Alec Innes, Albert Shamash, Stephen Birch and Ross Evans explore the benefits and challenges of collaboration with a bank for an insurer to gain access to long-dated loan markets
02 OCTOBER 2014 | ALEC INNES, ALBERT SHAMASH, STEPHEN BIRCH AND ROSS EVANS
In recent years the low interest rate environment and regulatory change for both banks and insurers has seen increased interest and investment by insurers in illiquid debt. This includes - but is not limited to -commercial real estate, infrastructure, social housing and education loans.
Favoured investments have, to date, tended to be longer-dated and investment grade quality senior loans, used primarily alongside corporate bonds and gilts to back fixed-rate UK annuity liabilities.
Insurer demand has been driven by three main factors: the illiquidity premium, favourable capital treatment versus corporate bonds, and the additional diversification as part of an overall portfolio investment strategy. As insurers develop additional experience and expertise, it seems likely that their use will be extended to other parts of their balance sheets. For example, shorter-term lending could act as an attractive equity substitute within with-profits funds.
We believe that the demand for illiquid lending will remain strong among insurers
in the coming years. Although new business volumes have been falling in the individual annuity market since the 2014 UK budget, the demand for additional yield to capture market share and to back other types of insurance liabilities, not least defined benefit bulk annuity deals, will remain significant.
In addition, insurers are beginning to gain clarity on the application of the Solvency II restrictions - in particular those relating to the need to have fixed cash flows in order to gain 'matching adjustment' treatment.
Practical solutions to the regulatory regime are now becoming established, from reconfiguring loan terms for new origination, through to structured overlays on existing loan portfolios, passing on pre-payment risk to other entities or parts of the balance sheet.
As a result, we expect continued significant demand for illiquid debt in 2015 and beyond.
Accessing the market
Once insurers have decided on the strategic merit of an allocation to illiquid lending, they need to consider the practical options for accessing the market.
Although bank back book assets do become available from time to time, for most this channel is unlikely to be practical. Banks will often be reluctant to accept the discount-to-par value that selling at current market pricing might imply. Secondly, the characteristics of historic loan books are often idiosyncratic, complex and varied, with a range of different pre-payment rules, credit quality, floating rather than fixed rates and covenant terms. These are often not in line with the preferred characteristics of insurers, making large-scale 'whole portfolio' purchases difficult. Instead, insurers are more likely to succeed in gaining exposure through new loan origination, according to terms which they know suit their needs. To date, most UK insurers have tended to focus on two, reasonably well-established models.
First, using third-party asset managers, which may be within the investment management division of another insurer. This has been the most common route for those insurers without the desire or scale needed to lend directly.
The third-party asset manager will take responsibility for sourcing, originating and subsequently administering and monitoring the debt, with differing degrees of discretion and need for sign off on individual loans from the insurance client's investment and risk committees.
Second, building their own origination teams and expertise. Larger insurers can lend directly and maintain these lending relationships on an ongoing basis. In some instances, the economics and costs associated with building an internal team have been supported through an effort to win third-party assets from other insurers and institutional clients.
Both models have been used successfully and it seems likely that they will continue to form the basis for many firms in accessing the market. Own origination requires the greatest investment into in-house expertise and is typically only possible for the very largest insurers. Using an asset manager provides the easiest access to these asset classes, but management fees will reduce the available illiquidity premium.
The most common challenge has probably been one of restricted deal flow, with a number of institutional investors being frustrated at the time taken to originate debt at a time when margins have been on a downward trajectory. Much of the delay has been associated with the market having to respond to a new environment in which banks have not been as willing to lend on their balance sheets. Borrowers have had to get comfortable with new sources of capital and lending relationships, and the insurers have had a steep learning curve in understanding what flexibilities and timescales are involved in signing off deals.
A third option?
A third route, yet to become fully established, is to enter into a preferred partnership with a commercial bank. In theory, this approach can offer mutual benefit to all parties.
? The insurer gains access to the bank's established network of historic borrower relationships, in addition to its practical experience in lending into these sectors over many years. The bank could also service the loans post-origination.
? The bank maintains its relationship with borrowers, using the insurer's capital for longer-term lending while providing its client with other, shorter-term banking services.
? The borrowers place value on having a single source of financing for their different short and longer-term needs, while maintaining their ongoing relationship with the bank.
Importantly, the bank does not act as the fiduciary with discretionary responsibility for managing the assets. The insurer will need to sign off or approve individual loan assets at the point of origination, as well as monitoring the credit quality of the assets over time.
Some internal resource and expertise will therefore be required to supervise the investment programme - as such, this model is likely to be most viable only for the larger insurers. Preferred partnerships will only work if both parties can identify and address concerns and conflicts of interest upfront.
Insurers have three typical concerns.
? Banks can be motivated by volume rather than price. This is a key concern in an area in which competitive or 'market' pricing can
be opaque.
? They may suffer from 'adverse selection', where the bank passes on or sources deals which are sub-optimal from the insurer's perspective, based on the bank's wider commercial interests.
? The bank might not remain fully committed to the sector over the long-term, which may prove troublesome if other servicing agents need to be found at a future date.
Banks, however, have different fears.
? The insurer's governance processes will unduly interfere with their ability to lend and ultimately damage borrower relationships.
? They need to protect competitively sensitive commercial information, such as the terms offered to borrowers from rival lenders and banks.
? They need confidence that the insurer will not disintermediate them in the future and that any partnership agreement does not cannibalise their other business such as bond origination or private placements and securitisation.
These legitimate concerns need to be managed and are best mitigated through upfront discussions. We can group potential solutions into four key areas.
1. Getting the right incentive structures in place. For example, it may be possible for banks to charge origination fees over the life of a loan, by taking a proportion of the loan margin, rather than charging upfront fees.
2. Offering appropriate levels of transparency. Defining carefully the parameters the insurer is looking for enables the bank to target lending opportunities that meet these requirements and reduces the risk of adverse selection. This must also be flexible enough to adapt to continually changing market conditions.
3. Sorting out the key operational procedures, from early stage loan evaluation through to eventual funding upfront. This reduces the potential for unintended delays and aborted loan negotiations with borrowers.
4. Having a back-up plan. For example, outsourced loan servicing companies are available, should the bank withdraw from providing this service.
New routes
The market for private debt is undergoing significant change as the providers of funding for vital longer-dated debt shift from the historic banking base, towards other institutional investors.
Many insurers remain at a relatively early stage of evaluating the different routes to market, although, for most, using a third-party asset manager will remain the most viable option.
However, larger insurers might want to consider entering into partnerships with banks in order to access their historic borrower networks and sector expertise. This will require a concerted effort to address and mitigate the different concerns and conflicts of interest upfront. The prize is improved access to deals and a scalable, repeatable process for different segments of the market.