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Roundtable: Tackling lower fixed income returns in a high-risk world and allocating to alternative areas to prompt higher investment returns. This roundtable debate is part of the annual Insurance Asset Management, Europe 2017 report.

Moderator:

Noel Hillmann, Managing Director, Clear Path Analysis

Panellists:

Celia Kapsomera, Vice President, Risk and Investment Management, AXA Liabilities Manager

David Rule, Executive Director, Insurance Supervision, Bank of England

Noel Hillmann: Can you talk to us about the growing role of alternative investments in insurance risk carriers portfolios? Has increased investing in alternative asset classes proven to be successful, so far?

Celia Kapsomera: The low yield investment environment has been a major challenge for all insurers and particularly the Life and Health carriers for several years now. Traditionally, insurers have relied on fixed income for the majority of their investments. Prior to the 2008 crisis, ¾ of insurers’ portfolios were invested in bonds.

Since 2008 low interest rates depressed bond yields to levels that significantly impacted profitability of insurance companies. This development drove companies to increase allocations of other types of assets that would provide higher yields (high yield bonds, emerging markets debt, equities) and to include in their portfolios alternative investments, such as hedge funds, private equity, limited real estate partnerships, infrastructure, housing tax credits, mineral rights, and mezzanine debt. It is worth noting that the definition of alternatives varies among insurers. For example, there are insurers who consider any non-traditional fixed income investment as alternative.

So far, this trend has been evolutionary. The larger parts of insurance portfolios continue to be invested in fixed income but alternatives, as a means to enhance yield and diversification, are here to stay and will grow. A new incentive to invest in alternatives arises from the need to counter the effect of interest rate increases. Since the largest portions of insurers’ portfolios are composed of bonds, an interest rate increase will cause the value of bonds to decline and that would need to be offset by other classes. For Life and Health insurers, rising interest rates can cause ALM mismatches as the size of certain liabilities will increase while the value of the fixed income assets will decrease. This effect, too, will need to be countered.

David Rule: Investment in alternative asset classes – for example, commercial real estate, infrastructure and equity release mortgages – is a growth area for many UK life insurance firms with annuity liabilities. We estimate that the current exposure in UK life insurance is around £50bn and this looks set to grow to around £100bn by the end of the decade, based on firms’ stated intentions.

From a regulatory perspective, it can be appropriate for life insurers with long-dated, sticky liabilities to allocate a prudent proportion of their assets to long-dated, illiquid liabilities provided they can manage the associated credit and other risks effectively. Success in alternative asset investment could be measured in different ways; such as, the ability to write deals, the ability to get access to the better deals and the ability to minimise credit and other losses.

Insurers have been relatively successful at writing deals through the growth of their portfolios to around £50bn, supported by the regulatory environment in the form of the Solvency I Liquidity Premium followed by the Solvency II Matching Adjustment.

Many insurers are still developing front office teams to support alternative investments.

Equally important is that they also invest in the relevant risk management, operational and internal audit expertise.

Noel: What percentage of insurers would you estimate have increased their allocations across a variety of alternative asset classes? And how much do speciality investments, such as infrastructure, mineral rights, aircraft leases and debt and real estate limited partnerships for instance, feature in such portfolios?

David: The large majority of significant UK annuity writers have plans to increase their asset allocation to illiquid assets going forward.

Lending secured against commercial real estate and direct ownership of commercial real estate (invariably existing income-producing rather than development properties) are two of the largest exposures at circa £14bn and circa £7bn respectively – overall commercial real estate exposure being the largest at £21bn.

Infrastructure loans account for c£9bn on loans and social housing c£7bn of loans.

Other material alternative investments are in equity release mortgages of over £12bn, residential ground rent loans circa £4bn, which - when added to the Social Housing Loan exposure – push the exposure to UK residential property market up to at least £23bn – a similar level to the commercial real estate exposure.

Object Finance (e.g. on Aircraft and Rolling Stock) also takes place, although to a lesser extent.

Celia: Insurers in the U.S. have gradually increased their allocations to alternative asset classes – which appear as Schedule BA assets in their statutory statements – from almost 4% of total invested assets in 2008 to 5.8% within 6 years. Property and Casualty (P&C) insurers have more flexibility to take advantage of higher returns from riskier assets and so they have increased their allocations from 4.6% to 8.4% in the period between 2008 and 2014, according to National Association Insurance Commissioners (NAIC) data. Life and health insurers had smaller increases given more stringent regulatory constraints of “buy and hold” and higher Risk Based Capital (RBC) charges.

Since 2008, U.S. insurers have added $150 billion of Schedule BA assets (such as infrastructure, mineral rights, aircraft leases, debt) in their portfolios. These do not include real estate and equity positions, which accounted for over 11% of total assets.

Hedge funds and private equity are a small portion compared to the total of Schedule BA assets. Still, their importance as a diversification tool and as a proposed non-correlated investment to other asset classes, is growing. Since 2008 hedge funds have grown at a cumulative annual growth rate of 11.4%, which surpassed the private equity growth of 8.9% (NAIC data as of 12/31/2014).

This growth is expected to continue as insurers with no exposure to hedge funds are considering adding them to the mix of their investments. In 2016, however, P&C insurers are cutting back on hedge funds considering that recent returns have been relatively low to high fees. In addition, a significant number of insurers admit that they do not have a sophisticated understanding of these instruments and remain cautious.

Noel: For many firms, such investments constitute a significant shift to their general investment practices. How are they settling into this dual function of enhancing returns alongside better managing risk through portfolio diversification?

David: Increased direct lending activity requires a significant shift in risk management practices. Investment in marketable securities involves use of asset managers supported by equity and bond analysts. Direct lending requires high quality underwriting and loan servicing teams together with an experienced, independent credit risk management function. Some insurers are relying on their investment managers to undertake these activities while others are developing expertise in-house.

Celia: Insurers are still learning how to go about creating and maintaining an effective strategy of investments in the alternative space. Large companies, particularly life and health, already have extensive investment departments and are adding to their bench strength by hiring analysts and risk managers specialising in the alternative asset classes in which they want to invest. Some insurers, in addition to investing in single manager funds, invest in funds of hedge funds (managed by hedge fund experts), or in hedge fund managed accounts (structures in which the insurers have direct ownership of the underlying securities) choosing to rely on the guidance and the capabilities of outside professional consultants and managers.

As I mentioned earlier, insurance companies are generally not highly experienced with hedge funds. Their primary concerns about these instruments are performance, the Remittance Basis Charge charges they carry, and their volatility.

Noel: As traditional fixed income strategies generate declining returns in the current low-yield environment, what other strategies are insurers deploying to harness the benefits of diversification?

Celia: Insurers are deploying different strategies in regards to alternatives. Some pursue a new alternatives program and create their own custom programs, others choose to refine their present strategy and hire an external advisor to guide them through the process of diversification, utilising alternatives.

Other strategies involve increasing equity, high yield fixed income, and structured securities positions, such as collateralised loan obligations, collateralised mortgage obligations, and asset-backed securities, newer vintages of which attract renewed interest after major impairments were taken by firms for bad structured mortgage deals in the years following the 2008 financial crisis.

Noel: What are some of the challenges you’ve experienced to executing an effective alternatives strategy?

David: In some cases, we find insurers set up a front office to originate deals but are slower to develop their risk management, operational and internal audit capabilities. This might be offset by an initially cautious approach to lending.

As these alternative strategies develop and mature, there will be an increasing need for insurers to invest in the people and systems to deal with work-out situations and maximise their recoveries. For insurers without distressed debt funds, it can seem like an unnecessary overhead to retain the skills to undertake work-outs. However, setting up an effective workout function takes time and delays in establishing workout capabilities, during a downturn, can increase the probability and severity of losses when borrowers struggle to repay.

Celia: Given the size of the portfolio and the legacy nature of the business in my companies, which requires giving priority to liquidity objectives, we have not had an internal investment department but have outsourced the asset management function to external portfolio managers. That constrained the ability to properly evaluate alternatives because there has been no internal knowledge or resources to develop it and our external managers have skills more closely aligned with the core assets.

A portfolio has to be big enough to attract high performing specialised managers, who would be given only a small piece to invest in alternatives. These managers should also be aware of the specific regulatory constraints that insurers face (such as higher capital charges by NAIC). Moreover, the returns should be attractive enough to justify the fees of alternatives.

Many alternatives managers are interested in providing an additional product, while our focus, as that of many insurers, has been to provide diversification that would be compatible with the other assets and have sufficient transparency for statutory reporting. That requires a solutions-oriented approach that often alternatives managers do not provide.


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