The growing wall of investment capital pouring into private assets and niche corners of the markets has only gained momentum since Covid-19 hit, a trend that drew widely varying responses from insurance executives at a forum last week.
The desire of institutional investors to increase their exposure to illiquid assets in the face of ultra-low interest rates is at this point well established. There has, for instance, been a 60% rise in the value of allocations to private equity by European insurers since the global market crash in March, according to Edinburgh-based Michael Shean of the insurance client team at US-based Clearwater Analytics.
Some market participants are voicing concerns about inflated valuations and under-appreciated liquidity risks. One was Dimitrios Palaiologos, head of financial risk at London-based specialty insurer Convex Insurance, speaking at the Insurance Asset Management Summit hosted by Clear Path Analysis last week.
Others express the view that regulators should accept that such investments are necessary if insurers are to achieve returns sufficient to fund their liabilities.
"PENAL" CAPITAL REQUIREMENTS
Ankit Shah, head of investments and treasury at Qatari insurance firm QIC Global, wants to see “penal” capital rules loosened to enable insurers to more easily access alternative or more niche assets, such as emerging market debt.
Regimes such as Europe’s Solvency II require insurers to set aside more cash according to the level of perceived risk carried by certain asset holdings. Investments in alternative assets and emerging markets tend to rank relatively high on that risk scale.
Discussions are taking place over whether such requirements should be eased to allow more money to flow into debt and equity infrastructure-related assets and thereby support Covid-hit economies.
Speaking on the same panel as Palaiologos, Shah said such debate should take into account how such changes would help insurers, as well as assessing their benefit for the broader economy.
He said he favoured illiquid alternatives because they were less volatile and longer-duration than equities. QIC Global has large allocations to emerging markets, including large allocations to Asia-Pacific, he added.
“With the overall growth coming from Asia and emerging markets, it's important that they should have a reasonable allocation into your portfolios,” Shah said.
QIC Global has stepped up its monitoring of illiquid investments – including conducting closer scrutiny of debt covenants – and the cost of doing so continues to constrain what it can invest in, he added.
In addition to increasing their private equity exposure since March, European insurers have raised their allocations to dollar-denominated emerging market bonds, while hedging them back to local currencies, said Shean.
OVERCROWDING CONCERNS
Convex’s Palaiologos worries that overcrowding of the more popular illiquid strategies is over-inflating valuations.
“[Illiquid alternatives have become] increasingly crowded over the past couple of years,” he said. “Ramping up the strategies [has led] to a bit of mispricing in this sector as well.” As a result it has become harder to identify suitable investments, he added.
Moreover, some insurers are increasingly moving into assets that they cannot understand in search of yield, Palaiologos said. And that trend is likely to accelerate as capital issuance will be low in the coming years as economies continued to recover from the effects of the crisis, he added.
“This means a smaller universe of traditional investments for insurers to go to, [increasing] the importance of the alternative asset classes. I think [this] will become increasingly problematic for the industry.”
Palaiologos also warned about the dangers of adopting illiquid assets solely because the lag in mark-to-market pricing appeared to dampen portfolio volatility.
“[By investing more into illiquids] you are not actually reducing total risk, you’re trading some of your market risk for liquidity risk, and there may be some credit risk as well,” he said.
Palaiologos’s concerns extend to emerging market debt, which he felt some smaller insurers may not fully understand. “They may be [getting] into geographies where [they] don’t have a very clear view on the microeconomics and practical fundamentals of the geographies,” he said.
Bigger insurers with a presence in emerging markets are at an advantage on this front, he added.
A further issue is that investors might be underestimating the operational costs associated with investing in new illiquid assets, Shean suggested.
“Do [yields] outweigh the operational costs of being able to run that illiquid security? Can you get that data through your system? Can you support that type of security? It has different requirements to [assets] that a general insurer or life insurer has usually supported,” he said.
Ultimately, strong liquidity stress testing, looking forward up to a year, is essential to consider what kind of events would cause firms to seek liquidity, Palaiologos said.
“The key message [from Covid] for insurers is to make sure that they manage their liquidity in a way so that they don't have to become forced sellers.”
