The Intelligent Quarterly from the publishers of The Insurance Insider

Summer 2017

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On an even keel

Heneg Parthenay and Simon Richards

In the present market environment where yields on many fixed income asset classes are low and in some cases even negative, investors have for some time been looking at alternatives to more traditional fixed income categories, where expected returns may be higher.

However, one consequence of this search is that many investors have been forced to seek out yields in riskier asset classes with lower credit ratings, longer durations and limited liquidity.

Now, investors are more concerned with the normalisation of interest rates and the end of quantitative easing (QE). The US Federal Reserve has indicated its desire to move interest rates higher while central banks in other key developed markets, including Europe and Japan, have intimated that current QE might not continue indefinitely. This has sent yields higher across the globe.

Given these factors, it is little surprise that investors have taken an interest in investments such as asset-backed securities (ABS) that enable investors to maintain credit quality, are liquid and provide a floating rate of interest to manage duration according to their preferences.

Asset-backed securities are securitised loans where the cash flows that derive from individual assets such as mortgages, car loans or corporate loans are pooled and sold as tradable securities.

While some investors associate ABS with the US sub-prime market that was at the origin of the credit crisis, the reality is that they have a similar credit spectrum to the public bond markets (where the universe goes from high quality, investment grade government bonds to high yield).

Indeed, much of the ABS market occupies the high end of the scale in terms of quality, with extremely low default rates. For example, AAA-rated UK residential mortgage-backed securities have never seen a default in the history of the asset class.

The UK market is notably different to the US mortgage market, as banks have the ability to pursue borrowers if they default and the value of the house is less than the value of the mortgage (negative equity). Investors therefore have recourse to the underlying borrower.

Possibly the greatest obstacle for European insurance investors is the capital treatment of structured credit investments such as ABS under Solvency II regulations, using the standard formula approach.

The Solvency II Directive, which codifies and harmonises EU insurance regulation, came into force on 1 January 2016 and, among other things, specifies the amount of capital insurers must hold in order to reduce insolvency risk and thereby ensure that their customers are suitably protected.

The significantly increased cost of holding ABS, alongside additional governance considerations, means that it is uneconomic for many insurers to hold them. This has led to a material reduction in the allocation to this asset class.

This ruling does not apply to insurance investors in the US, where regulatory capital charges associated with these instruments broadly align with the treatment of corporate bonds, allowing insurers to consider meaningful allocations to ABS in their portfolios.

An alternative to ABS

Fortunately, there are alternative ways of accessing the same type of economic risks (floating rate credit instruments secured by a pool of underlying assets) without the adverse capital charges, through other secured finance investments such as private loans. Private debt instruments are negotiated on a bespoke basis between a borrower and its lenders. Similar to ABS, these are investments based on contractual agreements that confer cash flows to the lender, backed by collateral.

Historically banks originated loans and kept them on their own balance sheets. The subsequent arrival of securitisation enabled banks to offload a proportion of the loans they originated to capital markets. This allowed banks to originate more business without growing their balance sheets at the same pace, limiting the need for additional capital reserves required by banking regulation. After the global financial crisis, it took time for structured credit to recover and some areas of the market never fully recovered. At the same time banks had to deleverage to address new capital requirements. Consequently, banks could not use either of the channels of the past, so they had to create a new way to source funding.

Today, banks offload a proportion of the loans they originate to institutional investors through private debt instruments and some borrowers have decided to bypass banks altogether and engage directly with institutional investors. This trend is accelerating and that is what we call secured finance.

Secured finance investments may be complex, requiring investors to model and evaluate all of the details of the underlying loans before they make an investment decision.

Credit analysis, structuring and quantitative modelling need to be conducted in-house by the lender. Some investments require hundreds of hours at a minimum to conduct this due diligence.

With relatively few investors able to perform the resource-intensive tasks required to pinpoint value, there is significant scope for attractive risk-adjusted returns for those that do have this capability and expertise. For this reason, returns can be higher than mainstream investments with the same credit risk.

Potential additional returns compared to similarly rated, and unsecured, public bonds reflect a complexity and an illiquidity premium rather than a credit risk premium. In other words, these assets reward specialist investment expertise including origination, structuring, modelling and research.

However, consideration must be given to the fact that secured finance investments are usually not publicly rated. Despite that, unrated debt backed by underlying collateral that satisfies certain conditions has a materially lower capital charge than ABS under Solvency II, broadly in line with that for A-rated corporate bonds.

Moreover, the European Commission is seeking evidence on the treatment of unrated debt from the European Insurance and Occupational Pensions Authority. The Commission aims to remove what it has termed "unjustified constraints" to real economy investments, which could potentially make it even more capital-efficient to invest in this asset class. Illiquid assets such as these are not usually suitable for inclusion in a traditional custody account. There are several options to hold these assets, depending on the circumstances of the insurer.

The valuation of these assets can also be challenging. However, the information made available to the asset manager about the underlying collateral can be used to support the valuation of the illiquid instrument.

Portfolios of these investments can be created with a focus on high-quality, low-risk opportunities spread across geographies and market segments in jurisdictions with strong legal frameworks for investor protection.

Naturally, each investment needs to stand on its own merit, yet this approach is able to combine an array of individual investments which have underlying characteristics and drivers based on real economic activities, differentiated by type and location.

At Insight, for example, we focus on secured lending opportunities backed by residential, commercial real estate and corporate cash flows.

A by-product of this is that a well-constructed secured finance portfolio will typically contain investments that exhibit low correlation to each other, as different industries operate under independent cycles, thus adding a natural degree of internal portfolio diversification.

In summary, secured finance investments such as private loans provide European insurers with many of the same desirable qualities as ABS yet avoid prohibitive capital charges, and hence are an attractive way for insurers to maintain or increase yields, while still maintaining the overall credit quality of their asset portfolios.

Secured finance investments

   

Investment characteristics of secured finance private loans at a glance:

  • Can provide high quality contractual cash flows, secured by assets
  • Make floating rate interest payments
  • Avoid non-economic capital charges for European insurers
   

Heneg Parthenay is head of insurance at Insight Investment

Simon Richards is head of insurance solutions at Insight Investment

This article was published as part of issue Summer 2017

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