Insurance companies are likely to up their allocations to private debt as a result of Solvency II guidelines, perhaps at the expense of private equity, market observers tell PDI. And every part of the private debt market – infrastructure, real estate and corporate lending – can expect to feel the change.
But the fundamental shifts in European financing go beyond new insurance regulation. Basel III, which burdens banks with stricter capital requirements, and an economic climate clouded by low yield are leading insurance companies to look for new opportunities.
“The low yield at the moment is forcing insurance companies to take more risk or find alternatives to ‘safe’ or less risky assets,” Dr Andreas Graflund, an expert on insurance and banking regulation and adviser to Nordic institutional investors, tells PDI.
According to a BlackRock survey published last year, around half of insurance companies expect to allocate at least 15 percent of their investments in private assets by 2017, up from around a quarter in 2014. This is a “massive” development in three years, says Patrick Liedtke, head of BlackRock’s financial institutions group for EMEA.
In May, the annual Mercer European Asset Allocation Survey also found that institutional investors were increasingly favouring private debt. The consultant has seen a rise in the proportion of plans investing in multi-asset credit and private debt, in recent years.
Against a backdrop of negative yield, insurers and fund managers are in talks with European authorities about taking another look at whether private debt investments, in particular, should carry lower Solvency II capital charges.
At the request of the European Commission, the European Insurance and Occupational Pensions Authority (EIOPA) published new guidelines on private infrastructure debt in July which, if introduced, would halve the capital that must be held against some infrastructure credit assets. The body has also advised on requirements for unrated corporate debt.
This has implications for private assets. Insurance companies, with a predilection for fixed-income are likely to consider private debt over private equity, some argue.
“It is good to some extent that private debt has been greeted favourably by Solvency II and more bad luck for private equity,” Hans-Peter Dohr, managing partner at DC Placement Advisors, tells PDI. Solvency II could provide an “easing mechanism” for private debt, he suggests.
Hans Stamm, a partner at law firm Dechert, adds: “It’s clearly positive for the whole [private debt] fund industry, because insurance companies will allocate some money out of bonds and they will not allocate it into equity because that has a high solvency weighting under Solvency II.”
In terms of infrastructure debt, two interpretations of the EIOPA guidelines suggest that the capital requirement on a BBB-rated 10-year infrastructure bond could be 17.1 percent or as low as 15.2 percent. This compares with 20 percent under current solvency rules, says Fitch, the rating agency.
Meaningful cuts like this could boost investment, particularly from German insurance companies, many of which lean heavily on fixed-income, with allocations sitting somewhere between 85 to 90 percent, according to market sources.
The EIOPA guidance builds on Solvency II recommendations published last year. These allow allocations to investment vehicles holding unrated corporate debt without triggering a 39 percent capital charge on the proviso that the funds can provide ‘look-through’ reporting on underlying loans.
Rather than classifying the holding as a fund share, a lower charge will apply, Stamm says.
There are hurdles ahead in terms of managers providing this level of reporting, though. And there are initiatives apart from Solvency II that might have a greater impact on allocations to private credit. Stamm highlights how Bafin, the German regulator, recently opened up investment by allowing firms to commit up to 7.5 percent of their portfolio to Alternative Investment Funds.
And for Zurich insurance company at least, risk/return targets remain the key driver when determining allocations.
Hansjörg Germann, head of strategy development for investment management at Zurich Insurance, tells PDI: “Regulatory capital charges are not a consideration when determining the allocation target for private debt.”
Private debt is used for asset liability matching (ALM), a strategy endorsed by Swiss regulator FINMA.
“As part of our ALM framework we determine our capacity for less liquid assets with a model, which allows us to prevent over-exposure to assets which will be difficult to trade during times of crisis, always making sure that we can pay our insurance liabilities when they become due, while at the same time optimising the return/risk contribution from our private debt allocation,” says Germann.
“We like the risk characteristics of private debt where recovery in case of default tends to be higher than for fixed income securities issued by corporations.”
However, with banks having dominated the European debt market for centuries, the switch to an institutional investor-friendly market will not happen overnight.
Liedtke says this is one reason for a perceived lack of opportunities, particularly in insurers’ preferred strategy: long-term infrastructure exposures.
Even where banks do slowly retreat, the gap left behind isn’t necessarily the right shape for insurers. Variable seven- to eight-year loans that the borrower can refinance are not attractive to insurers seeking long-term liability matching. Long-dated fixed-rate loans with non-call provisions are the dream asset.
“Insurers are increasingly putting their demand structure into the market and the supply will react to this, but it just takes a little bit of time,” Liedtke tells PDI. “So two or three years from now there is little doubt these markets will have developed very, very markedly.”
Other long-term strategies have been easier for insurers to adopt because of their longer history in investing directly. In real estate, Prudential, Allianz, AXA and Aviva, through their in-house asset managers, have been particularly visible in Europe, providing long-term bilateral loans to social housing, student housing and hospitals, all areas that banks are pulling back from.
Here, too, changes are taking place. In an effort to diversify their risk and guard against local real estate bubbles, insurers are branching into faster growing countries, especially in Asia, Liedtke says.
The last frontier is direct lending. Long-term infrastructure and real estate loans are natural fits for insurance companies, but squeezed returns mean corporate debt is one of the most attractive opportunities on a risk-adjusted return basis. Transitioning from investment grade or government paper debt to riskier mid-market lending is not straightforward. Hence the popularity of senior secured lending.
Direct lending is high on the list of assets that insurance companies say they want to do more of, Liedtke says. The pullback of banking from this domain is a huge factor. “They find that increasingly they have fewer competitors in the market for those assets,” he adds.
However, lack of experience has meant this has been a difficult market to access. “Interestingly, there were some insurers which announced in recent years that they would try to organise those activities themselves. Most of them have found this very difficult, though,” Liedtke says, adding that many are now talking to third-party managers.
UK insurer Legal & General went a step further and bought a 40 percent stake in direct lender Pemberton last year. The asset manager held a first close of €547 million on its first senior mid-market lending vehicle in July, attracting a number of commitments from insurance companies in Italy and France, PDI understands. It is eyeing a final close of more than €1.5 billion.
Ahead of the close, the firm provided a seven-year senior secured term loan to Faist, a non-sponsored German engineering company.
Ardian is another manager said to have attracted significant commitments from German insurance companies, while IKB Asset Management’s German senior lending strategy is backed by three insurers: Generali, Gothaer and NN Group.
Insurers are cautious investors, however. They want to make sure any corporate debt portfolio they build adheres to conservative characteristics.
“Insurers see the opportunity, but just like with infrastructure they want to do it on their terms,” Liedtke says.
Importantly, regulators also recognise the need for insurers to invest in high quality assets, he adds.
According to Graflund, who has held executive positions at Nykredit and Sparinvest, Nordic insurers are ahead of the curve in terms of regulation and investment.
He says that while the Solvency II rules allow for a transition period of up to seven years after they come into force on 1 January 2016 (depending on the country) Denmark, which already has similar legislation, will adapt from day one, along with Sweden and Finland.
In Switzerland, Zurich, the insurer, has, for a number of years, had to comply with Swiss Solvency Test capital requirements, which tend to be stricter than Solvency II.
The direct lending trend for insurance companies is just getting off the ground, Graflund believes, adding that the new European Capital Markets Union will also provide a boost.
“Large non-life insurance companies will be the main drivers in hiring their own in-house expertise,” he predicts. “Otherwise we will see the dawn of new asset management/fund structures. Banks will most likely also play the role as intermediaries working as brokers of loans.”
In Denmark, transactions between banks and insurance companies within the same conglomerates show that transferring assets from one part of the business to another can optimise the overall group.
The asset transfer analogy also summarises what is underway in Europe. Once the finishing touches are executed, Solvency II will help insurance companies pivot into the private debt market. It is the natural follow-on from the Basel III-imposed constraints on banks.
Now marks the opportunity for insurance companies to make their presence felt in the world of traditional banking.