Some insurance firms and fund managers are pushing financial regulators in various jurisdictions in Asia to change the risk charges they impose on certain asset classes under looming capital frameworks.
They are particularly believe there should be changes to the supervisory approaches to specific asset areas such as private credit, some equity strategies and risk diversification. Insurers are adding exposure to the former and other new investment types, particularly in the illiquid space.
Regulators require insurance firms to hold more capital against assets they deem riskier, and illiquidity can be considered a form of risk.
“Regulators are going to have to have honest conversations about the risks and capital requirements. They need to look at what insurers can invest in with a view to lowering capital charges to allow more opportunistic and higher-return type investments,” Richard Surrency, Asia head of alternatives at US fund house Franklin Templeton, told AsianInvestor.
He was referring to watchdogs in Asia as well as globally, but did not name specific jurisdictions.
“For their part, insurers need to start looking at longer-term income plays, but that is more difficult now, because the traditional credit space is no longer offering yields that support portfolio liabilities,” Singapore-based Surrency added. “So they need to look more at alternatives to bridge the return/income gap: infrastructure, real estate, private debt and private equity.”
He believes capital charges on private credit are still relatively high, but added that regulators are focusing on the asset class as a rising part of insurers’ investments.
“My instinct says they will move faster in that category, for a few reasons,” he said.
REASONS FOR REAPPRAISAL
Surrency believes one reason regulators could reconsider private credit is the fact that some of the underlying securities get assessed and rated by third parties like rating agencies. That, he believes, could make it easier for regulators to set capital charges.
In addition, private credit offers very strong documentation for senior-lien and first-lien rights, Surrency added. “As a result they can offer very secure, very low-risk and low-default returns.”
Unfortunately not all statutory capital regimes operating at the moment recognise the benefits of diversification or even the benefits of hedging some of the economic risk of our portfolios Guillermo Donadini, AIG
In general, Surrency conceded, the current risk capital charges applied to private credit are reasonable if insurers are buying AAA to A+ rated instruments. But he believes they become increasingly onerous from BBB+ rated instruments and below, which is where the majority of the yield available in the products lie today.
“Understandably the regulations are in place to protect insurers from a 2008-style collapse,” he added, “so the risk weights are there to dissuade insurers from investing in single-A onwards, irrespective of whether the underlying capital maintains liens and protections.”
"This would allow for insurers to position their portfolios in a manner they feel is more suited to their requirements while carefully managing the overall risk (and calculating the associated charges accordingly," he said.
Other industry participants are concerned that some RBC regimes do not make sufficient allowances for portfolio diversification or hedging. Guillermo Donadini, deputy chief investment officer of US insurer AIG, is in that camp.
“In theory ... capital efficiency should go hand in hand with more portfolio diversification. At the end of the day, with a more diverse portfolio you need less capital to back the portfolio because it’s more risk-efficient,” he said, speaking last month during AsianInvestor’s Insurance Investment Week event.
Europe’s Solvency 2 recognises diversification benefits “quite well”, meaning that increasing diversification increases capital efficiency at the same time, he said. “That makes a lot of sense.”
In some other regimes it doesn’t work that way, London-based Donadini said. “And given that the cost of capital has been falling, capital optimisation should in theory be a little less relevant than before compared to portfolio diversification, particularly when adding new sources of risk premia.
“Unfortunately not all statutory capital regimes operating at the moment recognise the benefits of diversification or even the benefits of hedging some of the economic risk of our portfolios, such as interest rate risk or foreign exchange risk," he noted.
Donadini cited Japan as an example, saying that there the accounting framework doesn’t recognise the economic loss or gain coming from asset-liability management (ALM) mismatches in currency or interest rate risk.
Instead, it forces the mark to market the derivatives to hedge the risk, disincentivising companies to hedge ALM risks to avoid profit-and-loss volatility. "Therefore life insurers in Japan have historically been running a massive ALM mismatch," said Donadini.
Richard Morrow contributed to this article.
This story was updated to include comments on equity strategies.