In part two of this InsuranceERM/Insurance Asset Risk and Standard Life Investments roundtable on illiquid assets, experts discuss the management capabilities required and how the assets fit into Solvency II
Miriam Arntz, Senior manager, ALM and capital management, Old Mutual Group
Meirion Board, Head of market and credit risk, Aspen
Atanas Christev, Head of investments, Direct Line Group
Hugo Coelho, Assistant editor, InsuranceERM
Gareth Collard, Director, investment management, Just Retirement
Iain Forrester, Investment director, insurance solutions, Standard Life Investments
Vicky Kubitscheck, Chief risk officer and compliance director, Police Mutual
Bruce Porteous, Director, investment solutions, Standard Life Investments
Chaired by Christopher Cundy, contributing editor, InsuranceERM
In the first part of this roundtable, participants discussed how illiquid assets confer an advantage over traditional fixed income, in that there is an opportunity to be involved in the resolution in the event of a covenant breach. However, this requires expertise that is usually found in banks, not insurers. The conversation continues here....
Hugo Coelho: After which point is it more appealing to seek the support of specialised asset managers rather than building your own capabilities?
Gareth Collard: We have significant holdings in equity-release mortgages, so have the skills to do that in-house. On the other hand, we outsource our investments in infrastructure and private placements, but also need some capabilities to feel comfortable that the asset managers we choose really know their stuff, though. We are a small organisation, but even in the case of large organisations it is not always logical for them to be experts in everything.
Vicky Kubitscheck: It is a similar story for us. We select external providers according to their expertise in specific asset classes, and we have also been developing our monitoring capabilities. We need to have clear line of sight and understanding of the trends and direction of travel. This is true at the board level too. The skillsets within boardrooms have increased as we expanded the range of asset classes in our portfolio.
Gareth Collard: There is definitely an exercise, when you move to a new asset class, of educating the board and in some cases senior management. They are going to be sceptical and nervous that you have done due diligence properly and that the business case for the asset class is valid. This is one of the reasons why the shift does not happen overnight; it is a long process.
Miriam Arntz: Management actions relating to these assets may be different to those for other asset classes; for example, large stakes or an expert resolutions team may increase an investor's ability to influence the outcome of a loan restructuring to suit their own interest. These management actions may not align with investment principles for other asset classes, such as diversification among issuers and limitation of relative ownership of single assets. However, the aim of resolution in my mind is to avoid default rather than management of exposure at default. I think this is part of the education that should to be delivered.
Bruce Porteous: With commercial real-estate too, you might be able to step into the borrower's shoes in advance of default. Not only can you avoid the default, but you can also avoid the maturity extension as you take control or bring someone else in to run the property to ensure it is delivering the right return.
Iain Forrester: When I was at Standard Life, we introduced commercial real estate debt into our annuity and shareholder portfolios. One of our key considerations in selecting that asset class was that we had the capability to manage the underlying assets that we could get back if there was a default on the debt.
Hugo Coelho: So this is almost like a covered bond, in a way, is it not?
Iain Forrester: Yes, but you need to have the right asset management skillset. This is not just to run and monitor the debt position. In a worst-case scenario, you must keep the asset that is securing that debt.
Chris Cundy: You are not cutting and running, which is the traditional insurance approach...
Iain Forrester: Selling the property immediately might be the optimal decision in some cases, but you need to be able to make that call at that time. You need to be at the decision table and you need to have a blocking vote.
Illiquidity premium under Solvency II
Chris Cundy: What are the obstacles for recognising the illiquidity premium under Solvency II?
Atanas Christev: At this stage, we have decided to apply to use the volatility adjustment (VA) in our pension-like liabilities, instead of going for the matching adjustment (MA), which comes with stricter rules on asset eligibility. Size was another factor; while we expect those liabilities to grow, they still account for a small share of total liabilities.
Bruce Porteous: Even if you want to go for the MA, could you find assets matching the cash-flows of PPOs?
Atanas Christev: It would be difficult and that is only one of the obstacles. This is why we are happy to use the VA. In addition to the capital benefit we also get a better return on these longer-dated illiquid assets.
Gareth Collard: Annuity writers in the UK are addicted to the illiquidity premium, so we have to go for the MA. But that has been a major exercise for us, no doubt. There is an awful lot of work to be done in order to make your portfolio of illiquid assets MA compliant. Furthermore, the MA itself goes away from the spirit of Solvency II in that it is imposing a very prescriptive view of how to measure an illiquidity premium. It allows you to take credit, but it is prescribed, hence it is not behaving in a manner that is consistent with other parts of your internal model.
Hugo Coelho: Call options are one of the features that make loans and private bonds ineligible for the MA, as they create pre-payment risk. Such options suit banks, which historically have originated the loans. With insurers entering that space, do you have flexibility to change the terms of lending?
Gareth Collard: Change is already happening, but it does not happen overnight. One thing that is important for us, other than the removal of pre-payment risk, is the preference for fixed rates, as opposed to floating rates.
Chris Cundy: Do you think the issuers understand the regulatory requirements insurers have to cope with?
Gareth Collard: We have to tell them and they understand that we will not invest, unless they meet our requirements. We have seen a few recent deals where a floating rate is linked to the consumer-price index. This is an example of where people that needed funding made concessions to the specific demands of a group of investors.
Iain Forrester: We are seeing pockets of that in the commercial real estate world, too. The term of the loan is an important factor here. Banks are still actively lending short-term without pre‑payment protection, so it is very hard to introduce the sort of clauses that insurers need in MA funds. However, at longer terms, where banks are less active, it is easier to do so.
Atanas Christev: I can give you another example, which is slightly out of the illiquid space: securitisations where there is a 5% skin-in-the-game requirement for the originator. We are hearing there are more issues in the pipeline that have that requirement met. Demand from insurance companies, which are the ones who need that, is probably helping.
Bruce Porteous: To confuse things even further, the European Commission is expected to change the capital charges under the standard formula for these investments and it looks like they are going to do this before 1 January 2016. So it might be best to wait, rather than rush to sell.
Hugo Coelho: We have been focusing on Solvency II, but the European Market Infrastructure Regulation is another large piece of regulation that forces insurers to manage their liquidity carefully. To what extent is this limiting your ability to plough into illiquid assets?
Atanas Christev: My treasury colleagues have been following developments there, but our investment strategy has not been affected by it yet.
Click here to read part 1 of this roundtable.