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Credit where it’s due – Finding value and fit for UK insurers

The ongoing Solvency UK reform provides a useful opportunity for UK insurers to review strategic asset allocation choices. In this article, our experts review a number of asset classes in private and alternative credit which we believe present particular value in the current market and regulatory environment.

20/03/2024
Commercial_property_UK

Authors

Ruolin Wang
Solutions Manager
Nicholas Pont
Investment Director, Schroders Capital
Emaad Sami
Portfolio and Solutions Director, Infrastructure Debt
Janice Zhong
Solutions Manager

Market and regulatory events in the last few years have brought asset liability management once again into the spotlight. With continued uncertainty around interest rates and now, under IFRS 9, without the perceived comfort blanket (in some cases) of amortised cost asset valuation, insurers are having to actively protect themselves against interest rate risk on both their liability-backing and surplus portfolios.

At the same time, with investment grade corporate spread levels tightening from their 2022 heights, the search for meaningful spread levels resumes.

The ongoing Solvency UK reform provides a useful opportunity for UK insurers to review strategic asset allocation choices. With the government’s flagship Risk Margin reduction already in place, firms (long-term insurers in particular) will see an easing of their solvency positions, which will allow them to take more risk – be it insurance or market risk. For Bulk Purchase Annuity (BPA) writers – established or aspiring – the Matching Adjustment changes expected by half-year will also open doors to new possibilities.

In this article, we review a number of asset classes in private and alternative credit which we believe present particular value in the current market and regulatory environment.

Building blocks

With higher rates propelling more pension schemes towards buyout, the need for high-quality, long-duration, predictable cash flows are becoming a structural phenomenon driving a substantial increase in demand for longer duration instruments.

Looking at the world’s largest public fixed income market – the USD market – whilst US Treasury issuance will have to increase long term to finance deficits, the options for backing liabilities with solely investment grade corporate bonds is increasingly likely to become more limited as issuance is constrained in this market and so investors need to review other sectors.

At higher interest rates, corporations, particularly those with cash, are less likely to want to lock in longer term rates. Indeed, long-term fixed income issuance declined by 34.2% from June 2022 to June 20231. The trend is likely to persist over the secular horizon in a world of higher interest rates. As such, illiquid assets will need to be a larger component to deliver attractive returns as a good match for long-dated liabilities.

Real estate debt is a widely used source of long-term fixed cash flows for insurers globally, with some insurers allocating over 10% of balance sheet to real estate debt across a spectrum of borrowers and financing stages. It is particularly popular in the US, UK and the EU. Under Solvency II, the recognition of the real estate asset as collateral means that senior and investment grade real estate debt, often with moderate loan-to-value ratios of <75%, can benefit from benign capital treatment under the Standard Formula. As a result, the Spread SCR can be as much as halved relative to the charge on a comparable corporate bond.

We are seeing good opportunities in loans which were typically and historically financed predominantly by banks, such as US Commercial Real Estate (CRE) lending. Banks are facing more restrictive capital requirements as part of ongoing and increasing regulation. This will make it less likely that banks will be competitive in these markets, providing an opportunity for our insurance clients. This presents opportunities for investors across the maturity spectrum to allow a fine tuning of portfolio income in lock step with liability needs.

Credit where it's due chart

Building a portfolio of loans allows the management of loan term, leverage, and location. We can focus on desirable markets and desirable property types that also comes with an additional pick up of 50–75bps of spread over corporate BBBs in most markets.

Thinking outside the box

Although, in the context of insurance asset management, we typically think of real estate debt as long-term, liability-backing investment grade loans, real estate debt actually encompasses a wide range of assets providing a range of risk and returns for investors of varying risk appetites. While investment grade loans are best known as liability-matching assets, high-yield, and opportunistic loans can also be suitable on an insurance balance sheet as surplus assets.

Conveniently for insurers, opportunistic real estate debt typically comes with shorter duration due to a combination of lower tenors and floating rate arrangements, meaning that as surplus assets they would not lead to a balance sheet duration mismatch or attract excess interest rate risk capital. Currently, we see spreads of up to c.1000bps in GBP terms for opportunistic debt. This represents an outstanding opportunity for those more unconstrained investors that can provide liquidity to an area where banks traditionally trafficked and can lock in private equity like returns with fixed income like debt protection measures but with a shorter tenor (2-3 years).

Powering on

Infrastructure debt provides a variety of contractual income, duration, and yield options, and has found a natural home in global insurers’ portfolios particularly given its ability to offer medium to long-term tenors.

As above, though, it is easy to forget that infrastructure debt spans the credit spectrum. Beyond long-duration investment grade debt, infrastructure debt can also come in high yield, junior and even hybrid forms, with quasi equity instruments which can offer capital-efficient returns as surplus assets. Currently, we see spreads ranging from c. 200bps to 600bps above risk-free depending on the seniority and structure of the asset.

Crucially, these yields are harvested through illiquidity and complexity premia achieved in transaction economics. From a risk perspective, the credit risk assumed is typically on the merits of the underlying infrastructure asset (or portfolio of assets), with debt service paid through long-term, predictable cash flows generated by the underlying infrastructure asset(s). Importantly, this means that infrastructure debt comes with inherent downside protection provided by essential hard assets, making it a compelling asset class for insurers looking to secure attractive risk-adjusted returns. Infrastructure debt is particularly known for its resilience and stability, providing stable income returns even through period of market stress with historically low credit migration. Long-term studies by Moody’s found that over the last c.40 years, the 10-year average loss rate of BBB-rated infrastructure debt was more comparable to A-rated corporate debt.

Credit where it's due chart

The recognition of this resilience is reflected in provisos for capital relief in many global regulatory capital regimes, including Solvency II (and other jurisdictional regimes such as the Bermudan Economic Balance Sheet, as well as the International Capital Standards), reflecting its lower risk and enhanced credit profile relative to equivalent corporate debt.

Boring is the new sexy

As much as we love illiquidity premia and capital efficiency, private debt cannot make up an insurer’s entire balance sheet. In some cases, for example Lloyd’s syndicates underwriting specialty risks, an insurer can experience large, unexpected cash flow needs at short notice and would therefore require a significant proportion of it assets to be high-quality and highly liquid.

Well, if I told you that by benefitting from some liquid inefficient markets, we could generate 7–8% income with low duration, low exposure to credit spread moves and low exposure to idiosyncratic risk, and all in an investment grade quality portfolio, would that be of interest?

In the UK and the EU, many insurers shy away from structured (or securitised) assets due to unfriendly Solvency II Standard Formula treatment of most securitised assets. This is despite the compelling economic characteristics of this wide-ranging spectrum of assets. In addition to enhancing return through a complexity premium, securitised products also provide risk protection through collateral backing, credit tranching and amortisation which provides shorter-term cash flows, low duration and reduces risk exposure over time.

No wonder, then, it is a staple investment on US insurance balance sheets, with almost a quarter of US bond portfolios – or $1.2 trillion2 of insurance assets – invested in various flavours of structured securities as of year-end 2022. For UK insurers with the appetite, including those with entities in jurisdictions where high-quality securitised assets are not penalised “Solvency II style” from a capital perspective (such as the US, Canada, Bermuda, Australia, and Hong Kong, to name a few), there may be an opportunity to access these benefits.

Credit chart

The Federal Reserve (and other central banks) is unlikely to continue crowding out other investors as it shifts to policy withdrawal. Banks in the US and elsewhere must shift gears as they reckon with regulation (Basel III) and higher capital requirements. These two elephants (Fed and banks) have been the largest buyers of Agency Mortgage-Backed Securities (MBS) and of highly rated (AAA) securitised credit for many years. Opportunity, therefore, lies in the sectors where banks and the Fed have represented the majority of the buyer base, but do so no longer.

As a fun fact, US banks own nearly one-third of all outstanding US AAA-rated collateralized loan obligation (CLO) securities.

While Basel III does treat AAA CLOs fairly well, it’s an example of a market where banks have been persistent portfolio buyers. This is true in other securitised sectors like Agency MBS, AAA MBS, and AAA Asset Backed Securities.

Notably, banks do not generally buy corporate debt for their portfolios. As such, a pull-back by the banks creates a disproportionate opportunity in securitised credit. Much like the familiar private market story in direct lending or real estate, the absence of banks has now created a similar opportunity across high quality securitised credit.

Relative value is skewed toward securitised credit

Credit where it's due chart

Uncertainty is real. With the vast majority of US mortgage debt established in the standard 30-year fixed rate mortgage, the sensitivity of the homeowner to interest rate changes is very low. Likewise, the prepayment function of the existing mortgages is likely not well-predicted by models relying on historical data from a very different era. This creates opportunity.

We see the mortgage-backed security (MBS) market as historically cheap (and history for us is more than 20 years, going back before the central bank buying of agency MBS). Agency MBS is guaranteed by the US government and as such this cheapness represents a non-credit risk premium. With much of the market at a discount dollar price, the ‘convexity’ (relationship between prices and yields) of the sector is very different than what most are familiar with. Again, that is opportunity.

Matching matters

For any fixed income portfolio supporting insurance liabilities, it is important for the portfolio to be tailored to the liabilities it is backing. This is particularly important for insurers writing or looking to write Bulk Purchase Annuity business, where an optimal (commercially and on a regulatory basis) and well-executed investment strategy is key to the company’s pricing competitiveness, financial resilience, and ultimate success.

The design and implementation of such a strategy require both investment and asset liability management expertise, including a deep understanding of the UK’s Matching Adjustment rules. For real estate debt and infrastructure debt investors, for example, this dual competency is essential for sourcing attractive and Matching Adjustment eligible deals.

Looking ahead to the Matching Adjustment reforms, insurers can expect more flexibility in their Matching Adjustment portfolios, being now able to take more prepayment risk and with less regulatory disincentive to invest in high-yield debt. For real estate debt and infrastructure debt investors, these changes will expand the eligible investment universe in both asset classes. Perhaps more excitingly, the “Highly Predictable” provision now opens up the possibility to incorporate securitised assets into Matching Adjustment portfolios.

The opportunity to incorporate new asset classes, however, always comes with the questions of “should we” and “how”. Once again, this is where asset class expertise can be best deployed with the right strategic asset allocation. For an insurer considering use of the “Highly Predictable” provision or allocation to sub investment grade debt, we would recommend first quantifying the relative economic and regulatory value of such allocations, balancing potential trade-offs between economic and Matching Adjustment spread as well as risk considerations.

The long and short of it

As market and regulatory events unravel, Solvency UK is offering help on both sides of the balance sheet to a broadening set of insurers. For existing BPA providers already taking advantage of Matching Adjustment, new entrants, as well as income protection and with-profit annuity providers considering Matching Adjustment for the first time, Solvency UK is prompting a reconsideration of asset allocation across the credit spectrum at an opportune time.

While traditional liquid markets are now offering meaningful yields, spread hunting can be a daunting game, and with insurers’ need for spread there continues to be an attractive case for private and alternative credit. Spread alone will also only go so far, and aligning balance sheet need to the opportunity set is a critical consideration. With the breadth of assets we have considered here, from floating rate opportunistic real estate to longer duration, more traditional infrastructure debt, we believe there is something of good value for everyone and for every component of the insurance balance sheet.

At Schroders we continually seek to evolve as market dynamics change to align to our clients' needs. We are at the forefront of capital markets and through a dynamic, flexible, client-first approach believe we are well-placed to work with clients globally to help with their investment needs.

Sources:

1 SIFMA, 2023.

2 NAIC, data as at year-end 2022.

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Issued in March 2024 by Schroder Investment Management Limited, 1 London Wall Place, London EC2Y 5AU.

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Authors

Ruolin Wang
Solutions Manager
Nicholas Pont
Investment Director, Schroders Capital
Emaad Sami
Portfolio and Solutions Director, Infrastructure Debt
Janice Zhong
Solutions Manager

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Please remember that the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

This marketing material is for professional investors or advisers only. This site is not suitable for retail clients.

Issued by Schroder Investment Management Limited, 1 London Wall Place, London EC2Y 5AU.

For illustrative purposes only and does not constitute a recommendation to invest in the above-mentioned security / sector / country.

Registered No: 1893220 England. Authorised and regulated by the Financial Conduct Authority.

For your security, communications may be recorded or monitored.

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