Illiquid credit attractiveness in late cycle

As insurers increasingly position their portfolio for a turn in the cycle, is illiquid credit an investment of choice? In part three of this roundtable from Insurance Asset Risk and NN Investment Partners participants discuss how to build resilience in illiquid credit portfolios as well as the as the current regulatory considerations on illiquid investments.

David Walker: Where do you add overheads versus using someone else externally?

Peter Vasey: We have our own debt origination team internally and that is supported by a credit team and we also have specialism within our risk function. We have good experience and good specialism in a reasonable number of asset classes. I mentioned earlier housing associations and things like student accommodation – I would expect us to be relatively quick at being able to make a decision in those classes.

I would definitely echo Hayley's comments about considered decisions. Just because we know an asset class, does not mean to say we should go running into everything that is presented to us on it. However, we will take as long as we need in order to get comfortable with understanding the risks. If our debt origination teams cannot understand the dynamics of what is going to shape the risk of the underlying, we cannot do this transaction, irrespective of how good the insurance wrap around it is.

We have been building a framework that basically says, how do we go about understanding the opportunity? Is that opportunity appropriate? We may be able to see there is sufficient opportunity to allocate assets in this space, and if that is the case then we will go through a process of designing a structure to understand the risks, making sure we price and value the asset appropriately, and assign a rating to it that is sensible.

That is a long process and we push back on the banks and the introducers by making sure we have enough time to consider the risks. We are very willing to consider investing in these spaces, but we are not going to do it at short notice. However, if we do it, we may seek to commit a reasonable allocation of our assets in the portfolio to it.

David Walker: Does the commitment always come through a direct investment, or will you build up some expertise in-house to monitor a manager that can do that for you externally?

Peter Vasey: Our model is generally to have it internally. If you cannot sit in front of a regulator and explain how you have been through the process of understanding the asset and just say, 'We gave it to someone else and we know they are okay with it', I suspect you would have a difficult conversation.

Vincent Huck: What are the current regulatory considerations on illiquid investments?

Erik Vynckier: We are a small insurer, so I cannot effectively compete against the people around this table. My trick is to co-invest with them so as to benefit from their expertise. We essentially co-invest through funds.

Vincent Huck: Co-investment is interesting. Have you seen the latest Solvency II review, which allows standard formula users to use the internal ratings of an internal model user when co-investing?

Hayley Rees: Our rating team is very cognisant of not being seen as an external rating agency, because they do not want to. They are an internal ratings team.

Prasun Mathur: The risk with such an arrangement is that the standard formula firm will need to establish contractual arrangements with the internal model firm for an ongoing assessment of credit risk and implied internal rating. That appears to be a difficult proposition, and so I agree with Hayley.

Jeev Muthulingam: This could be positive for the industry, by incentivising less reliance of standard formula users on external rating agencies and promoting access to illiquid strategies to smaller players. This is only permitted for debt issued by companies domiciled in the European Economic Area (EEA) and there are a number of practical caveats to overcome. For instance, the main co-investing insurer would need to define what to share with other co-investors in relation to calibration, modelling and other methodologies, including certain governance aspects. This should not be an issue with a confidentiality agreement in place, however, you have to be quite selective on who you choose when you partner. There may be cases where a global insurer would be disincentivised partnering with a smaller competitor writing a similar business in an overlapping market.

Erik Vynckier: It has been a very long-standing strategy for captive insurance asset managers who develop their skill and track record with the parent insurance company and then make profits by providing that same expertise and asset management opportunity to external, smaller insurers or even competitors. However, of course, that is an incentive for the asset manager, but it is not an incentive for the CEO of the parent insurance company.

Jeev Muthulingam: If you take a market like Germany, a few large insurers have internal models and the vast majority use the standard formula. There is a clear need for those standard formula firms to access illiquid credit and it would be challenging if you don't have the expertise and teams to come up with the assessment.

Erik Vynckier: It's all down to how good your credit skills are. For some it is a new skill, for others it isn't. And I would signal that while we have been doing this for a couple of years now, none of us has gone through a credit cycle, none of us has gone through an adverse economy. That is really the elephant in the room. How do these assets behave in a downturn?

Hayley Rees: I would disagree with the statement that none of us have been through the credit cycle. Actually insurers like ourselves have brought people in who have been through the credit cycle, who do understand the risk. Now, Legal & General Retirement may not have actually owned these assets through a credit cycle, but I certainly have been through credit cycles and my colleagues have been through credit cycles. It is about getting the right expertise into the firm who has been through those credit cycles and know how the assets act through those times.

Peter Vasey: Also, some of the private credit institutions in the UK have been through a credit cycle with those asset classes.

Prasun Mathur: The credit cycle forms part of the credit risk assessment process. A lot of risks are not possible to model or account for in rating scorecards. Nationalisation risk is a good example.

David Walker: To what extent have the markets for these asset classes changed since the last crisis? Does that limit the usefulness of backward-looking analysis?

Hayley Rees: It is not so much how the markets have changed: it is how the structure of the debt instrument may have changed.

Most of the debt instruments are a lot more solid than they were. If you go back to the crisis, real estate debt is a key one, because banks lost an awful lot of money. However, banks were lending at really high loan-to-value rates and putting no covenants in.

Now, we have risk appetites, saying where we are comfortable on a loan-to-value basis. You can stress assets against the property values over 20 years. That is how you apply that crisis into your overall investments and that is the same for all of the assets that we look at.

Prasun Mathur: When we go into a new asset type, we always ask what its experience has been in history? How much historical data do we need in that sector to be comfortable that we can understand and measure the risk? Sometimes you don't have that data and you figure out what the proxy would be to best assess that risk.

Erik Vynckier: Do you have a ready approach to recovery? Do you have a team for that, people with the skills to restructure a deal gone bad?

Prasun Mathur: We have more than one asset manager, and we find that every asset manager has a different way of managing recovery processes. The regulator, of course, is always interested in the collective ability of an insurer and its asset manager to risk-manage credit events in good times and bad.

Vincent Huck: Ian, going back to the fact that we are in the later stage of the credit cycle, what are you doing to build the resilience of the illiquid credit portfolio? Are you already making adjustments?

Ian Coulman: We have very limited exposure to illiquid credit to start with, except for exposure in the senior bank loan space. We have not committed yet to other illiquid credit. A lot of it is down to some of the comments that have been made already around the liquidity of it, what impact it has on our risk budget and our risk measures. What are the implications for valuation and getting comfortable with that? Only then can we recommend the strategy to the investment committee.

At this stage we remain somewhat concerned about committing anything of a material allocation to some of this illiquid credit. To be frank, erring on the side of caution, now does not appear to be the right time to be going into this space. It comes back to a previous point, that we have to think about it from a liquidity perspective. We have to be able to liquidate all our assets over a period of time to meet any payments as they fall due. While we have a zero capital charge, largely because we have the government guarantee behind us, and theoretically we could be insolvent overnight if there were to be a large event, the regulator still looks at us not unlike another reinsurance company, so the portfolio mix is still very conservative. The primary concern is twofold. One, making sure that the assets are available and liquid. Secondly, ensuring that the government guarantee stands behind us.

Jeev Muthulingam: European insurance asset allocation often has local biases. Historically, a range of reasons have contributed to this, nevertheless we see a tendency across individual countries to internationalise legacy books, for instance in Switzerland, Italy, Germany or Nordic countries such as Denmark.

For UK annuity writers, to achieve a competitive price, securing a high asset yield is critical, especially given they have significantly reinsured/transferred longevity risk and returns. As a result, UK insurers have shifted their strategies beyond 'vanilla' investment strategies into non-traditional asset classes and increasingly so accessing the same types of alternative credit strategies. However, this also implied being concentrated into common systemic risks, as if you look at social housing, ground rent, equity release, these are to a certain extent all backed by a common UK real estate risk factor. Is there any view around that problematic and whether there is a readiness or incentive to diversify out of that?

Erik Vynckier: I do have worries about the UK annuity books' love affair with ground rents. Parliament and the government are seemingly turning against the rights of freeholders in favour of the rights of leaseholders. And that makes it a tricky asset to be in.

Prasun Mathur: We differentiate between residential and commercial ground rents. The majority of the franchise issues have been observed on the residential side.

Peter Vasey: These things will have an underlying property asset, but they actually all behave differently; the cash flows are generated through different risk drivers. For example, housing associations have a different profile to the private rental sector, by definition. The same with the likes of equity release mortgages.

So, yes, you avoid concentrations in property overall, but you have to look at the way in which the various risk drivers to those individual property assets behave, and how you expect the cash flows to develop. It is not as easy as just saying you have a big exposure to property. You could also consider geographical diversification, for example.

We have student accommodation, for example. Technically it has a property characteristic to it, but actually it is as much about the franchise value of the university's attractiveness over 20 years and what is going to change in the education sector over that period, as it is about the actual property. The demand characteristics of it you would expect to be different to housing associations, for example.

To read part one of this round table click here. To read part two of this round table click here.

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