Private Assets at a Premium for Insurers

With bond yields at record lows and showing no signs of improving, insurance companies are exploring new markets to hit their return and yield targets.

Private markets — which include private equity, real estate and infrastructure assets — offer an alternative to traditional fixed income investments.

These asset classes offer potentially higher returns than bonds, particularly when yields are so low, while maintaining a match for investors’ long-term investment horizons. There are also opportunities to find investments that are less correlated to the economic cycle than corporate or treasury bonds.

Yet they are not without challenges including high barriers to entry; greater volatility than their bond counterparts; and illiquidity. Private markets are also subject to stringent capital demands and greater regulatory scrutiny.

Until recently, the obstacles associated with private markets have acted as a deterrent to insurers. However, as access to certain asset classes has improved and as more buyers and sellers enter the market there are clear signs private markets are attracting more interest from the insurance sector.

According to Aviva Investors’ 2020 Real Assets Study, almost half (49%) of the 532 insurers surveyed expect to increase their allocation to real assets investment strategies, such as real estate debt and private corporate debt. Just 16% were considering a reduction.

Similarly, Preqin’s second-half outlook report for the alternative assets market, published in August, also showed growing interest among institutional investors. More than half of survey respondents (51%) said they were looking to increase commitments to infrastructure, with venture capital, private equity, and private debt also popular.

“The increased allocation to private assets is a trend being reflected across the whole institutional investment market,” says

Moiz Khan, head of insurance and pension solutions at Aviva Investors. “Although a prolonged period of persistently low yields is a key driver of this trend, we think it’s part of a much longer-term pivot by insurers due to a range of other benefits of investing in private assets.”

Such benefits include diversification, as well as potentially higher returns and yields than the traditional bond markets.

In the wake of the global financial crisis of 2007-09, banks retreated from lending to off-market companies. This gap in funding was quickly bridged by other sources, including asset managers funded mainly by pension funds and insurance companies.

The growth in availability of private assets in the past decade has brought a broader range of investment options that meet the characteristics of an insurer’s individual liabilities. Long or short duration assets, low or high quality, fixed or floating rate, inflation-linked —all can be found in areas such as private debt, private real estate, and infrastructure.

Investments like these can provide stable, regular cashflows to match liabilities, along with a higher value compared to comparable public bonds, because of their lack of liquidity and sometimes complexity.

“This enhanced stability and better predictability of cash flows is driven by stronger covenants and collateral arrangements that can be agreed on an asset-by-asset basis,” says Aviva Investors’ Khan.

While there are more private market investment opportunities for insurers, these do not come without caveats.

These are often complex investments; they may be difficult to exit, and they could expose the insurers to additional risks. For example, investors in real estate could face falling rental income and loss of capital value depending on specific economic environments.

Kahn says it is critical to choose an asset manager with proven experience in private markets, that can identify the best opportunities and avoid unnecessary risk. Again, using the real estate market example, a worthy manager would secure long-term inflation-linked rental agreements with reliable tenants.

Kahn says: “It is fundamentally important that an insurer chooses an asset manager who not only has the skills and expertise to originate and manage real assets, but also has the correct alignment of interests when it comes to the security — for example, covenants — versus the return features in any individual asset.”

Liquidity is an obvious concern for insurers when it comes to private assets. As well as meeting their own liquidity needs for payouts, European insurers must meet the Solvency II regulations’ capital buffer requirements. Asset classes such as private equity carry a higher capital requirement, so have traditionally been off limits for insurers.

“It’s important to remember that not all private assets are illiquid,” says Russell Lee, head of insurance solutions at M&G. “For life insurers with long-dated illiquid liabilities, having illiquid assets backing these is typically not an issue. For general insurers, the allocation to illiquid assets is sized carefully, and is typically a smaller proportion of total assets.”

However, Solvency II has proven challenging. It allocates a capital charge of 49% for private equity, for example — one of the highest for any asset class. Post-Brexit, the Association of British Insurers (ABI) continues to make representations to the government in the hope of securing less stringent requirements for these investments.

There are two areas that may help insurers make the case for relaxing capital charge rules on private assets. The first relates to environmental, social and governance (ESG) investing, and the second to the UK’s need for infrastructure funding.

On ESG, the ABI has warned that the current capital buffer rules force insurers and long-term savings providers to invest heavily in highly rated corporate debt and sovereign bonds. As well as forcing asset allocators to buy ultra-low yield securities, the regulations also skew investment towards non-green assets and makes it harder to invest in renewable energy, infrastructure and companies that will be vital to a successful transition to a net zero economy.

HM Treasury is reviewing Solvency II rules for UK insurers following the country’s exit from the EU, and the ABI has expressed its eagerness for the industry to “meet the government’s ambitions and maximise our contribution to climate change investment.”

The UK government is determined to mobilise £650 billion of private sector and public sector money to refresh and expand the country’s infrastructure assets. Based on the United Nations’ Sustainable Development Goals, the plan involves upgrading and retrofitting existing assets as well as building new ones across society, with digital functionality at the core.

The government made it clear in an open letter to investors in August that it wants major asset owners such as pension funds and insurers to back UK infrastructure projects. Fortunately, some private assets — including infrastructure — receive “favourable” treatment under Solvency II, says M&G’s Lee.

Aviva Investors’ Khan adds: “Solvency II supports investment in qualifying private infrastructure in the form of lower capital charges for private infrastructure and real estate assets. It is expected that regulators will continue to support sound investments in real assets where their risks, such as illiquidity and concentration have been addressed.”

Plummeting bond yields drove insurers to consider alternative asset classes, and private markets appear to be a worthy successor. Yet even if bond yields return to their former glories, it seems unlikely that private markets will lose their appeal.

Their long-term, inflation-linked outperformance versus bonds and the increase in investment opportunities have earnt them a place in the insurance portfolio on their own merit.

All that stands in the way between private markets and complete acceptance for insurance investment strategies is the small matter of financial regulation. Private markets advocates can only hope that their role in rebuilding the economy is enough to make policymakers take a second look at the rules.