BY ERIKA MORPHY

Prompted by the difficult equity and bond market conditions of recent times, insurance companies have been turning more and more towards alternative investments to beef up portfolios. A study by Swiss Re last year found that most large insurers have increased their asset allocations in alternative investments such as hedge funds and could grow this sector by more than 10 percent a year for the next several years - a significant commitment since it is estimated that insurers' portfolios currently include some $10 billion to $15 billion in hedge fund investments.

So it was with some dismay that the industry reacted to the Securities and Exchange Commission's announcement last year that it was studying the possibility of regulating this notoriously unregulated industry. Should that happen, the conventional wisdom held, curbs on investment strategies would likely be levied and disclosures of holdings would possibly be mandated. In short, it would become a less efficient and more expensive investment vehicle.

A year-and-a half later, at the end of September, the SEC published its proposals. Registration and other information requirements have been suggested -- specifically that hedge funds register with the SEC under the Investment Advisors Act just as asset managers do, and they have a higher minimum net worth (a net worth of $1.5 million, compared with $1 million presently), or new annual income requirements. The SEC is also calling for better insight into hedge funds' bookkeeping.

"The issue here is that we need to get inside these funds and we need to understand not just the accounting that they're using and the pricing…but more importantly, whether some of the techniques being used are having an impact on the marketplace itself," SEC chairman William Donaldson said recently in a televised interview. Altogether, there are 7,000 or so hedge funds in existence and the size of the market is estimated at approximately $650 billion.

At the same time, though, the agency has indicated it understands the need for discretion, all but promising not to open the books for public view. All in all, these are proposals that don't come anywhere near the investment community's initial fears. In fact, some industry watchers believe these and other suggested changes - in one instance the SEC actually called for a relaxation of regulation - will help the industry.

For example, Michael Tannenbaum, senior partner at Tannenbaum Helpern Syracuse & Hirschtritt LLP, a New York-based firm whose financial group's expertise includes hedge funds, points to the registration requirement. "Either by law or by their own investment philosophies, insurance companies and pension funds gravitate towards registered rather than non-registered advisors," he says. By requiring hedge funds to be registered, new investments will become available to these institutions. "In short, they will have more choices."

Another element that bodes well for institutional investment in hedge funds is the SEC's proposal to relax the rules limiting advertising or publicity about these investments. "This is a very significant item and again should provide more choice to the investment community," Tannenbaum says.

It is still possible that SEC regulations could end up proving burdensome in their final form, at least for start-up hedge funds. "The extra expenses of complying could become a bar for new entrants," Tannenbaum says. "We have to wait and see if that happens."

Other hedge funds that might find the SEC regulations troublesome are foreign-based funds. UK-based companies in particular have voiced irritation at the prospect of having to register in the US as well as with the UK Financial Services Authority. "I think wecounted up that we actually have about a dozen regulators who affect Man Group business," Stanley Fink, CEO and managing director of the Man Group plc, told reporters during an earnings report conference call. "Given the number of regulatory visits we have going on around the world, I feel like we are one of the most over regulated industries in the world, not an unregulated industry [as is often reported]."

Not that the prospect of new US regulation is likely to stem the flow of foreign hedge funds into the country. Even though the more traditional capital bond and equity markets appear to have bottomed out from their free fall, most industry watchers expect to see demand continue for alternative investments. "Hedge funds are clearly on the radar screens of most insurance investment managers," Tannenbaum says. "They have to be at least considering them."

The Hennessee Group, a hedge fund consultant and index provider, reports that US hedge funds outperformed equity market indices in September - bringing year-to-date returns to a little over 13 percent.

"We do not believe growth will stop simply because the markets have returned to a bull market," Man's Fink said. "We think the need for diversification will be around for the next 10 to 15 years." In fact, he pointed to insurance and reinsurance as industries targeted by the Man Group, citing the cat bond recently issued by the FIFA World Cup as one example of an unmet need. "Some of the potential catastrophes are beginning to outstrip the balance sheets for the biggest insurance companies, who for regulatory reasons will not be able to reinsure these huge risks, or the cost of capital of doing so will be very large.

"We would expect," Fink added, "that the different mediation that will happen here, similar to the different mediation that happened in the banking market, would create a whole new class of catastrophe reinsurance bonds. A bit like credit derivatives have become a major market. We think this will be a great area for hedge funds to play in."