(July 9, 2013) — The solvency requirements hanging over European insurers have restrained investment into illiquid assets, according to Friends Life’s CIO.
Mark Versey told aiCIO of his frustration at Solvency II’s shadow over the industry, but he remains keen to gain exposure to the asset class, especially loans.
“We’re making sure that when we go into the markets, we’re doing it in as friendly a way to Solvency II as we can,” he explained.
“It’s a bit of an unknown, but for example [with loans] we’ll try and restrict the pre-payment risk. We can also constrain the ratings, the term of loans, and some of the conditions. In the detail, we can give ourselves the flexibility to change that mandate over time. We’re just trying not to take on anything today that we might regret under Solvency II.”
Versey oversees two major pools of assets–the legacy with-profits funds and the annuity business–in addition to the Friends Life Investment asset management arm. The total number of assets he is responsible for is £95 billion.
The traditional strategy for an annuity business is core fixed income, such as investment grade credit and government bonds. But, as with other insurers, Versey has shifted away from that in recent years, and is looking to more illiquid asset classes for yield.
The annuities side of the business is split into three areas, the short, medium, and long-dated.
“The typical illiquid strategy we might employ for those are infrastructure loans for the long end, commercial real estate loans for the medium term and loans to small and medium enterprises in the short end,” Versey said.
That philosophy can be seen in Friends Life’s recent announcement of a partnership with Pramerica Investment Management: the insurer awarded a £500 million mandate to Pramerica’s commercial mortgage business.
The mandate relates to the investment in commercial real estate (CREs) loans in Friends Life’s annuity funds. The CRE assets will be UK-based, senior secured, fixed rate loans with maturities of between five and 15 years, and originated by Pramerica’s London-based mortgage business, Pricoa Mortgage Capital Company.
CREs aren’t an entirely new venture for Friends Life; it already holds loans in its with-profit fund, but this new mandate is specifically designed for the annuity portfolios. Another mandate is due to be announced for the with-profit fund soon.
Despite his clear liking for illiquid assets, the recent flurry of announcements from fund managers claiming insurers are becoming more risk-on with their asset allocation confused Versey.
“The risk appetite of the insurance sector is very determined by the solvency constraints of the business. I would be very surprised to see the risk appetite of the insurance sector had gone up, because the regulatory environment hasn’t changed at all,” he said.
“Therefore the only reason risk appetite could have gone up is if, as the market rallied in almost all asset classes, it created surplus on the balance sheet of insurers and they decided to say ‘I’m going to use that surplus to increase my risk appetite’.
“That’s not something we’re doing here. I do see a move from insurance land into more illiquid asset classes, and [insurers acting] the potential replacement of banks for some of the loan market, particularly with infrastructure commercial real estate loans.
“But I don’t see that as increased risk, it’s diversification of existing risk. It’s an increase in illiquidity risk I’d guess, but most of the insurers have very illiquid liabilities so they’re in a good place to take those opportunities.”
Spotting opportunities
One of the better opportunities Versey took was to shift from gilts into corporate bonds. He names the decision as both the most challenging and the most rewarding of his job since the advent of the 2008 financial crisis.
Although seemingly a simple decision, Versey said it represented a change in the risk budget for the overall group, making it a difficult one.
But with QE in the UK pushing interest rates down to such low levels meant, he felt he had no choice but to sell gilts.
“Since then credit spreads have tightened quite significantly, which has made the [sale] valuable. Making the decision at the time wasn’t easy, but it seems easy in retrospect,” he added.
Where does Versey see the market going in future? In equities he continues to see value, even though the markets had “overshot somewhat” during the recent spring bull run, prompting him to trim some of his holdings.
“In terms of opportunities in the current market, we’re in a bit of a watch and wait scenario. Everything’s being led by the US government and its monetary policy. Here in the UK we’re waiting to see what Mark Carney will do,” he continued.
“On credit, which has been a great asset class for us, we continue to see value. The widening of spreads recently reflects a bit of an overshoot, and that gives us some opportunities to relook at our exposure, and potentially increase our holdings. It’s quite small beer in some senses though.”
With gilts, Versey’s biggest focus is on interest rate exposure. “We’ve spent a lot of time in the past few years focussing our management information to assess all of our liabilities and assets across the business, and which part of the curve they are exposed to,” he said.
For the with-profits section specifically, Friends Life has a fairly stable equity exposure, forcing Versey’s team to spend a lot of time managing the risks around the guarantees which lot of these products were sold with.
The rest of the asset mix comprises various fixed income and alternative assets, including private equity property, and private loan portfolios. Interestingly, Versey’s not currently an investor in hedge funds.
On the annuities side, Friends Life spends a lot of time on optimising its strategy and getting its risk management information correct, so it can break down liabilities into lots of different buckets.
Focussing on managing interest rate risk has also taken precedence recently, along with a lot of what he calls opportunistic investing.
This includes buying index-linked gilts on an asset swap, looking at illiquid asset classes, shifting ratings of buckets, investing in credit, as well as doing collateral upgrade transactions.
“A lot of [the decisions] in that portfolio has been opportunistic and it’s paid dividends,” he concluded.
Versey’s final focus is on the relatively new asset management arm. Friends Life Investments was launched in July 2012 with $6 billion, and currently has £11 billion under management.
The rise in assets is in part due to those captured from external managers, Versey said.
He continued: “Our core is fixed income, gilts, credit, cash. The direction of travel was to manage those in-house and, a year on, we’ve substantially expanded the amount of assets we’ve captured externally.”
It’s an interesting paradox at a time where we’ve seen rising numbers of insurers outsourcing all of all of their asset management.
The leading pension funds, and latterly sovereign wealth funds, have been bringing their asset management in-house–perhaps Friends Life is the start of insurers doing the same.
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