New directions

Darragh Culley, investment director at L&G Institutional Retirement explains how the market is not only changing but moving in new and interesting directions.

How would you define the market over the last couple of years?

There has been a definite evolution. If you look back at UK insurers fixed income portfolios twenty + years ago, they would have primarily been focused on having gilts and corporate bonds with some commercial real estate debt on the asset side of their balance sheets. Then they began to add investment grade infrastructure debt. Over the last five to ten years, we've seen increasing expertise and sourcing of alternative assets. That's things like off-balance-sheet loans to corporates and asset-based lending. All of that has been mirroring the wider buyside movement into private assets.

Are there any other reasons why we have seen this shift in direction?

It's primarily been driven by relative value and the much-discussed illiquidity premium that is available in private markets. You effectively get a BBB or a single-A private asset for the same (or better) underlying transition and default risk of a comparable rated public asset that pays a greater pickup in return for lower secondary liquidity. That's been the primary driver behind the increased allocation to private assets.

What are the big issues on your radar? What is it that are the main topics of conversation in offices like yours?

One thing on my radar is that private equity backed business and associated lending has grown to be a big part of the overall financial markets and, subsequently, if there are any risks that are associated with that. The Bank of England just covered this topic in their recent Financial Stability Report conducting a 'deep dive' into the UK financial markets ecosystem to look at what potential risks may be introduced due to the growth in private equity and associated lending.

Theoretically, is there anything that the Bank of England could do if it determines that there is a disproportionate effect or even a potential disproportionate effect on the market?

For banks, it would probably mean some kind of greater stress testing on their private equity related lending. For an insurer like us, the Bank of England is aware that we're investing in private assets, albeit focused on investment grade private credit the vast majority of which is secured on real assets. Where they ensure we are capturing the risk correctly is by focusing on internal ratings. So, the Prudential Regulation Authority will put a lot of emphasis on whether UK insurers are following the Prudent Person Principle. That's in relation to private assets that may not be rated by an external ratings agency. So, you need the right internal expertise, governance, and independent checks on whether the rating of the private asset is reflective of the risks. Due to conservative risk appetite focused on investment grade real asset-based lending, I don't have any big concerns around the private credit exposures on UK insurer's balance sheets.

Being UK based, you obviously have a specialty in the market. How would you say it differs from the US?

There are definite differences. The capital and lending markets are completely different. The US is a very capital markets-driven financial market. There are a lot of issuances done through public bonds and securitisations. In Europe, the banks are a much bigger component of financial markets, so they drive the market. What that means is that in the US, many deals are done through public markets. And in Europe, a lot of deals are done through the bilateral or syndicated bank deals In both cases, the US and the UK, they bring their own advantages and disadvantages. In Europe, the structures might be slightly closer to what we need from a prepayment protection perspective while in the US they will typically have a full public rating. European banks like to have prepayment protection or purely some form of protection against a movement in interest rates. That might be a break clause if the borrower wants to prepay earlier.

One topic that Insurance Asset Risk is interested in are the different models used—agented vs direct. That would not be something that necessarily concerns you guys over at L&G with your business model?

We're lucky to be lined up with L&G Asset Management, which is a market leading asset manager. The vast majority of our asset origination is done in-house. At the L&G group level, equity analysts are keen to understand how the asset management business is doing, what the synergies are between that business and the insurance business, and the value that is eventually being created at the group level. If we can build up the right teams in the asset management business who can originate assets on our behalf, it means that those asset management fees are kept within L&G. There's a synergy there. Now, there could be certain asset classes or areas where it does make sense to work with external asset managers. It could be a relatively niche area, so it would not make sense to build up a team within our Asset Management business. In those cases, we could still look outside L&G. But because we have broad internal capabilities, the vast majority of our origination is done internally.

There's been a pickup in investment into ABSs over the last year. How do you look at these products? And what are these early adopters looking for?

It's definitely an interesting area for us at L&G, and the timing of this question is a good one with the Solvency UK reforms. Those reforms will mean that we will be able to invest up to 10% of our UK MA portfolio (by MA benefit) into products classified as having Highly Predictable (HP) cashflows. There's the potential that ABSs will be considered under this. The challenge we face is that it is a market dominated by the US so, effectively, all the structuring is centred around the main buyers in that market. The result of that is that there will be some work to be done in terms of figuring out which will be the best areas that will work for us. At the same time, it's definitely an interesting area, particularly as it offers exposures to different sectors and different jurisdictions. The beauty with this is that you get access to a diversified global platform. That's a good diversifier compared to other exposures we have in the book offering potential exposures to areas such as consumer credit. That is an area in which a lot of UK insurers are not big investors in. ABSs are not something UK insurers have been able to invest much into date because Matching Adjustment rules are very restrictive about what we can do in this space. But I think, going forwards, they could be a part of the portfolio. At the same time, it will still be tightly controlled because of internal risk limits and regulatory constraints on the amount of HP assets.

Is there anything we haven't spoken about that you think is interesting in the market?

One area we haven't spoken about is clean energy financing opportunities such as EV charging, Solar Loans and CPACE. We particularly like private credit that mirrors our investing for good and renewable energy focus. Every transaction that goes through our investment committee needs to have its sustainability impact considered so transactions that offer a positive societal impact in the area will have an advantage. We've been active in renewables for quite a number of years around areas such as offshore wind farms and now in 2024, we're now looking at newer areas sometimes in ABS format as interesting developments in making them work for UK insurer balance sheets.

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