Ahead of a sessional paper release early next year on the potential risks and gains of non-traditional assets, Gareth Mee and Gareth Jones give an update from the IFoA working party to address these questions
The choice of assets used by life insurers to back their liabilities is a key driver of firms' profitability, capability to price new business attractively and financial strength. Historically, relatively 'vanilla' investment strategies proved sufficient for success, however insurers now increasingly need to broaden their horizons in order to maintain their ability to price business attractively, and maintain returns to shareholders.
In the past few years - partly driven by regulation - traditional bank lenders have become increasingly reluctant to tie up liquidity by lending for long durations. This reduced supply of long-dated credit has tended to increase the returns available in the market on some asset classes, with which insurers may hitherto have had little involvement. Insurers are typically subject to less pressure on liquidity than banks, which may allow them to fill the void in the long-term debt market, taking advantage of attractive pricing.
As more insurers adopt such strategies, the pressure on others increases to match levels of profitability or competitive pricing of products, such as annuities. While the opportunity to generate further yield is clear, the risks of managing some non-traditional assets are not trivial, and need to be carefully considered as part of the investment appraisal process.
A working party on 'non-traditional assets' was set up in late 2013 to research both the opportunities and the potential risks.The working party aims to release a sessional paper
in early 2015, a taste of which is provided here.
The working party has considered the universe of potentially interesting assets to UK insurers, and has attempted to identify common features, where possible, to group similar investments. The sub-groups considered are set out in Table 1 (below) with examples of specific assets within them.
While there are many potential reasons for insurers wishing to invest in non-traditional assets, including increased diversification or increased security/collateral, the opportunity for potential return is a key factor.
Some sample returns for the broad asset categories listed, which demonstrate the potential attraction for insurers in exploring the opportunities further, are illustrated in Figure 1
Specific considerations for creating cashflow certainty
There are a number of options available to insurers wishing to transform investments in order to make them more favourable in some way. An obvious consideration is eligibility for the matching adjustment, which is likely to be a key focus for annuity writers. Some may have options within the group, whereas smaller stand-alone insurers will have to rely on third parties.
In considering such options, an insurer needs to think about the following factors.
? The impact on the annuity insurer.
? The impact on the insurance group - for example, does the solution still help when the annuity insurer is consolidated into the group?
? The impact on the counterparty - is the counterparty a suitable holder of the risks, and what will be its capital treatment?
There are a number of potential structures currently being looked at in the industry. Many rely on transferring the assets to an SPV that issues a blend of equity and debt, the latter of which is intended to be matching adjustment eligible. The split between them is balanced to maximise the value in the debt while retaining a sufficient credit quality.
Alternatively, some have looked at leaving the assets on the balance sheet with an overlay derivative or reinsurance to provide greater certainty of cashflow.
While there is potential in such solutions, final interpretation of the regulations has not been confirmed at the time of writing and great care needs to be taken. In addition to all this, emergent risks can be hard to predict on long-term business - property-backed lending in Scotland could possibly end up being secured by an overseas asset, despite it being domestic when the contracts were first written.
Flooding in one part of the country could affect assets disproportionately if proper geographic diversification wasn't in place, which can be a challenge for large-scale infrastructure projects.There can be significant value released by investing in non-traditional illiquid assets, but the care and management needed should not be overlooked.
We hope this article, presentations at recent and forthcoming conferences, and the upcoming sessional paper on this topic will go some way to shedding light on both the opportunities and challenges involved.
The views expressed in this article are the views of the members of the working party, and not of their employers
Gareth Mee chairs the IFoA non-traditional assets working party, and is a director at EY
Gareth Jones is a member of the working party, and a senior actuarial manager at MGM Advantage