Erik Vynckier: We are an investor in public markets, which are in principle liquid, in normal market conditions, but also in private debt and private equity funds and those are illiquid by their very nature.
Overall, we can do that as an insurer because we have cash premium inflows, and our liabilities as a runoff of cash flows is fairly predictable.
We can - more than banks or asset managers can - invest in illiquid assets, and we do that if we think they are worth their while in returns at an acceptable, low default risk. They are worth investing in due to the extra return that we can achieve that way.
It seems that in current macroeconomic and market conditions, two particular types of assets stand out as the most interesting: namely private instruments and also, right now, real return assets because of the situation in terms of inflation.
It'd be wise to have a good handle on liabilities and expected cash inflows and outflows. Investing in illiquid assets requires us to know how to generate cash if it is needed, so we first need to have stress-testing in place so that we know what adverse requirements for prompt cash could be like and prepare plans to provide it.
Now, I said in principle that the public markets are illiquid, but I've seen the situation where we came from, and the public markets are not as liquid as we were used to in the past, before the credit crunch, where investment banks held large portfolios of bonds for trading. Typically, now our trading clip is €2 to 3m, whereas, in the past, it was €10m easily.
"Liquidity planning is now a must. Liquidity planning is a Pillar 2 task
for insurers, it is not particularly capitalised against following Pillar 1 rules."
Another factor is that in stressed conditions, in very adverse market conditions, liquidity dries up - even in the supposedly liquid public markets.
How do we manage all that? We have always a safe allocation invested in government bonds, which are always going to be liquid, and we do hold some cash, as little as possible given the faint returns on such assets, but minimising such ultra-liquid availability works against our potential demands in adverse conditions. Levels of cash, gilts and other, more yielding investments are calibrated through stress testing.
Liquidity planning is now a must. Liquidity planning is a Pillar 2 task for insurers, it is not particularly capitalised against following Pillar 1 rules. It's not present in Pillar 1, so if it is not in Pillar 1, and you think it's important, do it in Pillar 2, which is in private conversation with the regulator where you can address these topics.
Erik: We want to be invested. We don't want to store cash. We want to be invested in good assets and earn yields. But again, yields in commonly traded, liquid assets are not the most attractive investments at the moment.
If you want to be substantially invested in attractive assets in your return generating portfolio, you are going to be to some extent illiquid, knowingly, in private instruments, or illiquid in traded instruments under adverse market conditions, because if the credit market turns against you, you’ll have a lot of trouble generating liquidity out of a corporate debt portfolio.
"To be quite frank, even your bank line – a secured bank
line - you might post assets as security to the bank."
This means you need alternative access to liquidity. The alternatives can be things such as creating a pre-agreed credit line with a bank. Banks are present in the overnight markets, borrowing or lending cash for very short periods and are open to arranging credit lines with corporates. A secured credit line to an insurer should be easily affordable. You can have a credit line with a bank, which you should probably pre-agree terms and conditions for. By having that credit line from a bank, you will have the opportunity to invest more in the assets that you want to own and hence earn back the premium that you pay to your bank for the access to a credit line.
The other thing is the repo market. Make use of repo facilities where you temporarily sell and agree to buy back securities in return for short term cash. To be quite frank, even your bank line – a secured bank line - you might post assets as security to the bank. You remain beneficial owner of those assets and as beneficial owner continue to earn the returns on the posted instrument, but you give the legal security to the bank that you get the urgent cash loan from.
Those are the two basic ways of working – bank credit lines and repo markets.
Erik: In the remainder of 2022, I expect rates to go up. That's going to have an impact on the markets. Funding will generally be better remunerated, so we may get into a situation where it might be wise to hold a bit of cash back for the time being while rates mark up and fixed income marks down mechanically.
"Nominal rates are recovering from quantitative easing, but
real rates remain deeply in the negative territory."
As I said, cash doesn’t return much but that may improve. That means that at the same time, you'll have a difficult fixed income market you would be invested in: it is not going to behave all that well. We've seen a route in fixed income markets, which was just due to macroeconomics, not due to individual corporates struggling or per se negative credit conditions with defaults hitting so far, although that may yet materialise once a recession develops.
We saw rates go up, and with that, those fixed income portfolios all marked down badly so it was not a bad time to hold a bit of cash. I think that regime will continue for the rest of this year, and plausibly into next year. You may want to increase your cash position, a bit more than you usually would and that will help you on the liquidity side, although it will not help you earn back inflation. Nominal rates are recovering from quantitative easing, but real rates remain deeply in the negative territory.
Beyond that, funding is going to become valuable again, because, with that funding you can make some money, which was very difficult to do under the conditions of quantitative easing, unless you went into those alternative fixed income assets. It’s been very difficult to earn any money out of anything over the past few years.
