Finding opportunities in illiquid credit

Companies: Canopius, Legal & General Retirement, InsurTech Venture Partners, Institute & Faculty of Actuaries, Foresters Friendly Society, Aviva, Sumitomo Life, NN Investment Partners, Pool Reinsurance, Pension Insurance Corporation

People: Conor Sweeney, Jeev Muthulingam, Hayley Rees, Erik Vynckier, David Walker, Vincent Huck, David Epstein, Shiro Kodama, Suresh Hegde, Prasun Mathur, Ian Coulman, Peter Vasey

Insurers can sometimes find the illiquid credit space crowded, participants in part one of this roundtable from Insurance Asset Risk and NN Investment Partners discuss the opportunities and challenges to find the right assets competing not only with other insurers, but also with other institutional investors such as banks.

Insurance Asset Risk Roundtable

Conor Sweeney, investment risk and operations managerCanopius
David Epstein
, group ALM director, Aviva
David Walker, senior staff writer and head of projects, Insurance Asset Risk
Erik Vynckier, board member, Foresters Friendly Society
Hayley Rees, head of direct investments, Legal & General Retirement
Coulman, chief investment officer, Pool Reinsurance
Jeev Muthulingam, head of insurance investment solutions, NN Investment Partners
Peter Vasey, head of investment risk, Pension Insurance Corporation
Prasun Mathur, head of shareholder investment, UK & Ireland Life, Aviva
Suresh Hegde
, lead PM export finance & government loans, NN Investment Partners

Chaired by Vincent HuckeditorInsurance Asset Risk

Vincent Huck: We hear that when it comes to illiquids, insurers tend to chase the same deals, and as a result some parts of the market are overcrowded. Are you managing to find the right returns when investing in this space?

Hayley Rees: There is not more money chasing the assets – but the source of the money has switched from banks to institutions.
From the perspective of returns, you have to be disciplined in ensuring why you are investing. We invest to pay our pensions, so we have to be clear on the returns we need to get.

Peter Vasey: There are sectors where we have seen an increase in interest, for example social housing. There have been positions where illiquid social housing debt has been priced better than private debt, because of the amount of money chasing it.

I definitely echo Hayley's comments about having an obligation to pay long-term liabilities; we see the benefits from illiquid credit, but we are not going to take undue risk with that credit portfolio in order to chase return. We want to look at all of the characteristics of the particular asset, and make a judgement based on that for the long term.

We are seeing asset classes which 18 months ago were not typically presented to us – particularly things where there is built-in credit enhancement through a structure. There is an opportunity there, but we take great pains to understand the whole spectrum of risks associated with it.

You cannot just default to the 'You have an insurance wrap around it, or a structure that protects you'; you have to understand the overall risks associated with that transaction.

David Walker: Would those investments have been interesting without credit enhancement?

Peter Vasey: Some of these transactions are sub-investment grade by quite a long way prior to the credit enhancement. Even with that credit enhancement, you would not necessarily – certainly from our perspective – want to invest in them.

The reason we are starting to see those deals is partly because banks have retreated from some of the longer-dated assets and are having to put in structures that work from a Solvency II perspective.

Vincent Huck: Which parts of the illiquid credit market do you see as less crowded? Which asset classes are you looking into?

Legal & General Retirement's Hayley ReesHaley Rees: Infrastructure will always remain a very large market that we are looking into, and in the UK the supply is limited. We are definitely looking further afield, outside of the UK, for the infrastructure assets.

Housing is a very big investment and something we will continue to look at in all aspects, whether it is social housing, lifetime mortgages, or build to rent.

David Epstein: It is important to have a broad capability to invest across the spectrum of private credit. You could think about it over quite a long term, so not just one year but maybe three to five years or more.

Then, in an individual year, you are looking at what is available in the market, what the demand is like, what the pricing is like, and tactically you are going to change the amount you invest in an asset class, depending on how attractive it is at the time. You need to retain that flexibility and agility to be able to move between the various pieces of private credit as you see fit at the time.

Prasun Mather: The first aspect that needs to tick the box is credit underwriting. We can then assess whether the pricing works for us.

When it comes to new opportunities, our preference is to be able to fish in a lot of different ponds, so we are not reliant on the one pond that dries up.

David Walker: If you diversify geographically - outside the UK - to what extent do you find the national markets are covered by local insurers? German insurers will pick up German infrastructure, the Dutch will pick up the Dutch assets, etc.

Prasun Mather: Competition for European real assets is quite strong and is often dominated by the banks. Further, the bank-financed debt structures are not optimal for insurers. That constrains the universe of assets that we can invest in the continent.

David Epstein: Our group has businesses across the continent and they also buy private credit. From my perspective, would I prefer that a particular type of credit was bought locally, or would I prefer it was bought by our UK subsidiary as a foreign investment? It might make more sense if it was local. There is a balance to be had.

Around this table, there is bound to be a strong focus on what sits well in a UK matching adjustment (MA) portfolio. But in the private credit world there are an awful lot of other things out there that are very interesting, but not so good for an MA portfolio

Erik Vynckier: Although we have Solvency II, which ostensibly is a single harmonious regulation across the European Union – ostensibly – we have found this is just not the case - neither on the assets side nor on the liabilities side.

The European markets are still very national, but that is even more the case in the UK, which has a different currency from the Eurozone. However, this is much more than currency-related. Mortgages are held in bulk on Dutch insurance balance sheets; you do not see that anywhere else.

David Epstein: Of course, the asset could be great, but it depends on which currency you want to end up in. Right now, if you are sitting in Europe buying things from the US you would feel differently than if you were sitting in the UK.

Vincent Huck: Ian, you have a different business model. How do you approach these questions?

Pool Re's Ian CoulmanIan Coulman: Our liabilities are much more short term, we do not know when an event may happen or how large it might be. However, when it does happen, we will most likely be paying out in a relatively short timeframe.

We have a degree of illiquid credit in our multi-asset credit portfolios through bank loans, and we have been giving some consideration to whether we look further afield into other illiquid credit like trade finance, distressed debt and infrastructure.

The key to us every time is liquidity. We cannot be locked up for a period, like with private equity, for several years; we need to be able to get access to the liquidity. If there is an event that exceeds all our assets and our commercial retrocession, that is when we will need to borrow from HM Treasury. In such a situation we will be required to liquidate all our portfolio, before we can borrow from HM Treasury.

We have grown comfortable with the idea of infrastructure debt, not that we invest in it yet. Through a number of conversations with some of the consultants and managers in this asset class, we got comfortable with the idea that even in a stressed situation, we could get liquidity probably in about 12 months, so it is something we continue to monitor.

There are other investors, perhaps not so much on the insurance side, who I believe are chasing markets for yield. They see an opportunity, and they try to get on the back of that. That may mean hedge funds, but they see that short-term opportunity to capture the spread compression that is going to occur as investors rush into this market. As you say, with the banks, from their own solvency point of view divesting from this field, the insurance market has a great opportunity to capture value. However, we have to be selective in terms of where that money goes.

We were talking to one consultant recently about trade finance and distressed debt, among other things, and there appears to be a reasonable amount of money waiting on the sidelines to be deployed. That concerns me from the point of view of where we are in the economic cycle. It seems to be getting extended more and more; but we are near to that end of the cycle.

Conor Sweeney: Canopius has traditionally been a very catastrophe-heavy writer of general insurance business. But even if we get a cat, we do not necessarily expect to pay those claims out immediately. If you buy a reasonably illiquid asset, you can, in theory, sell it over of time.

However, besides the physical payment of claims, there are the regulatory nuances where, at the end of a given quarter, the reserving actuaries have calculated we need to hold x-million of reserves following a catastrophe event.

Those assets that were held to back a potential liability now back a specific claim (liability), and that is when the regulation kicks in: and all of a sudden, I cannot hold an asset that is not either A or AA rated, potentially forcing you to immediately liquidate.

Erik Vynckier: Of course, you can do things like trade invoice and inventory financing and so forth. Economically, these assets reprice very quickly, which makes it a short-term risk. The one catch here is that, if you want to be in these markets, you have a franchise issue. If you are in the market for only three months: your partners will abandon you.

Ian Coulman: With trade finance, you have to know the counterparty, you have to understand who the manager is and what are they helping you finance. It seems the greatest returns are out of emerging markets, however you have some risks there, and who owns or has possession of the assets? If there is a problem, you may have to go after that asset somehow.

David Epstein: On trade finance over the last two or three years, some banks have built their own platforms, so large investors can come in alongside them and would be able to dip in and out. If you have a list of names that you like or do not like, they could turn the taps on and off. It gives you a bit more flexibility. However, in practice, building the processing structure around this has been a lot harder than people originally thought, so they have not quite got there yet.

David Walker: In terms of what the banks do to make trade finance available, how do you feel about taking fees from the banks' books and the extent to which the banks might be trying to get rid of what they do not want?

Prasun Mathur: We work with banks as partners, and we often compete with them. It is not necessary that the structure they actually want works best for us. One simple example that we see across the market is inflation-linked debt. Insurers love inflation-linked assets, while the banks typically prefer if the debt coming out of the asset is fixed, even though the underlying revenues are inflation-linked. This permits them to make some money through purchasing inflation swaps from them and selling inflation in derivative format to insurers. We prefer inflation-linkage as part of the loan, rather than as a derivative. From a credit perspective that is the best way to structure the debt, but it is not necessarily what is always achieved in the market.

David Walker: Is the answer then to deal directly with the infrastructure provider, rather than go via a banker who may want things structured different?

Prasun Mathur: Often, yes.

Foresters Friendly Society's Erik Vynckier

Erik Vynckier: You have to achieve scale to permanently engage with infrastructure borrowers, but if you do that, of course go direct.

Peter Vasey: Banks are still learning what the insurance companies like and do not like.

The idea they are shifting big parts of their balance sheets over to insurers is a long way from happening, because a lot of these assets were structured in a way which does not work for insurers under Solvency II.

While they are coming up with ideas as to how to change certain characteristics of the structure to things that might be more acceptable, they come with additional complexity.

We have a fair degree of scepticism about whether or not the structures generally do what you anticipate them doing. We get a lot of things that are introduced to us by banks or have been on banks' balance sheets; but the proportion of things that are credible in our view is pretty small at the moment.

Part II of this roundtable will be published on 1 August 2019.