Private markets: The good and the bad of regulatory oversight

In the third and final part of this Insurance Asset Risk / Russell Investments roundtable, insurers discuss the increased regulatory oversight on their private investments, as well as expectations going forward

Vincent Huck: The role of regulators has been mentioned and there have been some amendments to Solvency II to facilitate investments in private assets. At the same time regulators have said they would step up oversight of liquidity risk, so have the regulators thus far been helpful, or are you concerned about greater oversight?

Emily Penn: To be honest, this is an area that the regulators do need to have a high level of scrutiny over, but I do not see there being a huge change from the recent amendments or announcements. It has been a huge area of focus over the last couple of years and it is only going one way, but I think it is the right direction of travel given the increasing presence of the insurance sector in this space.

It is important that the PRA does look into this, because it is easy to mess up. We look at these assets, and they are very complicated; Emily mentioned covenants. If there is a need to get specific covenants in to protect you against particular types of credit event, then that calls for a high degree of expertise and skill, in which case, should you be trying to invest in an asset you do not understand and cannot get the right protections for? But how easy is it for the PRA to judge that, and whether the right protections are there? This is a challenge, when do they necessarily have the expertise to make that judgement.

I perhaps prefer the PRA to ask structured questions about how we deal with the risk, and then allowing the market to find some sort of answers to those, as opposed to telling us how to do it.

Corrado Pistarino: Insurance companies need to be able to invest in complex, alternative assets, while demonstrating to the regulator that they discharge their fiduciary duty and act as a prudent person. Some insurers might believe they are not prepared to venture into this broadened investment space.
Yet, interest rates are zero or negative, and in the very words of central bankers, monetary policy is approaching the limits of its effectiveness. Fiscal policies will likely be centre stage in the years ahead. This would put increased pressure on institutional investors to pair up with governments to support the economic expansion. So, in my view, regulators will face increasing pressure to create conducive investment frameworks in alignment with government intervention.

Majid Khan: If you were to access assets through a specialist manager, does that adjust the regulatory risk reporting, or the regulatory risk conversation you have to have?

Emily Penn: If you are outsourcing through an asset manager, they want to have the assurance that you have the internal capabilities to still be able to understand, model the risk, manage the manager appropriately, so you still need a level of internal expertise as well.

Andrew Bailey: You cannot outsource responsibility.

Majid Khan: So, they will basically make the assumption of, worst case scenario, you now own the asset, therefore you must show that you can handle that asset?

Andrew Bailey: I think it is a reasonable defence to say, "Well we are a small company," or "This is a specialist area, we will hire a specialist". How do we know the specialist is any good at their job? In the same way as we would know if we interviewed someone.
So, effectively there is a certain point where judgements have to be made, and we know because we effectively leverage previous experience in other assets and talk to people in the market. It is that sort of work which is quite hard to evidence.

David Walker: The PRA has also come out and made pronouncements on use of the matching adjustment (MA) in COVID, and I just wondered if the users among you, of the MA, have found the MA protection even more useful during the pandemic, or a little painful if there have been downgrades and defaults, and if your view on using it, coming out of COVID, changes at all, as a result of what has happened?

Andrew Bailey: Matching adjustment is fantastic: it has done what it is designed to do, which is to allow insurance companies to look through short-term market disruption, so effectively spread risk is damped. It depends on how you model the change in the fundamental spread, given change in spread, and I understand unfortunately that differs across companies. But fundamentally, that big issue aside, it has done what it is designed to do.

Sam Woods, the Bank of England's deputy governor responsible for the PRA, said, and I paraphrase, "Look through the crisis, look through to the unprecedented government support and central bank support to the economy"; in other words, do not downgrade everyone straight away, because that would have been procyclical.

You then have to think, well to what extent are the rest of the regulations procyclical? While the matching adjustment is designed to dampen procyclicality we have lots of equity release mortgages, and as anyone who has ever done any work on EVT will know, it makes the MA strongly procyclical.
So we have the deputy governor telling us one thing, and the PRA and the regulators are acting in an opposite, procyclical, way. This is exactly what insurance companies like mine are trying not to do. We act to dampen market volatility in the economy, in the economic cycle.

Emily Penn: In terms of dampening the spread impact, the MA has worked, but it masks the real change in credit risk around credit quality, and certainly we have not experienced excessive downgrades to date. We are mindful of that risk remaining and the capital implications that will have, so that is something that is probably still to play out.

Nathan Robinson: Upcoming changes to regulation announced suggest there will be some changes in terms of some private asset being eligible in the matching adjustment portfolio post-Brexit. Has it been confirmed which ones they will be yet?

Emily Penn: I think that is what the industry is hoping for, but I do not think we have a lot of guidance yet on where that might end up.

Vincent Huck: Which one would you like to see become eligible?

Andrew Bailey: The PRA put in place the ability to restructure equity release mortgages to create eligible assets and we have done that successfully. If you push a firm, it can do a really good job and deal with the risk properly. I do not think we need to change the rules. EVT is the pain, with it being so pro-cyclical, but that is not really down to equity release mortgages being eligible or ineligible, it is just the way of measuring the risk over a long period of time.

Emily Penn: Do you think that has really improved your risk and understanding of the underlying asset? Or has it just added a load of regulatory and operational burdens around it? We have not restructured our equity release; for a number of reasons we have kept it outside of the MA fund, but I am just interested if you really think that has driven a better understanding of the risk associated with the asset?

Andrew Bailey: It is non-trivial and given our portfolio size, it is key, but it does deliver the fixed cash flows with investment grade notes that are needed for a matching investment portfolio. The question is, what do you do with the rest of the risk? Because you effectively concentrated the property risk somewhere else, but it is a reasonable approach that works really well. I do not think they need to change the regulations.

Solvency II, being completely market consistent, introduces a lot of volatility in what is a very long-term business. And that market consistency is damped, but it has still not gone away, and that is really your problem. That is the underlying issue; it is not really down to asset eligibility, it is just down to the structural Solvency II, one-year present value market consistent balance sheet philosophy.

Daniel Blamont: There are these talks about, "Outside the EU, could we do this? Could we do that?" It still feels like speculation and wishful thinking. It might allow the PRA to be less stringent in the interpretation of certain rules, but clearly the standards have improved and I do not see the PRA relaxing those standards. And on the whole, what they have introduced makes sense. Being outside of Solvency II might allow the PRA to be more proportional, a bit less black and white, but it is not going to be suddenly all completely different.

Corrado Pistarino: Probably the appetite of the FCA to diverge from equivalence would be minimal.

Majid Khan: How adventurous are the private markets or the private debt exposures getting, with regards to the type of underlying strategy? Is it still very much focused more on the lending side of things, with different types of collateral or are more innovative things making their way into insurance portfolios?

Daniel Blamont: Insurers are unlikely to go too broad anyway, because for every new investment you make, as we have discussed before, we need to document and demonstrate that we understand what we are doing. But if we push the boundaries, it is going to be more on complexity, rather than increasing credit risk. There might be more layers or moving parts to an investment, but ultimately you still want to be in the investment-grade space.

Majid Khan: As you push more into the private debt side of things, is the focus really more on a total return to the balance sheet or on an income paying coupon type structure?

Daniel Blamont: From an annuity fund perspective, it would be more the income because we are looking at illiquid liabilities being backed by illiquid assets. It is about cashflow matching. In shorter dated funds you could allocate a bit more total return type of assets. But for a UK life insurer, there is less scope in terms of the regulations, and in terms of the economics, to put private assets elsewhere than against annuities.

Majid Khan: What is the optimal level of income? I am sure it is slightly different for every organisation, but what is the kind of ballpark figure which is commensurate with the type of liabilities but also not too risky?

Andrew Bailey: Because we are matched, as a consequence, our pricing should ideally reflect the price in the market, so for us, we can survive. It is not ideal, if the market is very volatile though, because that makes pricing discipline very much more difficult.

Corrado Pistarino: We have a shorter duration book, so for us total return is a more relevant metric. Yield generation is a consideration, but we can manage liquidity through govvies and allocation to short-term credit assets, while the portfolio unlocks its latent value.

Majid Khan: In terms of the way you execute your activities with third parties, is it a preference to use managed accounts and evergreen structures, or do you have a preference to investing in third party funds? And do you see a trend occurring in either of those directions?

Daniel Blamont: There are always going to be segregated accounts, or managed accounts, because this means it is "your" mandate, and then you can therefore demonstrate that it fits your requirements and you are in control.

Corrado Pistarino: We have limited ability to enter into segregated accounts, so we remain focused on the quality of the due diligence on the managers of pooled funds at the point of entry. Because of the obvious constraints as to having a continuous dialogue with the managers and influence their investment decisions, it is no doubt a riskier configuration.

Part I is available here: Private debt in a post COVID-19 world
Part II is available here: Sourcing and stress testing private assets