This article is taken from the research report Insurance Asset Management, Europe 2017. To download the full report click here.
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.
"We estimate that the current exposure in UK life insurance is
around £50bn."
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.
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.
"The large majority of significant UK annuity writers have plans to increase
their asset allocation to illiquid assets."
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.
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.
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.
"Delays in establishing workout capabilities, during a downturn, can increase
the probability and severity of losses when borrowers struggle to repay."
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.
