The UK government’s plan to reform the country’s insurance regulatory regime took its latest step on 28th September with the publication of the Bank of England Prudential Regulatory Authority’s (PRA) Consultation Paper regarding the planned changes to matching adjustment (MA) portfolios.
One of the key points that British politicians are trying to push here is that they want the insurance sector to be able to invest in a wider range of assets than they currently can (because of the restrictions imposed by the existing Solvency II regulation). Pursuant to that objective, one of the most significant changes comes in the form of expanding the list of assets that qualify for MA portfolios from purely those with fixed cash flows (which is the current situation) to assets with ‘highly predictable’ cash flows, such as the infrastructure sector, an opportunity specifically called out in the November 2022 Consultation Response.
That sounds encouraging for infrastructure asset management firms. But the recent rise in interest rates means that liquid fixed income investments are back in vogue after more than a decade of central bank zero interest rate policy (ZIRP), which is causing appetite for illiquid assets generally to recede.
According to data and analytics firm Preqin, at 8th June, the global infrastructure market has raised just $6.5bn from 21 funds in 2023, compared with $185bn across 133 funds last year and $135bn from 187 funds in 2021. The story is similar in other private markets asset classes, with the private equity, venture capital, real estate and private debt all showing marked downturns in fundraising so far this year when compared to last. And it’s a trend that may not be short-lived.
“Insurers will compare the expected return on illiquid assets to the alternative of traded assets. All other things being equal, if spreads on traded assets increase, that makes illiquid assets less attractive, unless their prices also fall,” said David Burton, Partner at EY in London.
Another trend impacted by the rising interest rate environment is that of the relative boom in the UK’s bulk annuity market. Many defined benefit pensions have found themselves fully funded and are therefore turning to the pension risk transfer space to insure their schemes so they can remove them from their balance sheets. Life insurers are awash with bulk annuity capital, and that capital will need to find a home. But another potential hurdle comes in the form of a regulatory warning.
In April this year, Charlotte Gerken, the Bank of England’s Executive Director for Insurance Supervision, gave a speech at Westminster and City’s 20th Annual Conference on Bulk Annuities which covered three topics: an expansion of BPA insurer risk appetites; an increased reliance on third party capacity; and greater interconnectivity with the wider financial system. Within her remarks about risk appetites, Gerken referred to illiquid assets.
“The disruption in the UK gilt market last autumn resulted in some pension schemes being overweight in illiquid assets as gilt values fell significantly, and schemes sought to reduce their leverage under liability driven investment strategies. We see insurers increasingly developing solutions to accept illiquid assets as part of the BPA premium, as pension schemes may be reluctant to dispose of these assets in the open market, potentially at a large discount. This requires significant due diligence, and we are seeing insurers seeking more advice from third party specialists such as property valuation experts both for illiquid asset valuation and to calibrate adequate market value haircuts. Alternatively, we have seen deferrals of premiums incorporated in deals giving pension schemes time to dispose of such assets in an orderly fashion. These premium arrangements can be complex and potentially capital intensive due to the increased uncertainty they can create.”
Gerken’s remarks focused on pension funds’ existing exposure to illiquid assets during the scheme’s journey to buy-out via the pension risk transfer market as opposed to any risks that life insurance companies may take from new investments. But it is added fuel on the fire. Schemes that hold illiquid assets as part of their investment portfolio could find themselves at the back of the queue, because the PRT market is enduring something of a labour shortage, meaning that the market can’t absorb much more activity.
“Constraints on insurers’ asset allocation can arise from both the MA rules and also their specific MA and internal model applications,” said Burton. “As a result, there are many types of illiquid assets that insurers may find difficult to take onto their balance sheets and pension schemes will need to recognise this. Having liquid assets that allow the insurer to reposition the portfolio itself will make such schemes more attractive at a time when insurers are being asked to provide quotes for a larger number of schemes.”
So, manufacturers and distributors of illiquid asset strategies find themselves at something of an impasse in terms of desirability, at least from UK life insurance companies, at least in the short term.
“The Treasury hopes that the changes to the solvency regime will lead to more insurance investment in infrastructure, and other illiquid assets to support the UK economy. However, the impact of the proposed changes on insurers will very much depend not only on what the eventual rules say, but also how the PRA uses the increased discretion that it has in regulating. As a result, it is going to be a little while yet before we fully understand the impact of the new regulatory regime,” said Burton.
