Certain returns
Stephen Oxley, managing director at PAAMCO, says: “General insurers want to increase the returns on their portfolio. Many are interested in adding alternative investments to improve returns.” Hedge funds appeal to general insurers because they have absolute return targets that are usually short-term. But insurers want a greater transparency than hedge funds are used to providing, says Oxley.
Annuity funds are now looking at alternative asset classes but focusing only on those which provide a fair degree of certainty about the cash flows. Mark Gull, co-head of asset liability management at Pension Corporation, says: “We see increasing opportunities to providing longer dated financing where the banking sector used to be involved but is now avoiding because regulatory changes make it too expensive.”
There are number of assets which provide the necessary investment characteristics for insurance companies and are now more available because banks are less willing to lend. These include property-backed lending, sale and leaseback, ground rents, equity release as well as infrastructure lending. Roe says: “All these asset classes share a similar profile. They are providing direct lending to corporates or individuals but with a high certainty surrounding most of the cashflows.”
Commercial mortgage loans have become particularly popular among insurance companies. Abrahamsen says: “There is a huge swathe of commercial mortgages where the terms are due to expire and have to be refinanced. It’s unlikely that the banks will be able to fulfil the refinancing requirement.” Paul Sweeting, European head of the strategy group at JP Morgan Asset Management, adds: “US commercial mortgages are particularly attractive for insurance companies because they include a pre-payment penalty which gives a guarantee and predictability to cashflows.”
Other alternatives
Long-term investors like annuity providers and life insurers, unlike general insurers, can exploit the illiquidity premium associated either with long duration debt or the direct finance market. For those parts of the insurance market that do not have such long-term asset and liability matching constraints other alternative asset classes are appealing. “Asset classes such as high yield, leveraged loans and emerging market debt are more likely to appeal to either strong with-profit funds or to be used in a diversified growth fund that an insurance company has developed for unitised business,” says Roe.
However, Abrahamsen believes that fixed income asset classes with short duration such as leveraged loans could form part of an investment portfolio for an annuity provider or a life insurance company. “There is a duration mismatch between these assets and the annuity or life providers’ liability profile. But it’s possible to manage this mismatch by using interest rate swaps to swap from floating rate to fixed,” he adds. Many insurance companies may well have already used interest rate swaps to de-risk the portfolio and will be interested in investing in leveraged loans because it provides a cashflow that can be used to fund the cost of the swap. Insurance companies need to consider any potential new asset classes carefully.
Abrahamsen says: “We would caution against bumping up yield just because they are low and spreads have tightened. There has to be acceptable level of returns to compensate for risk.” Insurance companies need to keep an eye on all these different alternative asset classes and invest only when the pricing moves in their favour.
The effect of Solvency II
Unfortunately insurance companies have more to worry about that just finding the right type of investment to suit their particular requirements: they also need to think about how these investments will be treated by Solvency II. Ascertaining exactly how different investments will be treated by Solvency II has recently become much more nebulous. Derek McLean, F&C’s head of insurance advisory, says: “Solvency II seemed relatively well defined but that’s all changed. The introduction of this new regulation is now further in the future than we had previously assumed and there is much less certainty about what shape it will take.” McLean also believes that Solvency II has received somewhat of a bad press. “There is the assumption that Solvency II gives insurance companies less investment freedom but actually there was less freedom under Solvency I, which has a narrow list of allowed investments.”
An insurance company can invest in anything it likes but it just has to have the appropriate capital charge applied. “Solvency II will allow more freedom but the insurance company will have to have a solid understanding of those asset classes,” adds McLean. Sweeting says: “The trick is to find an asset class that has the same sort of credit rating as an investment with a low capital charge but will give you a higher yield.” The types of asset classes that meet these requirements include dollar-denominated emerging market debt, infrastructure debt and US commercial mortgages. The current low yield environment and the threat of a new unpredictable regulatory environment make life challenging for many insurance companies.
But perhaps the best response to such circumstances is to take a more strategic approach to the insurance investment. Roe says: “There has always been a small group of insurers who have decided to take a more economic and intelligent approach to their investments, with regulation a secondary constraint. But the current environment is encouraging a larger number to look at more alternative investments.”
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