William Gibbons is a senior insurance investment consultant at Mercer, based in the UK. Stephanie Thomes is senior insurance investment consultant within the same firm but based in the US. They spoke to Insurance Asset Risk about how the US and the UK differ in their investment grade private security markets.
Hi, William. Thanks for sitting down with Insurance Asset Risk. I thought I'd ask you first to introduce yourself and describe what it is that you do over at Mercer.
William Gibbons: Sure, I'm a senior insurance investment consultant, with a focus on the investment strategies of insurers in Europe alongside Bermuda and the Middle East, and I'm based in the UK, in London.
We're going to talk today about investment grade private credit. The report will be looking at this subject through both UK and US lenses. Being based in the UK, I thought you would prefer speaking about it from the former angle. In that respect, how has the market changed over the last couple of years?
Gibbons: In terms of UK life insurers, in particular, the big driver of investments has been pension buyouts. You've seen a relatively small number of players acquiring significant amounts of liabilities through pension buyout deals, and then they have to invest the cash off the back of that. They are very much constrained by the 'matching adjustment' in the UK. What that means is that you have to effectively ensure that the cash flows of your assets are fixed and predictable in order to get the capital treatment that insurers desire. That really restricts them to investing in a subset of fixed income, and it also restricts them from investment grade assets as well. That's a a big constraint on those players.
What other differences do you see from the UK side?
Gibbons: There's also a lot more done here in the origination space. If you look at insurers' websites, you can see the publicity that they put out. Sometimes they lend directly themselves. It's quite common across the industry for firms to do that so direct lending to individual borrowers is one thing. Equity release mortgages has been another big trend. People are trying to get cash out of their house, and then the insurers would take those mortgages and effectively rely on those cash flows to then make payments to annuitants. Other asset classes would be things like commercial real estate debt, and ground rents, which can be residential or commercial. They would also see a variety of deals through investment banks.
Stefanie, you're based in the US. How would you say the US market differs to the European?
Stephanie Thomes: The IG Private Credit market in the US differs in both volume and collateral type from the European market. A wave of regulatory reform post-GFC raised the regulatory environment for banks in the US, leading to a lending gap that's being filled by a proliferation of specialty finance corporations. These alternative lenders (over ~1,000 in the US and CAD alone) have stepped in to provide financing solutions across not only small to mid-sized corporations, but also large corporations, competing head to head with the traditional BSL market and driving up volumes.
There's obviously been a growth institutional appetite, aligned with a deepening of sophistication. What have we seen as that has happened?
Thomes: As institutional appetite and sophistication has grown, so too have the underlying collateral types in the US – which have come to include not only mortgages, auto or credit card securitisations but also more esoteric collateral across consumer finance, hard assets like equipment finance and ag lending, or even financial assets such as music royalties or media rights. We expect this expansion of collateral types to continue so long as there is investor appetite for the complexity and illiquidity of the asset class.
And all of this is coming against a backdrop in which the market has moved on considerably in recent years? I'm talking in regard to deals being made, which have tripled in value on average. That's a huge increase.
Gibbons: The pension buyouts have gone up tremendously. You can see that from the statistics. We used to think £25bn was a big number and, as things stand, it's gone significantly north of that. The latest statistics would place the reason for that as being the rise in interest rates. What that means is that pension buyouts have become more affordable for pension schemes, so they've done many of these deals with insurers, and deal size has increased. There's kind of an insatiable demand there, to be honest.
We're obviously covering both the UK and the US in this report, and the markets do have many similarities. But is this anything you see that is more specific to the UK than there is to the US?
Gibbons: There's a few things. Securitisation typically is frowned upon in Europe because of Solvency II rules, but that's a little bit nuanced. It's not completely that way for UK pension buyout insurers, but there's probably still a little bit of a tendency against securitisation, so that's a big deal. And then there is the matching adjustment, which is to have the fixed fixity of cash flows in order that the assets can be counted against the liabilities. That's all important. Those are some of the big differences. I would say that there are more specific deals in the UK, and if you look at the way that insurers are staffed, they've got more teams who are really focused on specific asset classes. For example, some insurers have bought equity release mortgage originators, so they have, as part of their business, an arm that would originate those mortgages themselves. Whereas in the US, you tend to find there's more tie ups with asset managers. Often insurers would be handing off to the asset manager to go out and kind of find assets and manage them. But for the bigger pension buyer players in the UK, I'd say they control more of that chain. Some originate commercial mortgages themselves.
The big UK insurers sometimes have these direct relationships with the customer in terms of lending, which you maybe see slightly less of in the US. I would say equity release mortgages is not such a big deal in the US. Commercial real estate debt probably is in both. Infrastructure is also in both. And in the US market, you probably get a bit more liquidity because it's just a bigger market. Those sorts of things, to me, are the big differences.
You've touched a little on Solvency II back there. Why is there more frowning upon in Europe towards securitisation?
Gibbons: Solvency II has a really high capital charge for securitisations compared to corporate bonds, and other things like that, so it's not very capital efficient. Why is that? Well, Solvency II came into force on 1 January 2016, and it was drafted basically in the wake of the global financial crisis. And what was everybody thinking about then? Well, you had all these AAA securitisations, CLOs, etc..., and it turned out that they were riskier than the credit rating might imply. The response of the European insurance regulator was to say, "Right, if you hold securitisations, we're going to apply quite a high capital charge to them." That's just discouraged people from doing it really.
It's amazing how we're still seeing the global financial crisis play out after all these years! Moving on, I'd like to talk a little about asset-backed securities (ABS). We've some early adopters of these in the space, particularly in the US. What's the current view on insurers on these products?
Gibbons:There are corners of the market which would go for things like this. But I would say it's more the minority. It's not where the vast majority of the portfolio is. But those things in principle can work. Yeah, absolutely.
Why is it only a minority that is going for these products? Is there some inherent drawback that readers of IAR should be aware of?
Gibbons: I think they're a bit more complex. You've got commercial mortgage lending, for example, and there's lots of organisations that need commercial mortgages. That means that you can assemble quite a big portfolio, similarly, with things like equity release. From there, you can get into these more-niche areas where perhaps there's less systemic demand, so it becomes harder to do the big tickets and to make the huge volumes,
If it's so complex, why is the minority going for it?
Gibbons: The insurers are looking to innovate. They have these big flows of money because of the pension buyouts that they need to deploy. The problem is that the UK market is not that big so they're scratching their heads while looking for opportunities that might fit the bill. If you have something that looks like it might work but there may be effort involved in getting it to a successful conclusion, they will still pursue that because they need the assets to match the liabilities.
Does that tally with you, Stephanie? What has been driving this early adoption of ABSs in the US?
Thomes: Securitisations are generally capital efficient under US regulations vs. Solvency II so that's certainly a driving force for the demand. But perhaps more importantly, ABS provides attractive diversification from the large, concentrated corporate credit allocations within many institutional investor portfolios. The esoteric collateral of ABS not only provides differentiated cash flow and risk profiles, but also a yield pickup over similarly rated corporate credit.
A last question—what do you think of the transformation of MML risk to IG risk through securitisation?
Gibbons: The classic UK example has been equity-release mortgages, which people have had to securitise. That's broadly worked, although it's an awful lot of paperwork and it takes a long time to make the regulator comfortable. There's a lot of headaches there and no one really wants to make that work, even if it does in the end. Or it did work in the respect of the asset class, because, and there's so much invested in equity related to mortgages that it made sense to do that as well. So yeah, it can work, but it's a big pain.