Are illiquid assets complex?

In part two of this Insurance Asset Risk / Aegon Asset Management roundtable, insurers discuss illiquidity and complexity risk and their views on where and how to allocate assets to these risks.



Corrado Pistarino, chief investment officer, Foresters Friendly Society
Daniel Blamont, head of investment strategy, The Phoenix Group
Emily Penn, capital initiatives and investment director, LV=
Gerard Moerman, chief investment solutions officer AAM Europe, Aegon Asset Management
Hayley Rees, strategic assets consultant, Pension Insurance Corporation
Mike Ashcroft, head of investment capital analysis, Scottish Widows
Prasun Mathur, private assets lead, Aviva UK
Russell Baird, senior investment solutions consultant, Kames Capital

Chaired by Vincent Huck, editor, Insurance Asset Risk

Vincent Huck: Mike, you mentioned illiquidity risk, you said everyone talks about it...

Mike Ashcroft: Yes, everybody talks about it at every conference. Certainly taking illiquidity risk is what most big insurers have been 'doing' for at least four or five years now. It makes absolute sense on an annuities portfolio, because obviously the liabilities are fixed and are illiquid, and as such we can take that risk – that is the whole point.

However, I hate the phrase 'illiquid,' because actually they are private assets and the credit protections on these private assets may actually make them more attractive to investors in an extreme downturn.

Then, to say 'corporate bonds are fully liquid' is also a fallacy. The actual liquidity of a corporate bond portfolio will vary depending on the multiple factors for the bonds in question.

Corrado Pistarino: Illiquidity and complexity tend to go hand in hand. Think of very common product like an SME loan fund – how robust are the underwriting criteria? Is the interaction between the sponsors and the investment manager totally transparent? How solid is the risk management framework underpinning the manager's ability to discharge its fiduciary duty? The complexity issue around illiquid assets is a critical one.

Insurance companies need to have in-house expertise first to assess suitability of what is potentially a wide range of complex assets, be it infrastructure, or private equity or SME loans; and secondly, to reach a level of comfort about the quality of the due diligence on those assets, or on their managers.

One of the key issues, in my view, is price discovery. When you buy shares in Barclays plc, price discovery takes place through a continuous transparent market process: these are liquid assets, accounted for on a mark-to-market basis, which means that the holding period is virtually one day.

Gerard Moerman: You said the price of an equity is transparent, but I would argue that is difficult. What would be the stock price of Barclays?

Corrado Pistarino: But there is a degree of transparency provided by a market price. And that transparency comes with liquidity, which allows you to reconsider the wisdom of your investment and change your mind at any time if you want to do so.

Gerard Moerman: That is what I would call tradeable, but I would not call the price discovery 'transparent,' because it is very difficult to come up with the equity value of any company. We are just more used to work with equity risk than we are with the risk on non-tradable assets like illiquid fixed income. And maybe because of this, the premium is still attractive.

Mike Ashcroft: But there is a market-visible price. You can then decide whether you agree with it or not, but the issue on private assets is that you have to mark-to-model. You start out with some of the metrics that feed into that – so there are market driven elements of the prices i.e. risk-free yields and comparable credit spreads and things like that – but you have to set those out in the methodology. Certainly, there is complexity, even in the valuation – and the PRA is also re-emphasising 'valuation uncertainty' as an important factor that companies need to consider.

When I was thinking about complexity, I was thinking about the complexity in the transaction, but you are right, there is a whole 'capability' piece. That is where you have to have absolute comfort that you understand the credit, you understand the legal documentation, you have the right operational processes to manage matters, and also to manage if it all 'goes south'. That is critically important, and the PRA have been vocal on it.

Prasun Mathur: I would not say that private assets are complex just because they are illiquid. Making that generalised statement is probably not fair, because one can invest in the same risk in private or public form. Just because there is price discovery does not mean that they are not complex assets.

For example, many of us would be invested in public utility bonds, which are whole business securitisations and complex credit to understand. Around the table, many us might have also invested in these in private form via private placements or swaps that utility providers have actually sold to banks and then those banks have offloaded onto us. Complexity should not be interlinked with liquidity, because there could be complex assets that could be liquid [and] there could be illiquid assets that could be simple.

In its latest draft supervisory statement, the PRA has come up with different terminology for illiquid assets, viz. 'tradeable assets' and 'non-tradeable assets'. That is putting another twist to how we look at the world, and we will see how the insurers respond to it.

PIC's Hayley Rees

Hayley Rees: I totally agree with you. You can hardly say that bond securitisation is not complex. You have to understand it to be able to buy. I agree with you that price discovery is the major difference between the fixed public markets and private markets.

In annuities, we have to hold the assets. We are not there to trade them. Actually, it is more to do with how we value our balance sheet in terms of that mark-to-market, than whether we can go out and trade [the investments] tomorrow, because we are not about to do that.

Corrado Pistarino: I disagree. I appreciate the overlap between illiquidity and complexity is not exact, and leaves some margins for disagreement. But take for instance the case of an external manager that invests in illiquid assets on the insurer's behalf. The company needs to be comfortable about the manager's decision-making process in respect of risk exposures that are expected to stay on its balance sheet for a considerable amount of time.

And it needs to be comfortable about the manager's risk management and valuation processes, amongst others, because oversight and control can only be exercised indirectly and intermittently. I believe this adds to the complexity of any investment proposition in illiquid assets.

Going back to the issue of price discovery, I would like to point out this is not just at the point where an asset is bought, but also throughout its lifespan, which may be lengthy. And this opens the debate around ongoing valuation, which is also an issue of internal governance. All these considerations point to a level of complexity that we are not expected to deal with when investing in traded bonds or shares.

Hayley Rees: It depends on the size of the company, because not all large insurers go through asset managers for their fixed income.

Then you have to build out the valuation models, you have to build out the capital models. Well, you can go to the standard model or choose to build your own capital models.

There is a cost associated with it, but there is a reward, and if there is sufficient reward, then it is worth investing. If it is a very small company, a very small balance sheet, then it is not worth it. However, if you have a lot more assets, then it can be.

Russell Baird: It also comes back to when UK annuity providers want to offer a more competitive price to customers, they are going to have to go beyond the current low levels offered from traditional bonds. As such, they are going to have to invest in something that is, by definition, more complex. And even these non-vanilla bonds still don't have overly attractive nominal yields relative to historic levels. It is understandable the regulator wants providers to demonstrate they fully understand the additional risks taken on, so that from an end-customer point of view, there is comfort in the ability to pay all benefits due at the end of the day.

Vincent Huck: Are you looking at increasing illiquid investments and if so which illiquids are you looking at?

Emily Penn: For us, we are very constrained by the standard model, so we are invested in commercial real estate loans and we continue to grow that portfolio as we write more business in that fund. It comes down to resource and just trying to get things through governance. We started investigating diversification out of sterling bonds into US dollar bonds two years ago and we still have not received approval.

Vincent Huck: Why is it so slow?

Emily Penn: To reduce the operational burden and risks associated with a default of a bond, we considered using an SPV structure. We said from a capital perspective, we would look through to the underlying assets and stress them, as you would, as they were held on the balance sheet. However this treatment under the standard formula has been challenged so we have reverted to the more traditional approach of overseas credit investment

Prasun Mathur: The PRA does differentiate when it comes to regulation between tradeable assets and non-tradeable assets. The PRA just wants us, as insurers, as more nascent investors in private credit, to be a little more careful when we invest in these for the long term. That is a fair ask.

Phoenix Group's Daniel Blamont

Daniel Blamont: Being cautious does not mean you understand anything any better, though.

Vincent Huck: Has anyone else looked at foreign currency debt and faced the same challenges Emily was talking about, like with US corporates?

Mike Ashcroft: Most companies, or at least the bigger players, have all partially diversified into the US market, primarily for liquidity reasons rather than credit reasons.

The MA [matching adjustment] regulations have driven most companies to follow a common approach for currency hedging – using full-term cross-currency swaps. That itself creates liquidity issues in the longer term and obviously it can make it more or less attractive, depending on the timing and the pricing.

Hayley Rees: Yes, and access too. Liquidity and access to market, being able to buy the assets when you need them. The market is more readily available in the US than it is in the UK if you want to buy a large slug.

Daniel Blamont: But to do any meaningful size, you need a collateral management framework. And that is not open to anyone.

Corrado Pistarino: Also, in regards to the hedging of the assets, you cannot put a cross-currency on top of most alternative assets, because of the unpredictable cash-flow pattern.

If you put a hedge in place, like rolling currency forwards, the hedge is going to leak, which means you have to allow yourself a return buffer to compensate for that leak. And additionally, you have to allow for a further return buffer because of the need to ensure that low-yielding collateral can be deployed at short notice to cover margins.

Daniel Blamont: If you do not have certain cash flows, you are probably not fitting it in the matching adjustment or in a place where the cross-currency swap is required. You can hedge with an FX forward. With a cross-currency swap, even if the bond defaults or goes away, you still have a currency swap, you can still find a replacement asset.

Corrado Pistarino: But actually if you have a default, you have a problem.

Daniel Blamont: You can always find a replacement, restructure; it is not about selling a 30-year swap. You might find a replacement asset at 29 years or 31 years and just trade the marginal risk.

Mike Ashcroft: We still have to match these, so you still have the liability there, so you are going to have to use the full proceeds effectively or reinvest to get another asset with a similar profile.

Scottish Widows' Mike Ashcroft

Emily Penn: You have to explain that on your MA application.

Prasun Mathur: A lot of insurers here are trying to go into non-sterling assets. It is quite topical. What we may find in a few years from now is very large cross-currencies swap books in different insurance companies with large moneyness.

That is similar to mature US insurers' experience where they have been diversifying into non-USD investments for longer, and investing alongside in cross-currencies swaps.

The size of their cross-currency books is quite material, and almost as big as any particular asset allocation. I do worry that locking in so much liquidity in large cross-currency swap exposures can create a systematic problem a few years down the line.

Mike Ashcroft: It does not mean you cannot reset. Ultimately, they are getting a risk-free return on a large part of their portfolio within swaps. You would be looking at whether that is the right matching strategy, and resetting them and reinvesting elsewhere.

Part one is available here. Part three is available here.