Following the financial crisis, many European banks have withdrawn from or reduced provision of capital to mid-sized corporates. There has been much speculation and widespread belief that European life insurers would step in to plug the gap between reluctant banks and capital-acquisitive businesses. This newsletter discusses how insurers are building their exposure to debt in order not only to diversify their investment portfolios but also to increase yield following a sustained period of low interest rates and poor yields on investments.
In recent years, life insurers have been faced with many challenges: regulatory upheaval, increased market competition and, most recently (and particularly in the UK), fundamental changes to their long-term annuities businesses. Asset managers in particular have emerged as growing competitors in the savings and investment products market and insurers have suffered a corresponding decline in new business in this area. Those insurers with large portfolios of life business with guarantees which are higher than the available risk-free return have also been negatively affected by the prolonged low interest rate environment in many markets. Accordingly, insurers are constantly searching for better yields.
At the same time, European banks are being subjected to a great deal of enhanced regulation, including CRD 4. The prospect of stronger liquidity requirements under CRD 4 is constraining their ability to fund long term loans with short term liabilities. This, coupled with the need for European banks to maintain their capital ratios to comply with strengthened CRD 4 capital requirements, has led to them deleveraging. An effect of which has been to make it more difficult for mid-sized corporates to borrow from European banks, which are now more selective about the risks they assume and therefore the companies to which they will lend. It has been estimated that those mid-sized corporates will need to raise €3.5 trillion in debt over the next five years [Source: Moody’s]. The timing of this demand is perfect for insurers looking to diversify and obtain the higher yields they need.
The retreat by European banks is clearing the way for insurers to access the lending market through a number of routes, including expanding their asset management capabilities, entering into partnerships with banks and combining their resources with other institutional investors in order to find the assets that match their long-dated liabilities. Solvency II is also driving European insurers across Europe to consider various types of illiquid assets, from secondary level infrastructure financing to mid-sized corporate lending.
Insurers’ requirements vary considerably from those of banks. Solvency II will have a significant impact on the amount of capital an insurer is required to hold and, to the extent an insurer writes long-term business, it will need to ensure that it can, as closely as possible, match its liabilities with appropriate assets.
The Solvency II matching adjustment and volatility adjustment relate to the discount rate that can be applied in valuing liabilities for the purposes of calculating technical provisions for long-term insurance products. Backing longer-term, illiquid liabilities with assets of a similar nature is not new for life insurers however, whether the matching adjustment can be applied in relation to insurance liabilities depends on whether certain criteria are met.
In order to apply a matching adjustment to calculate the best estimate of obligations (including annuities stemming from certain non-life insurance or reinsurance contracts) the following conditions must be met:
- the insurer should assign a portfolio of assets, consisting of bonds and other assets with similar cash-flow characteristics, to cover the best estimate of the (re)insurance obligations which are maintained over the lifetime of the obligations, except where cash flows have materially changed;
- the (re)insurance obligations to which the matching adjustment is applied and the assets should be identified, organised and managed separately from other activities of the insurer and the assets should not be used to cover other losses;
- the expected cash flows of the assets should replicate the obligations in the same currency and any mismatch should not be material;
- the contracts underlying the obligations should not give rise to future premium payments;
- the only risks that the obligations should be exposed to are longevity risk, expense risk, revision risk and mortality risk;
- the matching adjustment mortality risk stress scenarios should not result in an increase in the best estimate of obligations by more than 5%;
- the contracts underlying the obligations should not include any option for the policyholder (only a surrender option, where the surrender value does not exceed the value of the corresponding assets, is permitted);
- the cash flows of the assigned assets should be fixed and not changeable by the issuer of the asset or any third parties; and
- the (re)insurance obligations of a (re)insurance contract should not be split into different parts when composing the portfolio of (re)insurance obligations.
The matching adjustment rewards firms that match long-term liabilities with long-term assets in the form of an uplift to the rate at which they may discount liabilities. Whilst investing in real estate has been a popular and conventional option for insurers, they are now considering increasing investment in other asset classes. The matching adjustment will require insurers to predict future cash flows. This need for certainty will lead insurers away from some of the uncertain features of lending (i.e., lending with repayments based on floating interest rates) and towards a model which facilitates more predictable income streams (i.e., fixed rate lending). Loans with 5-7 year terms are seen to be the most attractive to insurers, with loans of less than 5 years still largely being provided by banks.
The financial crisis has also seen banks retreating from real estate lending and, as with lending to mid-sized corporates, many believed insurers would step in to plug the gap. However, the standard formula in the Solvency II Directive makes this unattractive to insurers. The standard formula requires insurers to hold a certain amount of capital to cover the potential fall in the value of their real estate investments. The draft level 2 Delegated Act states that the shock to be applied to direct real estate investments is 25% under the standard formula, which is likely to make such direct investment unattractive. To the extent that insurers are attracted to real estate lending, it is more likely to be on a repackaged basis where the insurer’s own internal model facilitates such lending and this internal model is approved by the PRA.
In its May 2014 Financial Stability Report, EIOPA identified that, for the sample of EU and Swiss insurers questioned, government bonds and bonds of financial institutions are still the most popular choice to match insurance liabilities in a specific country. EIOPA estimated that at the end of 2013, large European insurers held almost 30% of their investment portfolio in government bonds and 10% in financial bonds. The financial crisis exposed the risks associated with the bond market and showed that in fact they are not “risk-free”, contrary to pre-crisis perception. EIOPA has expressed its concerns relating to the risks faced by the insurance sector if there is a deterioration of sovereign credit quality and rating downgrades. As a result, EIOPA actively encourages risk mitigation strategies which ultimately diversify insurers’ portfolios. To counter their exposure to the bond market and unsecured bank debts, diversification into illiquid corporate loans provides insurers with a method to lower their regulatory capital requirements under the Solvency II Directive.
A number of insurance companies are playing an increasingly active role in the field of corporate lending. Entering into partnerships with banks and funds has proven to be successful for many insurance companies looking to build a portfolio of mid-market company debt, particularly in relation to those companies which invest in the real estate sector.
In the context of this background, there has been an increase in the number of insurers who either acquire bank originated loans or invest in private equity and real estate funds.
Acquisition of bank originated loans
Where a separate investment vehicle is used, often the insurance company may not lend directly to the corporate but instead acquire the receivables originated by a bank. This approach allows insurers to not only assess the credit of the borrower but also to play an active role in the negotiation of the terms and conditions of the principal loan. In some circumstances this approach also enables the insurer to make larger loans to mid-sized corporates without assuming all of the risks associated with the loan. It also provides the insurer with an opportunity to invest in corporate loans that it would not otherwise have the credit research and deal structuring skills to do. In recent years, M&G Investments and Legal & General have offered direct corporate loans, Delta Lloyd has (since 2007) lent more than €700m to corporates in the energy and infrastructure sector, AXA has announced its interest in the direct lending market and Allianz Global has offered infrastructure and property loans.
From an insurance perspective, private lending gives an illiquidity premium between 100 and 200 basis points above similar liquid loans. Fixed rate loans with a term of 5-7 years are attractive for insurance companies from a risk and capital charge point of view.
Investment in private equity and real estate funds
There has been a significant increase in the number of insurers investing in private equity and real estate funds whether through allocation of assets by internal asset management capability or by third party advisers. The extent to which they continue to do so under Solvency II will depend largely on whether the standard formula or internal model is used.
The demand for high yield, non-traditional, asset classes such as infrastructure projects will continue to grow. The long-term nature of infrastructure projects provides insurers with cash flows which are a suitable match for their long-term liabilities. Infrastructure assets traditionally provide cash flows which closely correspond to insurers’ liabilities. Although such investments may be illiquid, they have the potential for better volatility adjustment as well as the potential to offer high risk-adjusted returns.
The depth of the debt capital markets in the United States, and particularly the private placement market, is something that Europe has never been able to match. Before the 2008 crisis, this didn’t matter to issuers as European banks allowed their balance sheets to balloon. But as the banks have retreated they need to be replaced. At the moment, many European issuers still look to the US markets for their debt capital, but the new capital regime for European insurers could certainly be a catalyst for the emergence of a much stronger European debt market.