Insurers are currently in the midst of a ‘perfect storm’. Pricing pressures are squeezing premium incomes, investment returns from traditional asset classes are declining owing to continued low interest rates, and operating expenses are stubbornly high. Despite this, most insurers’ balance sheets remain strong, benefiting from high levels of capitalisation. But how long can this last before shareholders grow impatient with persistent low returns on capital?
Insurers can improve their profitability by earning higher yields from their investments, through increased allocation to illiquid assets in their portfolios. Illiquid asset classes provide average returns that are typically 150-200 basis points above the risk-free rate. In addition, liability matching utilising illiquid assets offers a significant reduction in Solvency II capital requirements*. The benefits of investing in illiquid assets is driving a shift in business strategy as 40% of insurers expect to increase allocations over the next 12-24 months.
Illiquid assets appear to be the gift that keeps on giving, however these high returns are associated with high risks. It is this “high risk – high return” premise of illiquid assets that needs to be managed carefully. Insurers’ approach must be founded on robust credit risk management practices related to illiquid assets. Specifically, firms need to fully understand and assess the various risks associated with illiquid asset classes. To be able to do so, they must design and implement adequate governance frameworks and the necessary processes and procedures to measure, monitor and mitigate these risks.
Typically, illiquid assets are not rated externally by rating agencies, and as such many insurers have had to develop their internal credit rating methodologies. This can be a tough challenge as the risks associated with illiquid assets are often idiosyncratic. A series of recent credit events bear this out. For example, commercial real estate investments have been exposed to the woes of the high street retailers with losses resulting from the collapses (or near collapses) of BHS, Debenhams, Maplin, and Toys R’ Us; infrastructure projects have been hit by the collapse of Carillion; and social housing schemes have been impacted by the cost of cladding replacement post Grenfell fire. In the view of many analysts, credit losses will be exacerbated as the cycle turns.
Furthermore, the ever-increasing proportion of illiquid assets coupled with the complexities in identifying and measuring the underlying risks has attracted regulatory scrutiny. In its business plan for 2018/2019, the PRA states “we will continue to review firms’ risk management and governance of these [illiquid] assets, including their internal ratings”. This statement has been backed up by a number of regulatory communications to address credit risk management, and many firms have already been subject to an assessment of their internal rating procedures and credit risk management operating model. With EIOPA embracing a similar approach, this regulatory scrutiny is not limited to the UK.
At Parker Fitzgerald, we have been working with the regulators and leading insurers to address the challenges posed by investing in illiquid assets. Based on our experience, it is clear that key industry players have taken some measures to improve their capabilities and strengthen their risk controls. These measures, however, fall short of the operating standards required to manage the increasing level of exposure, thus jeopardising the return premise of illiquid assets.
For insurers to succeed with their investments in illiquid assets, they must embrace a framework that starts with rigorous upfront due diligence, and relies on a robust operating model throughout the lifecycle of the investment. Our latest report ‘Optimising the risk-return of illiquid assets’ discusses the business case for illiquid assets, and the framework that insurers should put in place for the best possible risk-return.