Illiquid assets have the potential to boost the yield and diversification of insurers' investments, but they are not a shoo-in to the portfolio, as discussed in part one of this InsuranceERM/Insurance Asset Risk and Standard Life Investments roundtable
Participants
Miriam Arntz, Senior manager, ALM and capital management, Old Mutual Group
Meirion Board, Head of market and credit risk, Aspen
Atanas Christev, Head of investments, Direct Line Group
Hugo Coelho, Assistant editor, InsuranceERM
Gareth Collard, Director, investment management, Just Retirement
Iain Forrester, Investment director, insurance solutions, Standard Life Investments
Vicky Kubitscheck, Chief risk officer and compliance director, Police Mutual
Bruce Porteous, Director, investment solutions, Standard Life Investments
Chaired by Christopher Cundy, contributing editor, InsuranceERM
MEASURING ILLIQUIDITY
Chris Cundy: What kind of tools and techniques do you use to measure liquidity?
Gareth Collard: It is a bit like quantum physics – we need to stop things to measure them. You can only attempt quantify illiquidity in markets that are reasonably liquid. There are indicators that you can use, such as credit default swaps and things like that. But there is no scientific way to tell the risk premium from the illiquidity premium.
Vicky Kubitscheck: One should also take into account that the illiquidity premium will change according to market conditions.
Chris Cundy: There is currently a lack of liquidity in bond markets, which is in part driven by regulatory changes that constrain banks.
Gareth Collard: Indeed, the regulations that created an opportunity for us in terms of disintermediation also made some markets, which we used to see as highly liquid, less liquid than before. It is worth distinguishing between liquidity and ease of transaction. In some cases there may be a secondary market for a lot of these more obscure assets, but there are obstacles to trade them.
Miriam Arntz: I would also distinguish between assets that are illiquid in stressed market conditions and assets that are illiquid irrespective of market conditions. I am thinking of timber funds, which are illiquid irrespective of market conditions. I am wondering whether there is a difference in the liquidity of an underlying asset or the liquidity of a fund. Currently there appears to be material demand for infrastructure. It may be more economical to sell the fund, rather than liquidate the asset.
REGULATOR'S VIEW
What are illiquid assets?
Infrastructure is the asset class that immediately comes to mind when we talk of illiquid assets, but participants said the universe also includes property, investments in businesses, equity-release mortgages and some exotic assets, such as farms and timber plantations. The asset can be in the form of debt or equity and more often than not it is unlisted.
Because they are harder to liquidate, these investments typically yield higher returns that investments in liquid assets with a similar level of credit risk. Insurers tend to use illiquid assets to back long-term annuity-like liabilities. However, in the current low yield environment, illiquid assets also find a place in portfolios backing shorter-term liabilities and shareholder funds.
Chris Cundy: What is the regulator's take on liquidity? What are they requesting of firms in the internal model process?
Bruce Porteous: I think the PRA [Prudential Regulation Authority] may still believe in the 50% rule: in other words, half of the spread is due to illiquidity.
Gareth Collard: I have seen studies that back that, but there is huge subjectivity in them. As a general rule, I would use something pragmatic, something that fits in with the portfolio, rather than something scientific.
Vicky Kubitscheck: For those illiquid assets which are particularly hard to value, our approach is to get a range of the potential value of that illiquidity premium and use the lower quartile of that range. The regulators are keen to understand about the level of prudence being applied. As a general observation, I wonder if there is either a lag in regulator's perception of the illiquid assets market or they are required to be prudent at this stage.
Miriam Arntz: I suspect the PRA's main concern is to ensure prudence in the UK.
CREDIT RISK
Chris Cundy: How do you approach the issue of credit risk?
Atanas Christev: We rely on the portfolio managers' internal ratings for our infrastructure loans and the private placement investments. We went to great lengths to ensure the methodology used by the portfolio managers is aligned closely to the rating agencies' and, in the case of private placements, that bonds always have a NAIC [National Association of Insurance
Commissioners in the US] rating too.
Miriam Arntz: Availability of historic data is a material concern likely resulting for many UK insurers from a lack of long-term track record and unavailability of public data. For those who have a track record, prudent selection is significant, especially in an environment where demand exceeds the eligible asset universe.
Gareth Collard: We have delayed further investment in one of these asset classes for lack of clarity about the calibrations in our internal model and the ratings methodology – we need a response from the regulator. Hopefully, the uncertainty will end on 1 January and we can move ahead.
ASSET ALLOCATION
Chris Cundy: How do you factor all these considerations into your asset allocation strategy? Isn't it too much asking for liquidity and a liquidity premium?
Vicky Kubitscheck: Perhaps it is, but it does not stop us – nor the regulators – from seeking it. We like illiquid assets as they tend to provide higher returns, but we cannot simply lock our capital say for 10 or more years as we also need to comply with our liability settlement requirements. We must strike a balance, rather than choosing one over the other.
Iain Forrester: If you have annuity business, you can be comfortable using illiquid assets against those quite predictable cash flows. But if you have liquid liabilities with an expected maturity profile, how do you assess how much of your portfolio you can afford to tie up in illiquid assets and for how long?
Atanas Christev: We would not be able to add illiquid assets to the portfolio without having first ensured that we have sufficient liquidity to meet our liabilities under stressed scenarios. There is an amount of liquidity determined by our internal capital model, which we hold regardless of the portion of illiquid investments we may have. Our aim is to seek higher returns within the risk allowance determined by the capital model.
This brings me to another question. Our long-term liabilities, which account for only 10% of the overall, arise from periodic payment orders (PPOs) – claims of injured drivers that need long-term care. These are indexed against a specific wage inflation index, the Annual Survey of Hours and Earnings, which is difficult to match. We found that we would be better aiming for real returns, investing in floating rate assets or in property, than in long-dated fixed-income. This is another reason for us to invest in this asset class.
DIVERSIFICATION
Chris Cundy: High demand in the current low rate environment has caused the returns on illiquid investments to compress. Are illiquid assets less attractive than before?
Gareth Collard: Originally, there were two arguments for us to invest in this space. The sterling corporate bond market was too small, in terms of exposure to names and sectors, so you were diversifying by going into things like private placements and infrastructure. In addition, there was also a significant yield pick-up (the illiquidity premium). Since the pick-up largely disappeared, diversification is the reason why people have continued to invest in these.
Vicky Kubitscheck: I agree diversification is an important part, but I worry that the traditional bond markets are becoming less liquid. There is actually a change in the behaviour of different asset pots from our understanding in the traditional sense, so we need to take a prudent or conscious approach.
Miriam Arntz: I think in the event of a covenant breach, these assets however have the advantage that they offer the insurer or asset owner the opportunity to be involved in the resolution.
BEHAVING LIKE A BANK
Hugo Coelho: This calls for a different skillset. When do the costs of managing these assets outstrip the benefits?
Gareth Collard: In things like private placements you stand to gain, but you must start behaving like a bank, in terms of managing the asset.
Bruce Porteous: It is a banking skillset, rather than a traditional insurance skillset.
In part 2 of this roundtable, participants discuss outsourcing asset management, managing losses and how illiquid assets fit within Solvency II