Tighter spreads prompt insurers to rethink liquidity premium

Firms struggling to know whether returns justify buying illiquid assets

Extracting value from illiquid assets is getting harder

The ability to invest over the long term should be a clear source of value for insurers. Their annuity books and other long-term liabilities allow them to consider assets that are less attractive to most other investors because of their illiquidity, and for which insurers would naturally expect a premium. Furthermore, in the UK in particular, firms can benefit directly from a buy-and-maintain strategy through the Solvency II matching adjustment. At the same time, banks, which previously dominated the illiquid asset markets, are being pushed out by regulatory capital requirements.

But firms are reporting mixed experiences when trying to extract value from investing long term. Many are finding spreads lower than they had expected. Investing in illiquid assets is taking longer than insurers are used to with traditional corporate bonds. And where assets must be restructured, particularly to meet the strict eligibility conditions of the matching adjustment, liquidity and efficiency issues can significantly reduce the expected premium. Asset origination appears the most effective solution, but requires significant commitment of resources. Whatever the approach, new expertise and sometimes a change of business model is required.

At the heart of the issue is the fact that spreads on illiquid assets have tightened significantly compared with two or three years ago. For example, spreads on loans for social housing that were 150–300 basis points over government bonds in 2012 are now more likely to be at the bottom of that range. Other property and infrastructure asset spreads have shown a similar tightening. Some insurers have been caught out as a result, particularly by how quickly spreads have come in over the past year. Then there is the question – for UK insurers in particular – of how compliant the assets are with the eligibility criteria of the Solvency II matching adjustment – primarily in terms of being fixed in timing and amount and certainty over the full term, or with compensation clauses if the term is not completed.

Ideally, insurers want assets that offer both full matching adjustment eligibility and wide spreads. Assets such as long-dated, fixed rate commercial real estate or infrastructure loans often meet the matching adjustment criteria, but if available on the open market, demand can drive spreads down beyond the point where they still represent value. One solution is to seek more esoteric assets with the right features that retain an attractive spread. To assist with this, the UK Institute and Faculty of Actuaries (IFoA) established a working party on non-traditional assets and has identified a range of possibilities, including ground rent, student housing loans and aircraft and other transport financing. Another approach is to source assets with the required spread that might not exactly meet the matching adjustment criteria and put measures in place to achieve compliance.

"Existing assets available on the secondary market, often from banks, typically have features which make them ineligible for the matching adjustment, so insurers need to restructure them by, for example, putting in place derivatives," says Gareth Mee, an executive director of the insurance practice at EY in London who also chairs the IFoA working party on non-traditional assets. For example, banks often arrange loans with floating interest rates, which would require insurers to put in place swaps to achieve the fixed cashflows required by the matching adjustment. But such restructuring with derivatives leads to a whole new set of problems.

Companies have been having difficulties recently in extracting the value of illiquid investments because of the spread compression

With the move to central clearing, swaps counterparties are obliged to hold collateral in liquid assets. "Under the current regime, many insurers assume they have recourse to other parts of their group should they need to get hold of liquid assets, whereas under the matching adjustment there is more restriction as to what you can move in and out of the portfolio," says Andrew Kenyon, actuary in the insurance solutions team at Royal Bank of Scotland (RBS).

In a letter to the industry in June, the UK's Prudential Regulation Authority made it clear that any collateral required to support assets in the matching adjustment book must be held separately and not made available to any other part of the business. So, paradoxically, moving to illiquids can force insurers to hold more liquid assets to meet day-to-day cash outflows and collateral calls, bringing with it challenges in terms of pricing and managing liquidity that are new to many insurers. One such challenge is around repo.

Repo difficulties

"Central clearing may require some variation margin in cash, which means if you are holding your liquid assets in gilts you would need access to the repo market. But what if it is expensive or you can't access it?" says Mee.

New Basel III regulations require banks to include repo in their leverage ratio calculations, but do not allow them to offset high-quality assets they may hold as collateral for repo. "We have run some calculations looking at the impact of the current Basel III leverage ratio on repo and swap pricing, and it looks most significant on repo pricing," says Simon Freedman, director in the pensions solutions team at RBS.

"Assuming that banks will want to run some buffer over and above the Basel III 3% leverage ratio minimum, the result can be a 50–100bp cost for the repo, depending on return on equity targets and cost/income assumptions – not something the market is pricing in at present." There is also still considerable uncertainty around this pricing, because banks are lobbying hard to be allowed to offset high-quality collateral, and central counterparties such as LCH.Clearnet are looking at the possibility of buy-side repo clearing.

For the moment, say observers, insurers appear to be ignoring any potential increase in repo pricing – and, furthermore, assume that the repo market will always be accessible. That assumption is a concern for the PRA. It wants insurers to consider what would happen under adverse scenarios if they were holding collateral and the repo market closed for a period. So far, there has been no significant movement by insurers away from gilts to holding cash for liquidity purposes, says Mee, and "this suggests that although the PRA is asking questions [about collateral and repo], it is not pushing companies to do more than they are already doing."

Issues around repo and liquidity management are an inevitable consequence of using derivatives to try to force-fit asset types that are not inherently compliant into matching adjustment portfolios, say many in the industry. The inefficiencies and operational costs coupled with the tighter spreads can drag margins down to the point where they undermine the very purpose of using illiquids. "The point and spirit of the matching adjustment is to allow insurers to recognise the illiquidity premium in the Solvency II balance sheet by building a plain vanilla asset portfolio of illiquid assets that cashflow matches liabilities and is invested on a buy-and-maintain basis," says Bruce Porteous, investment solutions director at Standard Life Investments. The most effective – and some say the only – way to do this and achieve a worthwhile illiquidity premium is to originate.

"Whilst spreads have definitely come in, we are able to source good quality and low-risk assets that are still capable of earning around 200bp in excess of the relevant risk-free benchmark," says Porteous. Among the assets that Standard Life Investments has originated are a 10-year fixed rate loan to a hotel group, which is AA-rated and has a loan to value of less than 55%, that is yielding 225bp in excess of gilts, and a 10-year fixed rate loan to an office developer, which is AA-rated and has a loan to value of less than 50%, that is yielding 260bp in excess of gilts.

New skills

But originating illiquid assets is a change of business model for many firms, and even for those with some experience in the area, it can entail acquiring new skills and expertise. Legal & General Investment Management (LGIM) has been building an infrastructure capability to match its long-established property business and has recently brought the two disciplines together in a 'real assets' division with Bill Hughes as managing director.

To successfully extract value from the illiquidity premium, says Hughes, requires detailed understanding not only of the underlying assets, such as commercial real estate or infrastructure loans, but also of asset structuring, as well as what the insurer is trying to achieve with its capital and how this is affected by regulation. "All areas require deep knowledge and expertise and must be fully integrated. But if you have the skillset and are not bidding in the open market for competitive opportunities, then you can control your own destiny and achieve worthwhile rewards," says Hughes.

Having the knowledge and expertise enables a firm to find appropriate counterparties that are willing to discuss the tailoring of contracts that will achieve the insurer's aims. With a real estate lease, for example, this could include agreeing a longer time frame, or annual rather than five-yearly indexation, or agreement on caps and collars around inflation matching. "The actual detail of how a lease is constructed can be of significant importance to an annuity-type investor, but is often not necessarily so critical to the occupier," says Hughes.

Belgium-based Ageas, which has been investing in real estate and infrastructure for three years, takes a slightly different approach. In addition to its in-house expertise, the firm partners with banks on deals. "We like to work with banks where we are co-investing and where we share the risk," says Wim Vermeir, Brussels-based chief investment officer at Ageas. The firm has also developed specific processes and governance for its illiquid asset investing, with more checks and balances compared with bond investing. Vermeir uses a food analogy, where investing in bonds is like shopping at a supermarket compared with illiquid assets, which is more like foraging. "With things like infrastructure and real estate, you first have to find the target investment, then analyse it, then structure the deal and finally win the contract," he says.

john-whitworthJohn Whitworth (pictured), UK insurance partner at Oliver Wyman in London, points out that this foraging-type process takes time – especially compared with traditional bond investing. "Companies became used to investing hundreds of millions of pounds easily and quickly in the market through listed instruments. Now, if they move to commercial mortgages, it could take a year to invest £500 million, even with the right type of products," says Whitworth. This is borne out by Ageas, where the firm invested around €1.2 billion ($1.35 billion) in infrastructure and real estate loans over three years. It was also able to invest roughly a further €1.8 billion in corporate loan funds and government guaranteed loans, particularly those linked to social housing, over the same period. While Ageas is satisfied with this rate of investment, Whitworth says the extended investment period is yet one more adjustment that insurers must make when contemplating illiquid assets.

Like LGIM, Ageas does not go in for finding only partly suitable assets and force-fitting them to their liabilities with derivatives. "We don't use derivatives to meet the matching adjustment criteria – that must come from the lending itself. If you start to do swaps and repo, you need collateral. Then you can end up with a very illiquid asset, because not only is it illiquid by nature, which is not a problem if the liability that it is covering is also illiquid, but if you add derivatives and they go in a negative direction, you have to post collateral, so you are losing liquidity twice, which is not something we want to do," says Vermeir.

Big firms like Ageas have an advantage when contemplating illiquid investments because of the size and diversity of their liability books. An infrastructure project may have a particular set of requirements that many firms could only participate in by using derivatives. "Given the size of our books, we can usually find liabilities that match the particular requirements of an infrastructure contract," says Vermeir.

While insurers may be struggling with the issues around the illiquidity premium, the banks see opportunities, says EY's Mee. "There is a huge amount of innovation taking place in the banking sector to help with some of the structures. For example, equity release mortgages are one of the most sought-after assets by insurers, but they have some of the most problematic features. There are at least 10 banks now offering insurers help in structuring their equity release mortgages."

Whitworth sees the origination activities of the likes of Standard Life Investments, LGIM and Ageas as just the start of a trend. Meanwhile, spreads may turn around, which could ease the liquidity issues of restructuring of assets with derivatives. "Companies have been having difficulties recently in extracting the value of illiquid investments because of the spread compression. But spread compression is also related to the fall in interest rates and the generally high level of global liquidity as a result of government quantitative easing. Who knows what will happen when some of the liquidity begins to be withdrawn? Interest rates will clearly go up, but so potentially could spreads because there will be less money chasing those returns. So it is not a permanent problem. Investment in illiquid assets will carry on regardless of the compression in spreads," he says.

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