Out with the old, in with the new...?

On 1 January 2016, we entered a new era in the long history of UK and European insurance companies with Solvency II (SII). What next? Can we leverage off the detailed understanding of our assets and liabilities and the good work of SII, and look forward to new ways to add value to our policyholders and shareholders? Can we turn SII into a benefit to recoup some of the expenses of SII implementation?

Illiquid investments are commonly perceived as a good fit for insurance companies. The term illiquid assets can mean different things to different investors or even departments within a company. Generally, it is a security that cannot be easily converted into cash and/or converted at a perceived fair market value by the security holders.

Increased capital costs and post-crisis funding costs have been the catalyst for change in the long-established funding model, whereby the end-investor funded bank balance sheets, which held the illiquid assets. The universe of illiquid assets is expanding for non-banking institutional investors as a result of disintermediation.

Life insurers and some property and casualty (P&C) insurers with long-tail liabilities have natural long-term funding for illiquid assets. They can match assets against liabilities and hold assets to maturity.
This is a distinct advantage over banks. But, it's easier said than done for insurers to replace bank lending to longer-term borrowers. What will work for any particular insurance company will depend on its objectives, risk appetite and ability to transact and manage.

What is the illiquidity premium?
The benefit for life insurers who can get illiquid assets to work is the ability to profit from the illiquidity premium. This premium is the additional return investors receive as compensation for lack of liquidity or ability to trade; and other risks, such as the absence of market pricing, increased asset complexity and underwriting requirements.
We would typically break down the expected returns from an illiquid asset into four components:

1. Risk free rate - the market-discounted cash rate and any term/inflation risk premia (to compensate for inflation and interest rate uncertainty).
2. Credit risk - expected losses from defaults/migration plus additional credit risk premium and any equity-like risk.
3. Alpha - for an actively managed strategy (often required for illiquid assets), additional returns may be expected through manager skill or 'alpha' generated through skilful origination, credit underwriting, careful pricing, covenant negations and post-trade monitoring.
4. Illiquidity risk premium - the residual premium to compensate for lack of liquidity. However, in using market prices to determine other risk premia, we may capture any mispricing of these risk premia as mispricing of the illiquidity risk premium. In practice, alpha may be hard to isolate as it may manifest in a lower expected default rate/higher expected credit or illiquidity risk premium.

In order to achieve enhanced returns, expertise is important, along with the ability to source the quantity and quality of the asset in the desired timeframe. Identifying what is really additional credit risk versus true illiquidity premium is of paramount importance. As with other asset classes, the timing and price of entry are also key.

Illiquidity risk premium cycles and trends
As with liquid assets, illiquid assets experience a valuation cycle. Figure 1 (below) shows how our Illiquidity Risk Premium Index (IRPI) has varied over time. It takes a simple average of a particular universe of assets at a particular point in time and plots this against the approximate fair value. The universe of assets is based on a non-exhaustive sample of assets from the less liquid (for example, corporate bonds) to illiquid (direct lending). It has evolved over time from US and UK investment grade corporates and real estate to include assets we regard as potentially attractive, such as US and Euro loans, hard currency emerging market debt, UK long lease and senior real estate debt, and US and Euro direct lending.

Key observations we take from Figure 1 are:

• There are cycles in illiquidity premium and illiquidity is at times poorly rewarded
• The fact that there are longer periods when our measure is below fair value (illiquidity is poorly rewarded) than above may imply:
• Investors' average required illiquidity risk premium is too high relative to what is available
• We have mis-estimated that average
• Investors did not appreciate that the illiquidity premium was too low
• The level of attractiveness appears to have reduced in recent years but still offers value.

What to consider for investment?
There are a number of considerations for insurers interested in capitalising on the illiquidity premium, including:

1.Investment horizon

Illiquid assets may call for a long-term strategic plan. There may be little flexibility to change asset selection based on best prevailing risk reward opportunities. It is therefore important to match the illiquid asset to your investment strategy, liabilities and time horizon and recognise that it may not be possible to exit the asset before its full term

2. Regulatory considerations

SII formally introduced a risk-based approach with flexible asset selection and allocation. Insurers can invest as they wish, provided they meet the claims of their policy holders, maintain solvency and liquidity, and adhere to the Prudent Person Principle.

Insurers may also need to consult with the regulator to demonstrate a clear ability and skillset to underwrite and manage illiquid assets over their lifecycle. There may also be additional considerations with the volatility adjustment or matching adjustment eligibility.

Regulation is still evolving, but the direction of travel appears to be favourable in relation to capital charges for some of the new illiquid universe, such as small and medium-sized enterprise (SME) loans and infrastructure.

3. Capital charges and modelling

Asset allocation to illiquid investments can provide diversification advantages as well as some immunity from market fluctuations.

The ability to negotiate bespoke terms to match assets and liabilities can also be asset liability management- and capital-efficient.

By simply adding a private placement with an appropriate illiquidity premium, it is possible to produce a better return than the equivalent public bond on a risk-adjusted return on capital basis.

To efficiently calculate capital and understand the investment risk, it is important to have the ability to look through to the underlying data and assets. If fund level data is used, it is necessary to understand the investment mandate to validate the capital calculation.

Common to all investments under SII are transparency, data, reporting, and pricing. Which illiquid opportunity is best for you will not only depend on the above mentioned factors, but also how the risk is modelled.

A further consideration is whether the illiquid asset matches the capital approach taken. For example, does a standard formula approach suitably capture the underlying risks of the illiquid asset or might it be necessary to consider a (partial) internal model?

The business case
If you can identify, measure, manage, monitor, control and report risks and have enough capital and liquidity, then there is a new universe of assets that could potentially add superior risk-adjusted returns to yield stretched portfolios. With SII, however, the risk and the data drives the capital charge, so the insurance investor needs to maintain a detailed and disciplined approach for new assets.

It is important to weigh up all of the investment benefits, not just lower capital charges, and remember that some illiquid investments are a hold to maturity - not just because you want to, but because you could be stuck with them owing to market climate or a lack of ready buyers.

There is clearly an obtainable source of illiquidity premium, and insurers are ideally placed to take advantage of the potential uplifts from these assets, given the strategic fit with their liabilities and time horizon. For insurers that have not yet sought to profit from illiquidity premium, is it prudent to consider it? It may just be imprudent not to.

Keith Goodby is head of the insurance investment solutions group at Willis Towers Watson and Mary Boyle is an independent consultant.