Our expert panel considers the strength of appetite for private-markets investment and hears the driver for it goes beyond solvency rule changes. ESG implementation and ETF usage are also discussed.
Phil Irvine (director, PiRho Investment Consulting)
Ajeet Manjrekar (managing director, solutions, River and Mercantile Solutions)
Ankit Shah (head of investments & treasury, QIC Global/Antares Underwriting)
Sean Thompson (managing director, CAMRADATA)
Ric van Weelden (Senior partner, Indefi)
Funds Europe – Insurers have shown in surveys that they are willing to take on more investment risk, particularly using private equity and private debt. With recent changes in the Solvency II rules, how much less restrictive is the regulatory environment for firms to make higher allocations to private market investments?
Ajeet Manjrekar, River & Mercantile – The broader evolution in regulation has introduced a bit more flexibility for insurers, though it’s not a game-changer and private market assets should be considered alongside public market assets, not as a distinct area.
It’s a question dependent on the nature of the insurer, the type of insurance they’re writing, where the capital is coming from and whether it’s corporate or privately backed, or even mutually backed. There is a range of different stakeholders and risk appetite is key.
From my vantage point in advising insurance companies on asset allocation, I’ve seen a polarisation between insurers, some who want to maintain a certain level of yield and are shifting into private markets to do that, but also those at the other extreme who are making very little money on underwriting and – considering the market environment today – don’t want to double up on their bets from an investment perspective.
We’re actually seeing some institutions effectively lock down on both sides: writing less business and investing more conservatively in the interim on the basis that until yields or underwriting become more attractive, they’d rather keep their powder dry.
Phil Irvine, PiRho – Insurers are positive for private markets but the overall framework is still pretty prudent. The reduction in capital charges could make insurance companies look again at private equity, where the capital charge has dropped from 49% to 22%, but I don’t think it’s going to change the entire nature of the way they invest.
Ric van Weelden, Indefi – Across Europe, Solvency II is not really creating a level playing field, partly because in some markets, insurers continue to follow their own rules. But what is important is the persistence of low yields, which forces insurance companies to take on more risk and look at new asset classes. This didn’t come about overnight, it has been creeping in. German insurance companies have a long tradition of investing in private placements (Schuldschein), but the adoption of private debt loans is more recent. In the eurozone’s southern markets, yields remained higher for longer and therefore the move into new asset classes came later. However, it is happening, and Solvency II does play a role. For example, alternative assets in Italian insurers’ portfolios have experienced a double-digit growth over the last five years.
Ankit Shah, QIC/Antares – Solvency II’s treatment of liquid public and illiquid private equity or debt was brought to par under Solvency II and it was a time when a lot of insurers started looking at the asset classes. There has been an indirect push by regulators for insurers to go to illiquid markets, especially general insurance companies whose liabilities have a much shorter duration and for whom private markets were not viable. This has probably allowed a lot of those companies to reduce some volatility in their P&Ls, especially equity volatility, and at the same time enhance overall yield on a medium to long-term horizon.
Reduced capital charges are favourable but it won’t mean a dramatic change. A lot of insurance companies want an overall mix of assets in their books, mostly driven by liquidity requirements.
Also, while private markets are an attractive asset class, they’re not as attractive as they were probably two years ago. The spreads have come down significantly across the PE space and obviously PE is far more expensive. Finding the right manager and the right assets is becoming a challenge.
Sean Thompson, CAMRADATA – My worry with the relaxation of Solvency II rules is that some insurers could jump in without really understanding the asset class. Whilst clearly there are a large number of insurers with CIOs who do know what it’s about, there are a number of insurers who don’t have that expertise and will therefore need to be reliant on consultants to help them. That said, I think the private market sector is still limited in terms of what insurers can invest in. Their preference is probably more for private debt and infrastructure debt, as opposed to private equity.
Van Weelden – There is some allocation of private equity but it’s limited. The asset class has a massive capacity issue. It is not the first port of call. Private debt is a more logical extension. It’s closer to fixed income as an asset class, which people understand better.
Manjrekar – Yes, and this highlights product development from an asset management perspective. Managers need to be able to provide investors with the ‘look-through’ and information so clients not only understand what they’re investing in, but equally are able to feed it into their broader risk modelling and risk calculations.
Separately, a lot of private equity money is being financed via the private debt market, so that shows why it’s important to understand the underlying risk a particular investment strategy is exposed to because what looks like private debt may in fact overlap with other parts of portfolio.
Van Weelden – Potentially private equity is M&A and M&A activity gets financed through the issuance of debt, so essentially that’s the private debt aspect of a private equity deal.
Funds Europe – Pension funds have been investing in private equity for over a decade. Insurers have a lot of experience to learn from here. Generally speaking, how has the pension fund experience been?
Manjrekar – Private equity has been an asset class available to pension schemes for many years but the size of allocations has been relatively low. Today one may see 20% allocated to private markets and that covers a spectrum of infrastructure, real estate, as well as private debt and private equity. Schemes in Europe have much larger pools of capital than in the UK, with much larger in-house resource, and they offer some lessons. There are governance limitations to actually being able to build a portfolio that is sufficiently meaningful, not just from a solvency-capital standpoint but from a return-generation standpoint. There’s very little point unless you’ve got a sufficient pool of assets because it may not warrant the governance or modelling effort.
Irvine – Pension schemes in the UK have to take investment advice. It’s not the same for insurance companies. I would say that the average insurance committee has a finance director with more specialist financial market knowledge than many pension trustee boards. In terms of how private markets have been implemented, schemes have sought some form of secure income or alternatives, and private equity is a small part of that.
The key lesson to learn is that fund managers have ways of presenting performance using internal rates of return that show outperformance. But any number connected with volatility or risk from an illiquid asset is, by definition, going to be flawed because they’re not marked on a daily or a weekly basis properly. It’s such an obvious point, but managers will show numbers that suggest a better Sharpe ratio or improved measures of risk, but this can be because numbers are not quoted properly. You must still do your own homework and not overly rely on others.
Manjrekar – If you were in private equity a decade ago, you probably would have made decent returns. Return expectations are not as attractive today. The level of capital chasing opportunities or being drawn down continues to mount in both private equity and debt. The opportunities aren’t quite as large nor attractive net of fees as they were.
Thompson – General insurers’ liabilities are much shorter than pension schemes’. They’re just worlds apart. This very much restricts general insurers from putting much of their money into private equity.
Funds Europe – What impact will this move have on government bond markets, given that government bonds have featured heavily in portfolios owing to the solvency rules?
Irvine – I have tried to find out who owns UK debt using Office of National Statistics and ABI numbers to try and work out how much the insurance sector owns. If the premise of the question is that insurance companies are sellers of government bonds, then how disruptive could this be?
Broadly, a quarter of the debt is in overseas hands and a quarter is held now by the Bank of England. So, of the 50% left, I estimate 20% may belong to the insurance industry. If at the margin they’re now selling government bonds, I think it’ll have some short-term impact but not a huge amount, because pension schemes are still ongoing buyers and they’re not particularly price-sensitive. However, if yields do rise on the back of this, pension schemes will probably want to unload their pension liabilities to insurance companies, who will then probably buy more government debt, creating demand. So overall, at the margin, selling could have an impact, but there are so many other big players and long-term strategic issues that I think it will be just noise.
Shah – I don’t think the proposed changes will have significant impact on allocation to government bonds by insurance companies as the liquidity requirements will always drive it, as well as the flight to safety in times of market volatility. The ‘lower for longer’ environment continues to come back again and again, where the market thinks that it’s ending but it doesn’t. I think that, rather than change their allocations, insurance companies have been more stable in terms of government bond holdings. Allocations have not changed significantly, not only due to solvency rules, but due to safety, liquidity and yield movement which insurers can capture from government bonds. I doubt that is going to change regardless of Solvency II treatment making other assets attractive.
Manjrekar – I’d absolutely agree with that in terms of the experience we’ve seen from our clients with their government bond allocations, because they’re there for liquidity, regulatory capital as well as liability matching. General insurance allocations have remained pretty stable.
What is interesting is what is happening in short-dated credit markets. Short-term credit isn’t paying very much at all and so private market assets are coming into play. Even some of the short-duration high yield areas of the market are giving investors a slightly bigger yield pick-up compared to conventional portfolios.
Some clients I work with have a core of government bonds and push for a little extra yield in the short-duration space. Investment grade pays very little on a risk-adjusted basis. So that’s probably an area where we’re likely to see some insurance companies move their capital.
Shah – Due to the spread compression, I expect the insurance industry will still hold government debt but replace part of their investment grade holding, or even high yield, with illiquids.
Van Weelden – Insurance companies will always be allocated to government bonds in larger proportions as they use it to control the duration gap. In other words, this is not, I think, a trend that will resemble what has happened in pension funds, where more money is going into other assets rather than government bonds. What could happen is a galvanisation of change in the business mix where insurers enter more deeply into the unit-linked space. This is growing in markets like Germany, France and Italy.
Thompson – In the European insurance space, do you tend to find that European insurers will be mainly investing in local government debt as opposed to global government debt?
Van Weelden – Post the 2011 euro sovereign crisis, we have clearly witnessed a ‘renationalisation’ of government bond investments, especially at large pan-European insurance companies. Having said that, we can expect more eurozone diversification, especially from southern European insurance companies.
Shah – From what I generally see, emerging market debt is quite attractive, not only from the perspective of yield enhancement, but also as a good diversifier. Liquidity is very important for insurance companies and these bonds are liquid enough because they have grown significantly in size. There is a vast amount of issuance in hard currency, so that takes away your currency risk, and they still offer attractive spread compared to the similar rated duration bonds in your home market.
Manjrekar – Many insurers I’ve seen who want to enhance their risk profile play down the credit spectrum rather than across it. Consequently, emerging markets haven’t been as popular as you might expect, mainly from a quality standpoint.
Thompson – Do you perceive that emerging market allocations have sometimes been restricted because insurers – thinking about where they underwrite their insurance business – don’t want to have too much concentration of risk, or too many eggs in one basket?
Shah – Yes and no. Emerging markets are still underinsured. Allocating more money to developed markets, which are fully insured, actually would duplicate risk. That’s why, probably, not only from the portfolio perspective but from an overall risk perspective for an insurance company, I think emerging markets are good diversifiers.
Manjrekar – This has increasingly become a subject for discussion at risk committees who are considering their business footprint and their underwriting risk. Most insurer governance structures consist of three pillars – the chief investment officer/finance officer for investments, chief risk officer from a capital perspective, and chief underwriter – and those three typically only meet at the top as opposed to thinking about the business more holistically. For a lot of insurers, given compression in terms of underwriting profits and constraints from a higher capital requirement, they are facing big challenges.
Shah – I completely agree in the sense that this is something I have been doing actively within our insurance companies over the last two to three years, not taking these investment decisions in isolation, but trying to see how we are duplicating risk and to see if investment decisions have some sort of underwriting implication, or vice versa.
Funds Europe – How can insurers integrate sustainability principles (ESG) when considering their wide roles as risk managers, insurers and investors? How important would it be for firms to collaborate and create standardisation in this field?
Shah – The ESG debate has been more associated with investments and less on underwriting. They should go hand in hand. Insurers lack checks to see if what they are underwriting is ESG-compliant, although Lloyd’s of London is promoting ESG in the wider underwriting world.
The other challenge is the global acceptance of an overall ESG framework. ESG is more prevalent in Europe compared to elsewhere.
Van Weelden – Essentially, there’s no way back from it now, but where insurance companies are on this topic differs between jurisdictions across Europe. It can be regulatory-driven, or potentially it’s a question of culture. For instance, the regulatory driver is stronger in France, but in the Nordics and the Netherlands, it is the market itself demanding this. In either case, the Nordics, the Netherlands and France are ahead of the curve in Europe.
The more sophisticated insurance companies and institutional asset owners look at ESG as a major long-term risk issue over 20-30 years. However, the way people go about doing it is very different. Some people screen portfolios, some people carry out engagement, some do integration, and some do a combination of each.
Manjrekar – Risk is absolutely the key factor and recognition of this goes back to the topic of holistic balance sheets. The question is, “What’s going to blow you off course? What’s going to put you into a position where your capital gets constrained and you can’t write as much business?” ESG risks are fundamental to that.
However, I would caution against standardisation, because we would get different answers about what an ESG risk represents depending on each entity’s beliefs and risk appetite.
Thompson – It is a difficult topic for the insurance industry. They would have to factor in ESG requirements when deciding who to underwrite. This can be very different to their investment balance sheet and possibly even be a conflict with it. I think the insurance market is a little way off from solving that.
The difficulty on the investment side is that the majority of portfolios are fixed income, meaning insurers don’t have a place at the table in shareholder meetings. The asset management industry as a whole needs to work together on how they can exert influence in the fixed income world, get messages across to those companies whose debt they are investing in.
Some insurers will be happy to use an asset manager that has ticked the UNPRI. But really, they should do proper due diligence on the asset manager to fully understand what their ESG principles are and how they implement them.
Manjrekar – An underwriter is a specialist in terms of understanding risk and pricing it. While there might not be evidence of how ESG risks are incorporated in this, at least some of the discussions I have had with insurers suggest that although they don’t talk about it, when they’re pricing risk, they are taking on board ESG. They just don’t disclose it in the way that gets them recognition. On the investment side, there is a lot that needs doing and a lot can be done today. I’ve seen cases where we have footprinted clients’ credit portfolios. A lot of the clients that I work with are buy and hold for much of their core credit assets, so ESG becomes massively relevant to them because they are exposed to downgrades or forced selling.
Irvine – A quoted insurer should be engaging with shareholders because those are the questions that will be asked.
In the UK, ESG pressures and changes on pension schemes will percolate directly through to insurers. In June 2018, the Department for Work and Pensions forced all pension schemes to put into their Statement of Investment Principles how they think about ESG. The exact wording was, “how they take account of financially material considerations including but not limited to those arising from environmental, social and governance considerations, including climate change”.
Every pension meeting I go to at the moment has an ESG section because trustees have to have these updated statements in place by October this year.
Possibly all investors, whether they’re investing directly in equity or through debt – even though debt doesn’t have voting rights – will need to have ESG policies. All sorts of stakeholders will be asking those people, “If you’re stewarding other people’s money, how are you managing this money for our future?”
Thompson – The UK pension scheme NEST has just announced they are no longer going to invest in tobacco. This is not an unusual announcement from the pensions world and the insurance market has got to start noticing what is happening around them. However, the game of catch-up could be quick.
Funds Europe – Do ETFs have a role in insurance asset management and has the sector been an enthusiastic adopter of these funds?
Irvine – There have been many investors, including insurance companies, saying, “Why on earth are we paying for active management fees?” My experience of insurance clients is that they are particularly fee-sensitive and need to be doubly sure of the value of active management. Active has certainly cost an awful lot more than beta products, whether that’s expressed through ETFs or other passive investment. I think that’s a general trend for all sorts of relatively straightforward asset classes.
Thompson – However, you can’t take away from the fact there is a large group of active asset managers who have outperformed in asset classes they are good at. What has watered the average return down is the fact that there is also a large number of active managers who have underperformed.
I think it’s important to make sure you do the right amount of due diligence, look at an asset managers’ capabilities, at what they do and how they do it. This is because there is a large amount of active managers who are able to outperform in certain asset classes.
Of course, some asset classes you could argue should be passively managed if you think there’s not much more value that active management can add.
Irvine – I agree that active managers can add value and investors have got to give the asset manager flexibility. Large-cap US equities is a relatively tough market and I would argue you should save your fee budget up and spend it where you think you’ll make the biggest return.
Manjrekar – Again, it’s a case of looking at the different types of insurers out there in terms of risk appetite and their time horizon. Potentially for some life assurers, such as with-profit institutions, they have an allocation to risk-on assets and you see more of them use passive-type components there.
I think the other aspect, though, is many insurers don’t have a large quantum of assets that they are putting into risk assets – that is, not outside of their core fixed income allocations. But where they are allocating to risk assets, although it’s in small amounts, more often than not I see them going more active than passive.
For fixed income, being able to track an index net of all costs is very, very hard to do. We’re seeing a lot more smarter solutions that try to capture the spread that the index claims to deliver in a net-of -cost way. Passive in fixed income doesn’t work at the end of the day, net of all costs.
It does vary depending on where your insurer is, what their timeframe is, but certainly the duration of your underlying liability profile often dictates where you’re looking to use passive or active.
Shah – I’m sure there is always space for active managers because there are some good ones. If you spend enough time in due diligence of those managers and then stick to them, you’ll get alpha. However, there could be certain tactical allocations where ETFs definitely have a role. They’re never going to outperform, but could there be a significant fee benefit? Maybe a little bit, at times. But I think it’s just purely from the directional perspective where they may help.
You’ll find ETFs offering access to senior loans, some private credit, even CLOs. Let’s say if you want to just allocate 1%-2% of my assets to that. Is it worth the due diligence on five managers, or should I go into an ETF?
Thompson – In the UK, I don’t think insurers generally invest in ETFs. What about in Europe?
Van Weelden – No, in general they don’t massively buy ETFs. There’s a little bit for cashflow management and tactical positions. However, it depends. Some large insurance companies, which directly manage their money, or insurance companies’ affiliated asset managers, will use passive solutions.
Thompson – Is it because insurers have concerns about liquidity in bond ETFs?
Manjrekar – It’s more about set-up. An ETF is effectively a share, so you have to have a custodian, you have to have somebody to go and buy it for you. If I want a passive fund, I can just go and invest in a passive fund, just like that, by subscribing to units in the vehicle.
With the ETF, it’s just like buying BP – you have shares in an ETF, effectively, so you have to have somewhere to warehouse the shares. Pension scheme trustees can’t buy an ETF directly; they have to have a manager buy the ETF on their behalf and then hold it in a custodian, which is why you don’t see the take-up to the same extent. Some ETF houses have got an asset management sleeve with them, so they’ll buy the ETF on your behalf on a non-discretionary basis, but again, for the large part that limits the take-up unless you can buy it in-house.
Shah – For the reasons you have just said, we have not increased our allocation to ETFs. There isn’t the right set-up, you need a custody account, sometimes a brokerage set-up, and so on. In the insurance market, there is probably low awareness of the ETF offering. I don’t think ETF managers have made much noise about them in the past, whether talking to consultants or to insurers.
Funds Europe – Insurers feel they’ve missed the boat for alternative investments – a set of asset classes that highly appeals to them. What do you say to that?
Irvine – The flotilla has been missed and every boat has sailed!
We’re now in the late cycle from the low points of ten years ago and nothing looks cheap on an absolute basis. No doubt someone will find some exception to that, but basically, with the way bond yields have been driven down by governments and asset prices for the most part have been revalued, if you’re an absolute value investor, then there’s nothing out there that’s easy to buy.
So, in this type of environment it now becomes about looking forward: how quickly is it going to unwind and how do you manage the risks involved? The boat at the back of the flotilla may look relatively good value, but it’s still moved on quite a long way from where it was some ten years ago.
Manjrekar – Easy money is long gone in many respects. There are still opportunities out there, but it places the importance on doing the legwork and the due diligence. At the end of the day, there is one key fact: people need to modify their expectations around what net-of-cost they’re actually going to get.
The IRR [internal rate of return] point in private equity is a classic example. For any illiquid asset, you look at an IRR based on a vintage from five years ago. It looks great, but is that repeatable today against the wall of capital already in the queue from last year’s fundraise? No chance. But with the right level of due diligence, we continue to see talented managers in this space who are often a bit smaller by nature but, again, subject to us passing investment-operations due diligence, will give you a consistent, sustainable return.
Shah – ‘Missed the boat’ is a quite relative term. We can say the same thing for equities. I’d be regretting it if I hadn’t been in equities seven or eight years ago, certainly ten years ago because the returns could have been far, far better than any other asset class. I think the same applies to both private credit and private equity.
All asset classes have done similar and halved their spreads. So, in relative terms, if you are being compensated and it fits in with your overall strategy, then there is always some room for those assets, and then the ’missed the boat’ feeling slightly goes away.
In private credit, you may not have as high an IRR as in the past, but even in today’s market it is possible to find managers who can generate IRRs in the mid-teens. There are quite a few out there. One of the main reasons for that is because the world has been constantly moving and a private equity manager’s job is to get into more emerging companies, emerging technologies and emerging geographies. That’s where you still have scope to make higher returns. Asia, tech, AI, biotech and blockchain were not core private equity allocations five years ago and finding the right manager could still give you decent returns in private equity.
Van Weelden – This reminds me of a discussion I had in 2001 after I had just moved from New York. When I told someone I had bought a London property, she said I was insane because the market was at an all-time high. The answer to your question can only be given in about 20 years. You will then know that we were at the very low point in the yield cycle and the yield has picked up.
Thompson – If insurers took the view that everything was expensive, they would not invest in anything!
If you are going into the alternatives space you know it is a long-term strategic view and, once studied in detail and compared with traditional investments in a portfolio, it may be concluded that an allocation to alternatives will add value. You’re not changing your view of risk and so if your risk appetite means that you are prepared to allocate a certain amount of money into the alternatives space, you do your due diligence and then you allocate, just as you would if you were about to go into high yield or emerging market debt.
Funds Europe – Which assets, geographies, style or investment themes are insurers likely to feel most positive for, and most wary of, in the next two to three years?
Manjrekar – It’s difficult because we don’t know how long the lower-yield, lower-returning environment will persist, so the question goes back to the understanding of an asset class and also what assets may be worth if you need to liquidate.
Another point is that for many insurers, domestic bias continues to be a theme that you will see again just from a liability-matching perspective, but the things I would highlight, more in terms of being wary around, are liquidity needs, currency risk and political uncertainty.
There are assets, particularly in the alternatives space, that are attractive for a number of characteristics, but should that asset then get nationalised, it’s not going to be worth what you thought it was contractually for the next 20 years.
There are political risks, whether it’s ports or utilities. We are seeing some of the infrastructure or private equity-owned utility companies come under scrutiny on the level of dividend payments they’re paying out. Political change may well move the goalposts.
Similarly, CVAs – company voluntary arrangements, which can be used by companies to avoid going into administration – allow them to reduce the level of rents they pay. Arcadia did this. So, if you’ve bought a property on a leaseback arrangement that gives you a secure income for the next 20 years, then the primary tenant decides to go through with a CVA, it is effectively a financial adjustment to the balance sheet. The income is not as certain as you thought.
Irvine – No one’s been very good at getting duration right over the last ten years. Long deals look too low and, on historic measures, I think the industry will be taking relatively smaller bets on duration in their core holdings.
Some sort of barbell seems sensible. There is no point just incrementally moving along the spectrum of longer duration and slightly higher credit risk if you are not really getting paid for it. Once the portfolio has the core liquid element established in line with liabilities, then you can think carefully about taking additional risk.
What I would avoid are the siren calls of certain leveraged high-alpha strategies that look completely decorrelated, and I can show you an efficient frontier that appears to improve dramatically with non-directional hedge funds. I’m not saying skilful people don’t exist out there, but to be honest, their persistence is very low and the likelihood of picking those people beforehand as opposed to afterwards is even lower.
I think some sort of diversified credit strategies probably make sense. If you allow managers who can see different parts of the riskier portions of the debt market and allocate to them probably quicker than most insurance companies can, to me that makes sense.
Thompson – I do believe we’ll see an increase in allocations to non-traditional asset classes. I think the market as a whole has a lot more understanding of the various asset classes in this space and boards are now becoming a little bit more knowledgeable of the asset classes that are available.
And ESG is going to play a much bigger part in how insurers allocate their monies.
Van Weelden – I think we all agree that the investment landscape is very tricky. I think short-term, the consequence will be a trend towards private assets. Alternative assets will continue, with the exception of perhaps hedge funds.
The trickiness will probably lead to more insurers looking at their business and essentially doing what many pension funds have done: move the risk from the corporate to the investor, to the client. In other words, there will be a continuing move into unit-linked investment.
Shah – ESG will be a major theme with the growing awareness from the regulatory and shareholder perspective.
However, the other challenge is from thin margins, meaning investment is becoming a core function that puts more onus on investment teams to achieve profitability for insurance companies. This has implications for their traditionally conservative investments and may lead to more risk appetite. I think they will continue to be more and more active in terms of their investment, looking into wider asset classes in both the liquid and illiquid space.
There could be a push for insurance companies to come out of their home markets, perhaps looking at high yield and emerging market debt. I think we’re going to see in the next two to three years more and more shift towards that and we will see that insurance companies’ investment book becoming a lot more diversified than we see today.
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