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.

Richard Surrency,
Franklin Templeton

“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.”

Private credit has been able to historically generate returns of 8% to 10% over six to 10 years, even when these periods follow major economic dislocations such as the 2008 global financial crisis or the impact of the Covid-19 pandemic, he said. 

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.”

CHANCES OF CHANGE
 
However, not everybody believes private credit should be regulators' top focus.
 
Rick Wei, JP Morgan AM
Rick Wei, head of insurance strategy for Asia ex-Japan at JP Morgan Asset Management, notes that the current and incoming risk-based capital rules in Asia place the highest capital charges on equity strategies, especially for private strategies.
 
"The prohibitive capital charge for equity strategies could be very onerous for Asia insurers, given that the equity exposure of Asia insurers are much higher than their peers in the US and Europe," he told AsianInvestor in emailed comments. 
 
"We think this needs to be reconsidered because within the equity investment spectrum, not all strategies are high-risk-high-return type, some strategies have much lower risk than others." 
 
He suggested that equity strategies that could potentially receive preferential capital charges could include qualified infrastructure, ESG investments and equity strategies with systematic hedging solutions.
 
Doing so would have precedent; Wei noted that "under the European Solvency II [capital rules], long-term equity’s capital charge was reduced to 22.5% from 40% to 50% last year, which could incentivise insurers to increase allocatiton equities as long-term investors".
 
On the other hand, by failing to differentiate between equity strategies in Asia, regulators may discourage insurers from prudently investing into the asset class, which could in turn reduce the appeal of products. 
 
Wei believes that taking a more nuanced approach to equity investments is more urgent than lowering private credit capital charges, in part because "some private credit strategies could be riskier than equity strategies". He added that the spread risk charge for unrated loans and debt in many of Asia's capital regimes is already quite low, typically averaging the level required by BBB and BB rated bonds.
 
Ultimately, industry participants believe insurer capital charges should be balanced to reflect the current environment and to allow insurers to secure a suitable return. However, the chances that regulators will adapt their capital charge levels in the short term does not appear to be very high.
Jaijit Kumar, Invesco
 
Jaijit Kumar, head of Asia insurance solutions at Invesco, believes they might only become more willing to change them over time as the portfolio compositions of regional insurers evolve.
 
"There may be more willingness [by regulators] to engage on a more granular level – going down to sub-asset classes or specific buckets of asset types," he told AsianInvestor in an emailed reply.
 
He believes one potential enhancement would be for regulators to allow for internal models from insurers, something allowed under Solvency II.

"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.

DETERRING DIVERSIFICATION? 

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.

Guillermo Donadini, AIG

“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.