the industry’s fiduciary responsibilities have joined to concentrate insurance investments in the least vola-tile and most liquid asset classes. So an incremental allocation to illiquid assets like alternatives may consume an outsized portion of an insurer’s total adjusted capital—capital available to cover unexpected losses—but it can also deliver comparably large diversification benefits and a hefty premium for liquidity (Exhibit 4).

A business argument reinforces the logical argument of complementing a liquid portfolio core with an allocation to illiquid alternatives. Most alternative investments generate much of their alpha over lengthy holding periods. With their long-dated liabilities, life insurers in particular have an institutional capacity for the patience required for an investment of that nature to pay off. The long view gives them the flexibility to rebalance alternatives distributions according to market conditions, creating a steady source of value over time. Moreover, by consistently investing surplus premium income through rising and volatile markets, alternatives’ good

THE RIGHT FIT IN A NUTSHELLIn their fundamentals and structures, alternative investments align well with the insurance model.

• A little goes a long way: Because most insurance company investment portfolios have a naturally concentrated position in investment grade fixed income, it takes only a relatively small alternatives allocation to move the return dial.

• A built-in safety brake: Regulatory capital charges impose a limit on downside exposure.

• Cash flow compatibility: The structure of alternative invest-ment short-term capital calls and long-term distributions coincides with the structure of policyholder premiums and payouts.

• Smoothing the valuation wrinkles: Alternative investments, which typically mark to model, tend to reduce the quarterly volatility that comes with marking to market.

• A P&C hedge: A long position in real estate and infrastruc-ture offsets the implicit short in a property insurer’s cover-age of policyholders’ insured real assets.

• Exclusive shareholder benefits: Not only can an alternatives allocation enhance insurers’ ability to pay policyholder claims over the long term, it can give shareholders indirect exposure to cutting-edge strategies and managers they could not otherwise access.


Alternatives’ outsized share of total adjusted capital puts a regulatory floor under their downsideEXHIBIT 4: SCHEDULE BA UNAFFILIATED ALTERNATIVE ASSETS AS A PERCENTAGE OF TOTAL ADJUSTED CAPITAL

Life P&C

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2008 2009 2010 2011 2012 2013

Alte

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%)

years can offset the bad. This institutional form of the retail investor’s dollar cost averaging—inter-temporal diversification, as some investors call it—adds the diversifying dimension of time to diversification across asset classes and risk factors. It functions to smooth results, channeling higher expected alternatives returns into a relatively consistent stream.




Diversifying with a small allocation to alternatives, life and health insurers can moderate increased capital chargesEXHIBIT 6: MARGINAL RISK-BASED CAPITAL CHARGES

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l, po

st-d

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d ta

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Schedule BA incremental investment (% of total)

BB bonds B bonds Private equity and hedge funds

Source: J.P. Morgan, Long-term Capital Market Return Assumptions 2014.

*Surplus volatility equals the expected volatility of the capital surplus after matching portfolio assets to liabilities with a five-year duration.

Diversifying the typical insurance portfolio, alternatives can shift risk-adjusted returns decisively upwardEXHIBIT 5: EFFICIENT PORTFOLIO FRONTIERS, USING EQUILIBRIUM RETURN ASSUMPTIONS

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Fixed incomeFixed income+equitiesFixed income+equities+alternatives

Looking ahead with the aid of J.P. Morgan’s proprietary Long-term Capital Market Return Assumptions 2014, we can highlight and quantify the risk-adjusted return potential that an alternatives allocation can add to a general account portfolio. Exhibit 5 compares three hypothetical efficient frontiers:3 a pure fixed income portfolio of cash, Treasuries and investment grade corporates; the same portfolio that reduces the fixed income allocation to invest in a mix of large cap stocks, ranging up to 5%; and a third portfolio that adds a blend of alternatives to the mix—hedge funds, private equity, Schedule BA private debt, real estate and infrastructure.4

3 The efficient frontiers are based on assumptions and calculations using data available to J.P. Morgan and in light of current market conditions and available investment opportunities. They are intended for illustrative purposes only and are subject to significant limitations. Under different liability, risk and capital constraints, the optimal portfolios will clearly differ from the analysis presented above for a notional insurance company.

4 See Appendix A for a breakdown of the allocation at each data point.

As Exhibit 5 shows, the addition of alternatives to the allocation mix substantially increases the model portfolio’s expected risk-adjusted returns. At a targeted return of about 4.5%, for example, the portfolio diversified with a 6% allocation to alternatives would have a projected volatility of 2.3%. At 3.8%, the projected volatility of the portfolio diversified with equities alone would be almost three-quarters more. For the pure fixed income portfolio, it comes to nearly three times more.

So despite alternatives’ inherent volatility—and thanks to the added diversification they bring—their risk-adjusted return potential can actually moderate overall portfolio risk, a fact also reflected in incremental capital charges (Exhibit 6). The dotted line in the exhibit represents the incremental regulatory capital charges for an allocation of hedge funds and private equity, ranging up to 6% of a typical insurance company’s total investment portfolio. The solid lines represent capital charges for high yield bonds. At moderate levels, as the allocation shifts away from B and BB bonds toward alternatives, the capital charges levied against the alternatives enjoy an incremental cost advantage—up to a 2% allocation compared with the charges assessed on BB bonds. The advantage persists up to 4.5% vs. lower-rated B bonds.

The alternatives allocation combines the firm’s equilibrium long-term rate assumption, developed by our analysts for each alternative strategy, to look past shorter-term deviations and plot a return trend over a time horizon of 10 to 15 years. Drawn entirely from the fixed income portion of the portfolio, the alternatives allocation ranges up to 6%.


5 International Association for the Study of Insurance Economics (Geneva Association), “Surrenders in the Life Insurance Industry and Their Impact on Liquidity” (August 2012): page 22.

6 Douglas Niemann. “Making the most of ‘interesting times’ in the bond markets,” J.P. Morgan, April 2014.

7 It is worth noting that an alternatives allocation can address a public insurer’s responsibility to its individual shareholders in yet another way. A company’s decision to invest with a top manager affords them indirect exposure to otherwise inaccessible alpha.

The trade-off: liquidity in the balanceLiquidity is the public insurance company’s proverbial double-edged sword. For the policyholder, the risk lies in not having enough; for the shareholder, it lies in having too much. Following the credit crisis, the balance of liquidity shifted toward policyholders. Life insurers and P&C companies have provisioned in excess of the most extreme annuity redemp-tions and catastrophic losses in recent history. The Geneva Association, an industry think tank, reports that life insurers remained cash flow positive despite the surrenders occasioned by the financial crisis.5


Hypothetical P&C alternatives allocation: private equity 40%, hedge funds 50%, real estate 5%, infrastructure 5%

An alternatives allocation would have had a smoothing effect on long-term GAAP earningsEXHIBIT 7A: U.S. P&C GAAP EARNINGS, HISTORICAL AND ADDING HISTORICAL RETURNS OF A 5% ALTERNATIVES ALLOCATION

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bn)

Alternatives Net income Total

Sample includes all insurers in SNL’s GAAP filings database with consistently minimal allocation to alternatives over the last 10 years—a total of 14 P&C and eight life and health companies.


Hypothetical life and health alternatives allocation: private equity 70%, hedge funds 20%, real estate 5%, infrastructure 5%

EXHIBIT 7B: U.S. LIFE AND HEALTH GAAP EARNINGS, HISTORICAL AND ADDING HISTORICAL RETURNS OF A 3% ALTERNATIVES ALLOCATION

Qua

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Alternatives Net income Total

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-3-2-1012345678

Likewise, the stresses of the hurricane year of 2005, and 2013, in the aftermath of Superstorm Sandy, did not challenge robust P&C liquidity.6 Even as they maintain this liquidity cushion, however, a persistent low yield environment challenges public companies to preserve their dividend, and a rallying stock market raises expectations that they will increase it.7

Exhibits 7A and 7B show how an allocation to alternatives would have served in the past to meet conflicting stakeholder demands by simultaneously smoothing and boosting the investment earnings trajectory.



The exhibits track actual GAAP earnings, compiled by SNL Financial, for the two insurance sectors over the 40 quarters beginning with the first quarter of 2004 and ending with the fourth quarter of 2013. Property and casualty insurers reported negative GAAP income in five of those quarters and life insurers in three. We then modeled results using the historical quarterly returns plus a small alternatives allocation diversified as before: 5% for the P&C sector and 3% for life insurers with their larger balance sheets.8 In 14 out of a total of 80 reporting quarters, alternative returns in one sector or the other would have detracted from overall results. Alternatives would have enhanced results in better than four of five reporting periods, in other words.

Alternatives would also have smoothed the overall record for P&C, reducing the number of losing quarters from five to four. Alternatives’ performance in extreme events is more mixed in the case of life insurers. In the credit crisis, our hypothetical allocation would have lifted returns into positive territory in two out of the three negative quarters, but it would have driven pos-itive returns into negative territory in two quarters and added to losses in a third. Our alternatives allocation would have detracted as well during the outbreak of rate volatility in 2011.

Hunting vs. gatheringConventional investment results tend to converge on a bench-mark mean as investors pile into a successful strategy and arbitrage away the competitive edge. Over the last decade, for example, top quartile long-only equity funds outperformed the median manager by 0.7% to 2.3% per year.9 By contrast, idio-syncratic, often proprietary alternative investment results tend to diverge (Exhibit 8).10

The tendency has several important implications. Median returns in alternative investing mean less, and track records count for more. A recent study by consultants at McKinsey &

Source: J.P. Morgan, Long-term Capital Market Return Assumptions 2014. See Appendix B for methodology and sources used in determining manager dispersions.

More than anything else, the wide dispersion of manager returns characterizes alternative investmentsEXHIBIT 8: EXPECTED LONG-TERM DISPERSION OF MANAGER RETURNS

5.25 6.004.50 4.75 5.00

7.756.00 6.5

-10

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20

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Equityhedged

Eventdriven

Diversified Macro Relativevalue

PE/Buyout

U.S. real

estate

Long-only equity funds

Retu

rn (%

)

Bottom quartile

MedianTop quartile

2014 equilibrium assumption

8 In fact, the Schedule BA allocations over the period averaged 7% for the P&C sector and 3% for life insurers, with their typically larger portfolios. We adjusted the allocations downward to eliminate the Schedule BA assets that we excluded from our analysis: private loans and master limited partnerships.

9 Morningstar US OE Large Blend category, as of December 31, 2013.10 See Appendix B for an explanation of the methodologies used to determine

expected manager dispersion.11 Sacha Ghai, Conor Kehoe and Gary Pinkus. Private equity: Changing

perceptions and new realities. McKinsey & Company, 2014.

Company found that private equity returns in a given vintage year have ranged from 50% for the top managers down to -30% for those at the bottom.11 The dispersion stands to rea-son—successful managers see the more promising deals and accumulate more experience in judging their merits. In private equity’s earlier days, the majority of top quartile funds sus-tained their top quartile performance. McKinsey observes that the persistence has declined since 2000, as it has among alternatives managers generally. More competition, better competition and, in private equity, subtler ways of creating value beyond cut-and-paste financial engineering all help explain the trend.

The same factors also point to the need for state-of-the-art due diligence capabilities. A thorough understanding of what portions of manager performance to attribute to luck, to skill and to process, as essential as that is, no longer suffices. Effective due diligence today calls for a well-reasoned, exhaus-tively researched view of how a manager’s process will fare in a constantly shifting dynamic of opportunity.


Source: J.P. Morgan Long-term Capital Market Return Assumptions 2014.

Managers exercise a decisive influence on expected alternatives returnsEXHIBIT 9: EFFICIENT PORTFOLIO FRONTIERS WITH ALTERNATIVE ASSETS: EQUILIBRIUM FORECAST, TOP AND BOTTOM QUARTILE MANAGERS13

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12 See Appendix C for a breakdown of the allocation at each data point.13 See page 4, footnote 3 for further detail on our efficient frontier calculation. 14 A.M. Best. “Best’s Special Report: Trend Review 2014.”

A question of quartilesExhibit 9 takes a closer look at the hypothetical blended fixed income-equity-alternatives efficient frontier diagrammed in Exhibit 5. It shows a range of expected long-term gross returns for the top and bottom quartile alternative asset managers, derived from our equilibrium assumption (the middle line, which we posit as the median manager return) and based on our experience with return dispersions. The allocation, to the same group of alternatives as in Exhibit 5, varies somewhat from the 6% median.12 For the top quartile, it starts at 4.7%, rises to 5.9% at the second data point and to 6% thereafter. For the bottom, it drops to 5.5% at the last data point.

At lower levels of targeted return, we expect dramatically reduced volatility. At a 4.4% total portfolio return target, annualized volatility for portfolios with the top alternatives managers should run about 0.9%. We estimate the median would experience 2.3% volatility and a portfolio with bottom quartile investments might undergo more than three-and-a-half times the volatility of the portfolio with the top alternatives managers. Aiming for the highest return with a maximum 6% allocation to alternatives, the top quartile manager could attain a 5.8% return, compared with a 5.6% median and 5.2% for a bottom quartile manager. The real difference comes in the volatility expected to attain those returns: 5.7% for the top, 8.1% for the medium and 7.6% for the bottom quartiles (for which, remember, our model optimizer pared back the alternatives allocation to 5.5%).

Caveat venator: hunter bewareSo the compelling potential of alternative investments for the insurance investor comes packaged with a warning label: The potential is compelling only for the top managers. Indeed, effective alternative investing adds a fourth leg to the classic strategic triangle. Besides the three basics of sound traditional investing—formulating a coherent strategy, diversifying effec-tively through the business cycle and rebalancing rigorously—adding alternative assets to an insurance portfolio requires access to the top managers. Contrary to conventional wisdom that holds that the supply of attractive deals is the limiting factor in alternative investing, we have found that the supply of capable managers is. A dynamic economy will always gen-erate attractive deals, and their sources will always vary. The ability to hunt down the attractive deals and the foresight to recognize them will always be the scarce resource.

Alpha’s ephemeral nature further complicates the search for it. Alpha depends not only on manager ability but on how that ability coincides with market opportunity and macroeconomic circumstance. That lends a decidedly tactical character to alternative investments as a strategic asset class. Alternative investments don’t lend themselves to “set it and forget it” oversight. Optimizing the allocation not only calls for an approach sensitive to the global economy and markets and aware of their likely portfolio impact, it also requires an informed view of the most capable managers across the broad alternatives spectrum. The insurance rating agencies, among others, recognize the complexities. A.M. Best has stated that “although management fees may be higher using a fund-of-funds approach, it may be more cost effective … than trying to build this capability in house,” and it does not penalize compa-nies for outsourcing alternative investing expertise.14

Insurance companies enjoy the advantages of scale, credibility and patience in the pursuit of management talent capable of selecting, structuring and monitoring alternatives portfolios. They can make investments big enough to matter. Their repu-tation as long-term institutional investors enhances a manag-er’s credibility and leverage in the deal-making universe. Not least important, insurers have a compatible time horizon: As noted, their ability to capitalize on liquidity premiums and inter-temporal diversification gives them a cash flow that par-allels that of alternative investments.



Overcoming the last hurdle: feesInsurance companies can command the attention of the best alternatives managers, but they have limited influence on their fees. As in any endeavor where talent is the bottleneck—in professional sports or the arts, for example—the best will forever reap the benefits of excess demand. As long as alpha persists, those who can capture it can charge essentially what-ever the traffic will bear. When it has eroded, fees come down and managers seek other employment.

While investors have little control over what the best manag-ers charge, they can determine what they will pay. For an alternatives allocation to benefit a general account portfolio, the expected incremental return must exceed the company’s cost of capital, multiplied by the incremental capital charge entailed in the investment. Any other compensation arrange-ment is objectively uneconomic. Assume, for instance, that an investor in an insurer expects a return on capital of 12%.13 In a simplified example, the insurer invests $100 with a top quar-tile private equity fund returning 20% annually, in confor-mance with its recent history. If the fund assesses the standard 2% management fee and the insurer agrees to a performance fee of 20% of returns above the investor’s 12% target, the insurer will realize a return of $16.40 (Exhibit 10). Assuming a 35% corporate tax rate, the after-tax return drops to $10.66. Deducting the 12% from the $26.30 a life insurer must set aside to support the investment, and the $22.50 a P&C compa-ny must, according to National Association of Insurance Commissioners’ (NAIC) risk-based capital requirements, leaves net returns of $7.50 and $7.96, respectively. These figures include the diversification benefit to the overall portfolios assumed by the NAIC from reallocating a portion of assets away from purely investment grade bonds.

Applying the same formula to the median historical private equity return presents a sharply contrasting picture—and rein-forces the importance of manager selection. The median return, at 10%, comes to about half the top quartile return and below the 12% target. Even sparing the incentive fee, the insurer’s realized return shrinks to less than half that of the top quartile manager’s: $8.00 compared with $16.40. After subtracting taxes and the cost of the capital set aside from the realized return, the investment with the median manager still does more than achieve breakeven: $5.20 – $3.16 = $2.04 for life and $5.20 – $2.70 = $2.50 for P&C. Such returns under-score the contribution alternative assets can make to yield, return and diversification, but they may make it difficult to jus-tify the illiquidity involved and the extraneous risks incurred.

13 Most alternatives managers in our experience have hurdle rates in the 7%–9% range.

Source: J.P Morgan. For illustrative purposes only.

Management fee, performance fee, tax and cost of capital are based on assumptions, which may differ materially from actual costs. The total returns are for illustrative purposes only and are subject to significant limitations.

Quantifying the value a top alternatives manager can addEXHIBIT 10: HYPOTHETICAL RETURN ON A $100 SCHEDULE BA ALTERNATIVES INVESTMENT

Top quartile Median

Manager ranking Life P&C Life P&C

Total return $20.00 $20.00 $10.00 $10.00

Management fee -2.00 -2.00 -2.00 -2.00

Performance fee -1.60 -1.60 — —

Net return $16.40 $16.40 $8.00 $8.00

Tax (@35%) -5.74 -5.74 -2.80 -2.80

After-tax return $10.66 $10.66 $5.20 $5.20

Capital required -3.16 -2.70 -3.16 -2.70

Capital-adjusted net return $7.50 $7.96 $2.04 $2.50

Conclusion: the right fitAlternative investments appear in many respects to constitute, for lack of a better term, the best alternative for insurance portfolios today. Alternatives managers pursue idiosyncratic alpha in an environment where the outlook for beta in tradi-tional insurance investments seems increasingly problematic. Though alternatives are risky in themselves, the diversification that comes from their pursuit of unconventional sources of return and unique risk factors can actually moderate overall risk in the typically concentrated insurance portfolio. Similarly, their mark-to-model structure can tamp down the volatility of mark-to-market reporting. Perhaps most crucially, alternative investments give insurers the means to take more complete advantage of their own business model by capturing a premi-um both for the excess liquidity in their investment portfolios and the relative predictability of their liabilities.

The upside of alternative investment is clear, but it calls for careful attention to the downside. Alpha itself is transient, and its pursuit calls for superior manager skills and acute investor vigilance. Capturing it consistently demands insight and flexi-bility. Insurers have the resources to identify and retain the top talent and the scale to spread their positions effectively across the spectrum of alternatives. With discipline and methodical persistence in finding and monitoring their invest-ment partners, they can make the most of their allocations.


Appendix A: Model portfolio efficient frontiersUsing returns projected from J.P. Morgan’s Long-term Capital Market Return Assumptions 2014, we developed efficient fron-tiers for Exhibit 5, with the following allocations at each data point. The efficient frontiers are based on assumptions and calculations using data available to J.P. Morgan and in light of current market conditions and available investment opportuni-ties. They are intended for illustrative purposes only and are subject to significant limitations.

Fixed income (%)

Expected rtn. 3.6 3.8 4.0 4.2 4.4

Expected vol. 0.6 1.4 2.7 3.9 5.1

ALLOCATION

Cash 34.7 29.7 27.3 24.9 22.5

Treasury 65.3 60.4 44.7 29.0 13.3

Corporate 0.0 9.9 28.0 46.1 64.2

Hedge fund 0.0 0.0 0.0 0.0 0.0

Private equity 0.0 0.0 0.0 0.0 0.0

Loans 0.0 0.0 0.0 0.0 0.0

Equity 0.0 0.0 0.0 0.0 0.0

Real estate 0.0 0.0 0.0 0.0 0.0

Infrastructure 0.0 0.0 0.0 0.0 0.0

TOTAL ASSETS 100.0 100.0 100.0 100.0 100.0

Fixed income, plus U.S. large cap equity (%)

Expected rtn. 3.6 3.8 4.0 4.2 4.4

Expected vol. 0.6 1.0 1.7 2.7 3.8

ALLOCATION

Cash 34.7 29.3 26.1 23.7 21.3

Treasury 65.3 69.0 69.1 54.9 39.2

Corporate 0.0 0.0 0.0 16.4 34.5

Hedge fund 0.0 0.0 0.0 0.0 0.0

Private equity 0.0 0.0 0.0 0.0 0.0

Loans 0.0 0.0 0.0 0.0 0.0

Equity 0.0 1.7 4.7 5.0 5.0

Real estate 0.0 0.0 0.0 0.0 0.0


TOTAL ASSETS 100.0 100.0 100.0 100.0 100.0

Fixed income, plus U.S. large cap equity, plus alternatives (%)

Expected rtn. 4.4 4.6 4.8 5.0 5.2 5.4 5.6

Expected vol. 2.3 3.1 3.9 4.9 5.9 6.9 8.1

ALLOCATION

Cash 18.8 12.1 8.1 5.7 3.3 0.9 0.0Treasury 69.3 69.3 59.4 43.7 28.0 12.3 0.0

Corporate 0.0 0.0 11.4 29.5 47.6 65.7 80.0

Hedge fund 0.5 0.5 0.5 0.5 0.5 0.5 0.5

Private equity 0.5 0.5 0.5 0.5 0.5 0.5 3.8

Loans 0.9 7.6 10.0 10.0 10.0 10.0 9.0

Equity 5.0 5.0 5.0 5.0 5.0 5.0 5.0

Real estate 0.5 0.5 0.5 0.5 0.5 0.5 0.5

Infrastructure 4.5 4.5 4.5 4.5 4.5 4.5 1.2

TOTAL ASSETS 100.0 100.0 100.0 100.0 100.0 100.0 100.0



Appendix B: Expected alternatives manager return dispersionHedge fund manager returns are taken from Bloomberg and internal J.P. Morgan databases. The historical range is given at twenty-fifth, fiftieth and seventy-fifth percentiles using annual-ized returns from July 2005 to June 2013, with the exception of private equity data.

For historical private equity dispersion, Thomson Venture Economics is used for the 10-year pooled horizon return data, broken down by quartiles. Thomson Venture Economics private equity 10-year pooled horizon return is calculated by pooling all cash flows from a sample of funds over a 10-year time period, along with the sample’s net asset value at the begin-ning and ending points of the calculation. Based on this pooled series of cash flows, the pooled internal rate of return (IRR) is calculated. When reporting the 10-year pooled horizon return by quartile, a fund’s quartile position would be based on where

the fund’s cumulative IRR falls compared with funds with simi-lar primary market, vintage year and fund stage focus. Cash flows of funds with similar quartiles would be pooled together to find the 10-year pooled horizon return by quartile.

Value-added real estate dispersion is sourced from Preqin data for the category value-added real estate funds from vin-tage years of 2001 to 2008. The numbers show the average IRR quartiles for the first and third quartiles, and the median IRR across these vintage years.

Long-only funds projects the historical dispersion of the Morningstar US OE Large Blend category from January 1, 2004, through December 31, 2013, onto J.P. Morgan’s equilibrium equity returns.

Given the complex risk-reward trade-off in these assets, we counsel clients to rely on judgment rather than quantitative optimization approaches in setting strategic allocations to these asset class strategies.


Appendix C: Alternatives manager efficient frontiersStarting with the equilibrium returns projected from J.P. Morgan’s Long-term Capital Market Return Assumptions 2014 for a blended portfolio of fixed income, large cap U.S. stocks and alternative investments, we developed efficient frontiers in Exhibit 9 for the

Top quartile (%)

Expected rtn. 4.4 4.6 4.8 5.0 5.2 5.4 5.6 5.8

Expected vol. 0.9 1.0 1.5 2.1 2.9 3.7 4.7 5.7

ALLOCATION

Cash 26.1 24.9 23.0 19.9 13.5 8.6 6.2 3.8

Treasury 69.1 69.2 69.2 69.3 69.3 62.7 47.0 31.3

Corporate 0.0 0.0 0.0 0.0 0.0 7.6 25.7 43.8

Hedge fund 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5

Private equity 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5

Loans 0.0 0.0 0.0 0.0 6.1 10.0 10.0 10.0

Equity 0.0 0.0 1.7 4.8 5.0 5.0 5.0 5.0

Real estate 2.0 2.6 0.5 0.5 0.5 0.5 0.5 0.5

Infrastructure 1.7 2.4 4.5 4.5 4.5 4.5 4.5 4.5

TOTAL ASSETS 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Bottom quartile (%)

Expected rtn. 4.4 4.6 4.8 5.0 5.2

Expected vol. 3.5 4.4 5.4 6.5 7.6

ALLOCATION

Cash 9.2 6.8 4.4 2.0 0.0

Treasury 66.6 50.9 35.2 19.6 3.1

Corporate 3.1 21.2 39.3 57.4 76.4

Hedge fund 0.5 0.5 0.5 0.5 0.5

Private equity 0.5 0.5 0.5 0.5 0.5

Loans 10.0 10.0 10.0 10.0 10.0

Equity 5.0 5.0 5.0 5.0 5.0

Real estate 4.5 4.5 4.5 4.5 4.0


TOTAL ASSETS 100.0 100.0 100.0 100.0 100.0

top quartile percentile alternatives manager returns and the bottom quartile percentile manager returns, with the following allocations at each data point. The efficient frontiers are based on assumptions and calculations using data available to J.P. Morgan and in light of current market conditions and available investment opportunities. They are intended for illustrative purposes only and are subject to significant limitations.

FOR INSTITUTIONAL/WHOLESALE OR PROFESSIONAL CLIENT USE ONLY | NOT FOR RETAIL DISTRIBUTION

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NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for Institutional/Wholesale Investors as well as Professional Clients as defined by local laws and regulation.

The opinions, estimates, forecasts, and statements of financial markets expressed are those held by J.P. Morgan Asset Management at the time of going to print and are subject to change. Reliance upon information in this material is at the sole discretion of the recipient. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as advice or a recommendation relating to the buying or selling of investments. Furthermore, this material does not contain sufficient information to support an investment decision and the recipient should ensure that all relevant information is obtained before making any investment. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data.

J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication may be issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.; in Switzerland by J.P. Morgan (Suisse) SA; in Hong Kong+C94 by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited; in India by JPMorgan Asset Management India Private Limited; in Singapore by JPMorgan Asset Management (Singapore) Limited, or JPMorgan Asset Management Real Assets (Singapore) Pte Ltd; in Australia by JPMorgan Asset Management (Australia) Limited ; in Taiwan by JPMorgan Asset Management (Taiwan) Limited and JPMorgan Funds (Taiwan) Limited; in Brazil by Banco J.P. Morgan S.A.; in Canada by JPMorgan Asset Management (Canada) Inc., and in the United States by J.P. Morgan Investment Management Inc., JPMorgan Distribution Services Inc., and J.P. Morgan Institutional Investments, Inc. member FINRA/SIPC.

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