Sourcing and stress testing private assets

In the second part of this Insurance Asset Risk / Russell Investments roundtable, insurers discuss the challenges they face in sourcing private assets at home and abroad, as well as stress testing them

Nathan Robinson: From a UK insurer's perspective, what sort of challenges do you have, sourcing opportunities outside of the UK?

Daniel Blamont: We have seen interesting opportunities by just casting our net a bit wider, not just in the UK. Over the past year and half, we have seen guaranteed opportunities where there is some form of social housing or an infrastructure project in an emerging market country for example, where you need the involvement of a supranational entity, like the World Bank, to help it get off the ground.

We just have to be flexible enough in our corporate risk bracket to be able to explore a range of slightly different opportunities.

Nathan Robinson: But would you go as far afield as the USA and global private debt, or would you keep it European only?

Daniel Blamont: We have gone beyond the UK, especially on what we call corporate credit. It is always a bit more difficult when you start venturing into global commercial real estate (CRE), global infrastructure, because from a regulatory and legal angle the actual physical location matters much more.

Corrado Pistarino: Diversification remains a key principle for portfolio construction. Yet, if I look back to my own experience, the most profitable trades at the time of the last financial crisis were those driven by the presence of forced sellers. There are less of those this time around, because people had more robust balance sheets. But still, if there are opportunities in this area, I would look very attentively at that.

For instance, funds that buy LPs in the secondary market, that to me is very interesting proposition. Of course, there must be a rigorous due diligence on the fund manager, and the way the stated investment discipline is translated into daily practice.
During a crisis, opportunities emerge in specific segments of the investment universe. Back in 2010, opportunities were around the liquidity theme. If I think about taking advantage from distressed balance sheets, I can be less specific in terms of geography or type of credit risk, as long as the risk-adjusted profile generates value.

Emily Penn: In terms of overseas exposure, we are doing it in the more liquid space but we have not pursued that on the illiquid side. Echoing Daniel's thoughts about the regulator, it is just a lot more burdensome journey with the regulator, if you are going outside of the UK.

Nathan Robinson: Does that apply for Europe as well, aren't the UK and Europe on par in terms of regulation?

Emily Penn: It is more about the due diligence around the asset and the different legal regimes, rather than insurance capital.

Andrew Bailey: And the legal protections. For us it is all about the credit and the underwriting of the credit and understanding the credit risk. If the entity you are lending other than GBP to a non-UK based company, working in a non-English law system where the asset is in a third country, it is a lot more complicated.

The public debt markets make things easier, in this respect, so accessing those markets is easier with public debt. Private debt, the difficulty is all on our shoulders, and care is warranted.

It is reasonable for the regulator to ask the question; how do you know that you are able to underwrite this correctly? That is where the expertise of the people you use, the partners you have, comes into play. It is almost impossible for any company, whether it is Phoenix-sized, or whether it is a small friendly society, to underwrite every asset in every country in every jurisdiction. None of us have got the expertise everywhere so we buy in expertise, and it is important to recognise that that is a key part of the strategy to access the market.

We have to know what questions to ask, in order to know that the answer makes sense. Frankly, if we do not ask those questions, then we cannot demonstrate that we understand the risk profile. It is not the Prudential Regulation Authority's (PRA) choice what assets we invest in, but it is important that they assess whether we have recognised the risk properly.

Majid Khan: Even the selection of the partner is quite a complex process, how much of your time do you use to understand that landscape of appropriate managers and partners? How do you analyse them, and manage their riskiness, as a supplement to your direct investment capabilities?

Andrew Bailey: We have been pushing for long-term relationships with asset managers, because we need to trust their judgement, we need to understand when they tell us an asset is underperforming and why, and what they recommend us to do; it is critical information.

Emily Penn: I agree about the long-term relationships, the relationships, that reflect the long-term nature of the assets we are investing in. It is a lengthy process to onboard an asset manager in this space, because you have to build that trust and belief in their underwriting process, as well as your own.

Corrado Pistarino: This is a salient theme for a small insurer like Foresters. We first investigate a space which we think offers an investment opportunity, and then we engage with an external consultant to help us launch an RFP. It is a multi-stage process that ends with a beauty parade, a two-hour conversation with the short-listed managers. The due diligence on the legal documentation is conducted in parallel.

It is a significant effort. It is complex, time-consuming, and there is always a lingering doubt: whether we have asked all the relevant questions, whether there is any area that we did not properly investigate, and so on. Of course, working together with an external consultant provides additional scope for cross-verification. The process usually lasts around six months, from the point in which we decide that we want to explore an investment opportunity up to a point in which the manager selection process is completed.

David Walker: Andrew, you mentioned about the administrative decisions that came out of the pandemic. When Insurance Risk Data looked at the scenarios that insurers mentioned for pandemics, it was a life and health scenario, around mortality, not really around investments. Did you feel there were any stress tests or scenarios that you had, which were more useful to guide you through this year? Did your views on modelling and scenarios change, or did you develop new scenarios for your investments, coming out of what has happened?

Andrew Bailey: Did anyone foresee the pandemic, and the impacts of it? And given that we are supposed to do scenario modelling looking forwards, did anyone? My answer is, I certainly did not. I will put my hand up to that. I know that in February I went to the Bank of England's biennial stress tests on climate change stress tests, and they were still talking about that as being the greatest threat to our generation. And I was thinking, what about the pandemic coming out of China? Even in February, the regulator was not looking at this as a live stress test, so firms can be forgiven for not having this on their radar. That said, probably by the end of the week before we actually went into lockdown, we had economic scenarios and credit views on the table. We had consistent scenarios on how this would play out through to 2022 really, in terms of the timeline and what things would happen, because we saw that this was going to be a huge issue.

So, we managed to get what needed to be done, done very quickly, but it was a failure of imagination; everyone thought pandemics were going to be a health crisis. No-one watched the movie 'Contagion', and thought: "Well, no one is going shopping. No one is going to work; what does that mean?"

Risk fails to think big enough in this particular instance, and the regulator certainly was not thinking big enough, from what I saw of the discussion.

Now the question is, looking forward, how do we work it out? Think about credit, think about where these assets are, think about the liabilities, it has not really changed our view on whether private assets are still valuable or not.

David Walker: When we dragged all of the data out of the SFCRs, all the scenarios and stress tests used were on the public investments, there was only one test for property, the result of which was not made public. It did not look as though stress testing was being applied to the long-term illiquid private markets assets as much. Would that be a fair comment to say that generally insurers will see the stress tests as for what happens with their day-to-day investments, not what really happens if they buy something and hold it for another 10 or 15 years?

Emily Penn: Regulatory capital is based on a one-year time horizon whereas the risks associated with illiquid assets are more likely to materialise over a longer term. This tends to be reflected in stress and scenario testing as part of the ORSA.

Andrew Bailey: Our stresses are going to reflect our balance sheet; the private assets are part of our balance sheet. There are a lot of people who look back on past statistics, but when you look at the universities for example, they are not given history.

Their credit criteria were not there, we are relying on lots and lots of judgements; stressing these is very difficult. You are making some very complicated judgements, and just mechanically applying things, might be wrong or might be right. That is the thing to be aware of.

Daniel Blamont: We must be careful, in the actuarial world that we live in, to not confuse a lot of data with good data. We have 100 years of default experience and we have transition matrix data since the 1970s, quite easily available. But how relevant were the companies of the 1920s? I think there is only one company that is in the Dow Jones now that was in Dow Jones 100 years ago.

So yes, we have loads of data, but it does not necessarily mean that what drove this transition and those defaults back then is always relevant to today.

Andrew Bailey: Did we see the pandemic as being the way it played out? Not until we started working from home, and then we did, we got a pretty good handle on it, and our predictions are playing out in terms of the timescale, but as time goes on, the uncertainty grows.

A point was made earlier about airlines, who knows what the future of airlines is? The contracts for engine maintenance that have been securitised or turned into securities, to what extent are those still credit worthy? To what extent is your aircraft leasing asset still a good asset?

I had questions even before this, or how much an A380 was going to be worth in the long run, but now, people are talking about what the second-hand value is of even 737s and A320s.

And that is fundamental to the credit assessment, so if it is difficult for those sorts of assets, it becomes sort of doubly/trebly difficult, for the ones that Daniel was mentioning.

Vincent Huck: Is it a question of sector, or is it cherry picking the assets within those sectors?

Daniel Blamont: There was some stock-picking before, and now it is even more important. But stock-picking is part of the process. We do not just invest in an asset class broadly when backing annuity liabilities.

Corrado Pistarino: It is extremely difficult to identify where the next crisis will come from and the channels through which it propagates across the global economy. Ten years ago, the epicentre of the crisis was the USA mortgage market, with a contagion effect that engulfed the whole of the financial system through a liquidity crisis that evolved into a major credit crisis.

The COVID pandemic has exposed weaknesses, which probably a lot of people – including me – did not forecast. A few years down the line we might experience another crisis linked, for instance, to climate change.

Because it is very difficult to understand how a crisis will originate and how it will develop, a balanced and defensive portfolio must include exposure across different sectors and different geographies in a well-diversified portfolio, together with an allocation to assets that are expected to act as storage for value and liquidity.

Part III is available here: Private markets: The good and the bad of regulatory oversight