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US life insurers are backing Americans’ policies with bigger slugs of riskier, higher-yielding investments.

Holdings of real estate, below-investment-grade bonds, mortgage loans, private equity, hedge funds, limited partnerships and privately placed debt increased 39% from 2015 to 2020, outpacing the 26% increase in total cash and invested assets, according to a new report by Moody’s Investors Service.

As a result, these so-called illiquid assets represented about 35% of insurers’ $4.04 trillion in investments as of Dec. 31, 2020, up from 32% out of $3.2 trillion in 2015.

Higher yields from these investments have helped slow an industrywide decline in investment income since U.S. interest rates plummeted during the financial crisis of 2008-09, Moody’s said. Investment income as a percentage of cash and invested assets has fallen to 4.3% from 5% since 2015, according to Moody’s.

A drawback to the trend is that the assets can be harder to sell than the publicly traded bonds they tend to replace. Should an insurer need to raise a lot of cash quickly, they could be especially difficult to unload in an economic downturn.

So far at least, the industry has plenty of other assets to tap for quick sale. “These investments generate higher returns than other traditional long-term investments and are a good match for insurance companies’ long-term insurance liabilities and capital surplus," Manoj Jethani, a senior analyst at Moody’s, said about the rise in illiquid investments.

This helps to outweigh their riskier characteristics, as long as the insurer has strong investment capabilities and maintains adequate overall liquidity, he said.

Carriers invest customers’ premiums until needed to pay claims, and under state-insurance-department guidelines aimed at protecting consumers, they typically have chosen high-quality publicly traded bonds.

In general, life insurers have leeway to go with longer-term investments because most policies can’t be cashed out on demand by consumers. Instead, policies paying death benefits, long-term-care bills and monthly annuity income can be on their books for decades.

“The prolonged low interest-rate environment that began following the great financial crisis has required insurers to search for assets that earn higher yields while managing overall risk," MetLife Inc. Chief Investment Officer Steven Goulart said in an interview.

MetLife said its U.S. insurance operations increased investments in the categories detailed by Moody’s to 44.6% of total cash and invested assets in 2020, up from 38.1% in 2015. MetLife, the nation’s largest publicly traded life insurer, has a long history with a wide array of assets, including private agriculture loans as far back as the 1920s.

At MetLife during the third quarter, unusually strong private-equity investment gains more than offset costs from a surge in Covid-19 deaths and a return to more-normal use of dental insurance in employee-benefit programs. Adjusted earnings for its U.S. group-benefits business dropped 72% to $111 million, while its private-equity investments returned $1.5 billion, or 12.6%.

Private equity has been “the standout performer over the last year," Mr. Goulart said. Quarterly returns for the asset class in each of the past three quarters has met or exceeded its annual guidance." At $12.8 billion, private-equity funds represent just under 3% of MetLife’s total cash and invested assets of $488 billion.

Mr. Goulart cautioned that the insurer expects annual performance of the asset class “to moderate and revert closer to our long-run expectations of low double digits."

The rising percentage of illiquid investments across the U.S. life-insurance industry has gotten relatively scant attention in recent years, as analysts have largely focused on a subset of carriers that have made more-aggressive investment strategies part of their business model: life-insurance companies acquired by private-equity, asset-management and other investment firms.

Many of these new owners say their expertise with less-common investments, such as privately placed corporate debt and asset-backed securities, gives them a competitive edge over more cautious insurers. They have scooped up insurance businesses as some carriers have retreated from products most hurt by low interest rates, such as certain types of annuities.

U.S. life insurers aren’t alone in turning to private-equity funds for higher yields. University endowments have been reporting impressive returns from such holdings, and pension funds have been loading up on illiquid assets such as private equity, private loans to companies and real estate.

The venture-capital subset of private-equity funds in particular has paid off well this year, thanks to rallying stock markets that have driven up valuations and made initial public offerings appealing for portfolio companies.

The outsize results at publicly traded life insurers will make for tough year-over-year comparisons in 2022, Wall Street analysts are cautioning.

Shareholders could be disappointed after a year of turbocharged results, said Mark Dwelle, an analyst with RBC Capital Markets.

“In revising our models for fourth-quarter alternative investment income, we actually struggled to remember what ‘normal’ looked like," he said.

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