At an Aberdeen Standard Investments Insurance Seminar held in November, Matthew Smith (MS), Investment Director – Insurance Solutions, chaired a lively panel discussion on how illiquid and sophisticated assets can be used efficiently by insurance firms. Speaking are Richard Pereira (RP), Investment Director, Neil Odom-Haslett (NOH), Head of Commercial Real Estate Lending and Gareth Mee (GM), Partner at EY. All views expressed by the panellists are their own.
MS: How much appetite is there for private debt among insurers globally?
The majority of European insurers have a home bias with many investing in domestic assets in their home currency. But looking ahead one of the challenges for insurers will be a lack of supply of domestic opportunities, which will likely lead many of them to widen their search for both public and private assets.
MS: All private debt is not made equal. Which assets within this broad spectrum are proving most popular among insurers?
GM: All insurers would love to invest in infrastructure debt but restrictions such as those within the Solvency II regulation has meant that hasn’t always been easy. In the future, we may move closer to the US model where insurers are staple lenders in infrastructure. We have also seen large uptake in commercial real estate (CRE) debt, although there is again a lack of supply so finding strong asset management and origination capabilities is increasingly important. Insurance companies are also allocating to small and medium enterprise lending and trade finance, although at lower levels than infrastructure and CRE debt.
MS: What is driving flows into private debt for insurers?
RP: Yield enhancement is a major factor, in particular the illiquidity premia over equivalent public market credit. A second reason is diversification, in terms of names, sectors and economic drivers. Finally, there is the opportunity with private debt to reduce risk by tailoring covenants and security packages.
MS: Private debt is a sophisticated asset class and not traditionally in the domain of many asset managers, never mind insurance companies. Are you seeing insurers now incorporating private assets into their investment strategies?
RP: Insurers are generally focussing on governance and meeting governance requirements, particularly in the areas of valuation methodology, valuation uncertainty and internal rating processes. Liquidity management is also a critical factor when investing in private debt and depends on the type of policies that insurance companies write.
Solvency II is a key consideration for European insurers investing in private credit assets. A recent report in October 2017 from the UK Treasury Committee highlighted concerns and made recommendations including more flexibility and the desire not to create unreasonable barriers to insurers investing in long-term assets.
MS: Traditionally, life insurers have been the biggest investors in private credit. Is this changing?
GM: Yes, we are seeing syndicates and general insurers coming into this space, for example in shorter-dated trade finance. The greater level of competition in general insurance means they have an appetite and need to squeeze more yield from these assets. However, some private credit assets are less suitable for property and casualty insurers than life insurers. Many of them do not have established internal investment teams compared to life insurers so have to outsource investment to external asset managers.
MS: How real is the supply challenge, particularly in CRE lending?
NOH: The proportion of the CRE market that is held by alternate lenders including insurers has grown rapidly since the global financial crisis. In 2008, insurers held around 4% of the UK CRE lending market. Today, following changes to capital regulations for banks that came into force following the crisis, insurers and alternate lenders’ share has increased to around 35% of the UK CRE market, which totals around £60-65 billion per year.
At ASI, we have seen strong deal flows in CRE lending. Much of our success is down to having strong relationships with borrowers and understanding their needs. Our mandates are well diversified across asset classes and geographies. We deploy money carefully and based on client-specific requirements. As an asset class, I don’t understand why more insurers and not coming into this space. For our investors this a defensive asset class and provides secure longer-term income offering a premium on a risk-adjusted basis.
MS: Analysing private debt requires a greater research effort and ongoing governance compared to public assets. How do you go about this?
NOH: It’s amazing how many CRE lenders prior to the global financial crisis did not even view the properties they lent against – and some still don’t. At ASI, we conduct thorough research into the property, tenants, flexibility of the space, location, demand in the area and transport links, among other things and our underwriting standards are second to none. Within the team, we will view each property separately and then compare notes. We need to understand how the asset works (for example, a shopping centre or office) and what it’s like, particularly when it is quiet. If we are not happy, we will either not lend, or if we do lend, it will be under terms which are more appropriate.
MS: Pensions funds have started to enter the CRE lending space. How are you managing this competition in terms of securing new opportunities?
NOH: Yes, it is a competitive marketplace. Ultimately, we are not willing to compromise our lending standards to secure deals. We have to be patient to secure the right opportunities for our investors.
GM: Yes, but insurance companies really need to become more active in areas such as CRE lending. In competitive markets, insurers often do not move fast enough because they have governance processes that are set up to reject such investments. This can be costly in terms of missed opportunities, particularly in the private credit space.
NOH: Banks are nimbler and quicker than insurance companies, partly because the default position with insurers is often ‘No’, rather than ‘Yes, but how can we get there?’ This suggests that asset managers like ASI have a role to play in helping to educate insurers and investors about the opportunities available.
MS: What do insurance companies need from asset managers and consultants to enable them to invest in private debt?
GM: In general, insurance companies, unlike pension funds, do not take formal investment advice. Insurance clients generally come to us for help in executing a deal, valuing an asset, conducting an internal credit assessment, understanding governance processes and building a capital model. But they don’t approach us to invest in a particular asset class or asset manager.
RP: Asset managers should focus on delivering a high-quality investment process and strong investment performance that is sustainable. Quality of client service is also critical. Understanding the language of insurers, their regulatory requirements (for example, Solvency requirements) and why the private debt asset class adds value from an asset-liability management and return on capital perspective.
MS: How much of a burden are the additional reporting requirements of private assets?
GM: There is somewhat of a language barrier between asset managers and insurers, partly because few asset managers have insurance professionals and vice versa. Because private assets do not have market values, several new inputs are required and to gather all this data requires a harmonious relationship between asset managers and insurers.
RP: Being able to understand and appreciate the extent of valuation uncertainty across private assets is very important. In terms of frequency and granularity of reporting for private market investment mandates, insurers should expect to do a deeper dive into the positions. For CRE loans, for example, this would include reviewing the location of a property, how the team has sourced the asset, the underwriting process, ongoing portfolio management, the covenants (in particular, loan-to-value, debt service coverage ratios), tenant quality and credit quality. These considerations should be a central element of the reporting discussion between insurers and asset managers.
NOH: Yes, from my experience engaging with insurance clients, that is all true. Some of the challenges stem from the opaqueness of the CRE lending industry – it’s not screen traded so there is no information on margins, spreads, arrangement fees or the terms of loans. As a result, it’s difficult to make comparisons between deals. The Prudential Regulation Authority is now proposing computer-based models to evaluate deals. Personally, I think this is concerning – CRE lending at its heart requires human judgement. Furthermore, it’s very difficult for computers to analyse a market where no two loans are the same and each loan is bespoke. Therefore, trying to homogenise CRE lending is simply not practical.
MS: Is private credit here to stay on insurance balance sheets or could something trigger a move away from private credit?
RP: I expect there to be a core element of private credit in insurance portfolios, with the amount depending on the types of liabilities being written. For example, as more pension funds de-risk, the insurance companies that take on these liabilities may increase demand for private credit. It will also depend on the yield environment in public markets and insurers’ prior experience in the use of private credit.
GM: Markets are becoming more competitive, and insurers need to push the envelope with their investments. Longer-dated private credit can play a key role as insurers have patient capital, unlike banks.
NOH: Private credit is here to stay. My only fear is regulation that tries to be one-size-fits-all.