Bermuda's re/insurers' take on real assets

In a low yield environment, real assets has become the game in town for insurers globally. In part two of this Insurance Asset Risk / Aviva Investors roundtable Bermudian re/insurers discuss their approach to the asset class.

Vincent Huck: Have you increased allocation to real assets? What are you looking at in that sphere and are you happy with the supply?

Wendy Yu: This year we have focused on equipment financing, secured by what we call 'hard assets' – so construction equipment and that sort of thing.

We are now late in the credit cycle, so the question is: what are the things we can do from a risk management perspective to give ourselves comfort? We have gotten comfort with this asset class not only through the credit underwriting of the individual loans but also through loan portfolio optimisation.

We work with Apollo Asset Management Europe. They are overseeing these portfolios and making sure it is meeting our criteria from granularity and diversification perspectives across geographies, also across different equipment types. And then of course the company that is actually originating the loans will continue to make sure that we all understand, if a borrower were to default, how long it would take to actually realise the collateral and how much value at the end we would realise.

Of course the lending conditions are changing, so there are ongoing discussions about updating the best practices, in terms of this whole control framework.

Josh Braverman: For dollar investors, the US dollar real estate market and real assets markets are functioning fine with very low loss rates. Commercial mortgages and residential mortgages have all performed well.

I do not think there is necessarily any supply restriction. There are certainly views around structure. If you want to participate at the mezzanine level in a A or BBB rated structured security, you are going to get high-yield-like spreads with an investment-grade rating.

Alex Wharton: I would support Josh's point about supply in Europe. We still have capacity to supply real assets, both in sterling and euro. We try to encourage our clients, where possible, to take a more outcome-orientated approach, allowing the investment manager to think more about an overall outcome than the split between specific asset classes. We find that taking a multi-asset approach to real assets can lead to a better result.

Wendy Yu: In other words, structure the investment guidelines to be broader in terms of individual asset classes to be more flexible.

Kevin Hovi: And the other option is you structure the vehicle to match what your guidelines are. The banks are always working on different structures to accommodate what insurance companies need.

Vincent Huck: Thomas, you were saying before we started this discussion, that everyone does real assets, but the question is how to innovate? And you raised the question of sustainability. Can you tell us more about your approach?

Thomas Olunloyo: The question of sustainability and ESG is one that is of increasing prominence, certainly for European insurers and reinsurers. Regulators have started focusing on that as well.

You asked the question, 'what are we doing most differently from this point last year?'. It is really to focus on the carbon intensity of the assets in our portfolio, bringing that down and having a stronger ESG focus in the assets that we hold.

Ultimately, climate risk is one of the biggest global threats so as long-term investors we recognise that we have a significant role to play.

Vincent Huck: And in adding that additional filter, do you still find enough supply?

Thomas Olunloyo: There is significant supply, and this will only increase in the future as more companies reduce their carbon intensity. We therefore certainly feel we can achieve our investment goals with a low carbon footprint. We expect the industry as a whole will focus on this increasingly going forward.

Vincent Huck: Are you all looking at sustainability investment?

Sylvia Oliveira: No, not at this time.

Josh Braverman: It is more advanced in Europe, and driven to some extent from a regulatory perspective. In the US, with state-based regulators, it has not been applied in the same way and to the same extent. It is becoming more of a focus of shareholders.

Kevin Hovi: But you would hope the free market will sort that out over time. There are reasons tobacco spreads are wider than other bonds: it is because it is a risky business. Coal is not probably going to be a great long-term buy. If the rest of the world is likely to move, whether it is through government reform or not, away from those asset classes, naturally we are going to stay away from the bonds.

Iain Forrester: That becomes even more relevant if you are looking at portfolios with 15-, 20-year terms. That is where considerations around the sustainability of the underlying business, and the potential for reputational or legal risks, may ultimately affect the performance of your bond portfolio. However, if you are looking at the shorter-term holdings in your portfolios, then maybe it is a bit more nuanced in some markets.

Steve Hales: I was just going to say the same thing. Why would you look at things like coal if you are looking to match 30-year-plus cashflows?

Iain Forrester: Going back to real assets, one area that we focus on particularly is infrastructure. We see a number of insurers looking at infrastructure leases, long-dated infrastructure, even real estate. One area of focus is sovereign-backed regeneration schemes – backed by local authorities or municipal entities – which provide very long-term secure cashflows, but that are often structured as an equity holding, rather than a bond.

I am interested in understanding whether the substance or the form is more important when looking at investments. If it ultimately pays a fixed set of cash flows, even with an equity holding, does that then come through in your equity lines or does it come through as a bond? Is that one of the structures that you might look at?

Kevin Hovi: You can. There have been structures that allow you to hold fixed income-like equities in a fixed-income form. They are expensive and they are more complicated to structure. The challenge is, like Josh mentioned earlier, capital charges. It can be the most predictable 8% capital stream, and if you put it in the form of a rated preference share, it is great; if you put it in the form of an unrated common, then it is not great. It just comes down to structure.
Thomas Olunloyo: Under Solvency II, matching adjustment (MA) rules are very relevant to the assessment of value of fixed income like equities as they may not meet the requirements and therefore liabilities backed by these assets will be discounted at the risk free rate which is likely to be uneconomical!

Iain Forrester: Under a MA perspective, they potentially can be treated very well. There is a difference between those and long-dated equity holdings. Let us take a lease structure as an example, such as a town regeneration project, with a 50-year lease that is inflation linked., At the end of the lease, the council buys back the deal for £1, so you have no equity market risk. In effect, you have a local-government-backed lease over a 50-year time horizon that is providing you with a fixed cash flow.

So under the MA, firm can effectively treat those sorts of assets – amortising real estate or lease-type structures –as a bond.

Thomas Olunloyo: So, how do the capital charges differ if it is equity versus a bond?

Iain Forrester: It is likely to depend on the capital model being used by the firms. For firms using the Standard Formula, the capital charge will be higher if it is structured as an equity. For firms using an internal model, the capital charge may be aligned to the nature of the risk exposures rather than the legal structure.

Wendy Yu: But the debt tranche you are describing would not be rated.

Iain Forrester: There would not typically be a rating from a credit rating agency.

Wendy Yu: Okay, so then in Bermuda it would be the punitive 35% charge without an internal model.

Part one of this roundtable is available here. Part three is availble here.

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