Tangled Risk Budgets | Chief Investment Officer

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That the devil is in the detail has become the slogan of our time—or at least the phrase most often used about financial regulation.

In this regard, the European Insurance and Occupational Pensions Authority (EIOPA) did not disappoint with its latest epistle to insurers. Its small, innocuous looking release on Solvency II technical standards at the beginning of April was largely glossed over, thanks to everything seeming to be largely the same.

But one key element did change: the timing. Previously, insurers were given until January 1, 2016, to get their annuity-backing assets ready for Solvency II. EIOPA’s missive brought forward that deadline by six months. Crucially, however, the lack of clarity on how some assets would be classified in terms of capital adequacy did not change.

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So how are insurers preparing their assets? And given cripplingly low rates, how are they squeezing the most out of their budgets?

The defining factor is how well capitalised the insurer is. The more capital they have to play with, the more esoteric the assets they can use.

Bruce Porteous, head of Solvency II regulatory development at Standard Life, tells aiCIO his general account assets are largely held in vanilla securities: a lot of UK gilts and highly rated corporate bonds, for example. “We do have a risk element for equities and so on, and with Solvency II coming along, it is opening up the possibility for investing more in alternatives,” he says. Infrastructure bonds, emerging market debt, bespoke private equity funds, and direct lending to small and medium-sized businesses are attractive, “if you can structure these in such a way that you crystallise the returns under Solvency II”.

But the lack of clarity means insurers are still allocating in the dark. “That makes it tricky to make investments, in case they’re suddenly not eligible anymore, which is why insurance asset managers need to keep on top of developments,” says Porteous.

Of course, that hasn’t stopped some insurers piling in. Last year, Mark Versey—the former CIO for Friends Life—told aiCIO about his illiquid strategy, which saw his £95 billion fund invest in 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.

“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.”

Other insurers are starting to adopt this method, according to Shazia Azim, partner at PwC’s risk, capital, and insurance division.

“The Solvency II debate has seen a shift from corporate bonds and gilts into more illiquid assets, such as social housing, infrastructure, and private finance initiative loans, as insurers search for yield,” she says. “That prompts questions on how to manage those assets with Solvency II. How do you value and model these assets? What’s the default risk? How can you calculate the illiquidity premium? Insurers are entering into direct negotiations with issuers to make the cash flows and maturities more certain.”

Outside of alternatives, any innovation in an insurer’s fixed-income portfolio is again determined by their capitalisation. Very few are taking on more structured options such as convertible bonds or collective loan obligations.

“There’s less interest here than with pension funds because the capital charge looks hefty,” says Azim. “Insurers that are well capitalised can invest in some of these more esoteric securities, but those who aren’t may find it harder to justify the capital tied up in them.”

In addition, these instruments are often too complicated for many insurers to feel entirely comfortable, according to Azim. “Traditionally, these sorts of instruments were used by hedge funds, banks, and private equity houses,” she says. “They’re difficult to model and are more illiquid than other assets.”

Research firm Cerulli Associates noted earlier this year that this lack of knowledge has led to a surge in outsourcing for esoteric fixed income assets, especially in credit and infrastructure debt.

As the search for yield continues, many believe 2014 will be the year when insurers will outsource more than ever before—and there, too, the devil will most definitely be in the detail.

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The UK’s Chancellor took the insurance world by surprise in March when he effectively abolished defined contribution (DC) fund members’ need to annuitise.

New rules will allow DC members to draw down, annuitise, or cash in their pension pots from the age of 55. The result? The populist press praising the liberation of the public’s savings—and a third being wiped off the share price of some annuity providers. Ouch.

As share prices recover, pension funds and providers are rethinking their lifecycle strategies. Currently, lifecycle strategies are the default option for most, and they are nearly always geared towards members targeting annuitisation at retirement. Now there are other choices: how will the construction of lifecycle funds be affected?

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“The Chancellor’s reforms may result in a change of destination for the majority of members, and such an alteration will need to be taken into account in the design of future lifestyle strategies,” says Morten Nilsson, CEO of NOW: Pensions. The company confirmed it is reviewing the structure of its funds to ensure they are suitable for this new environment.

Lifecycle products will now have to evolve to target different aims: “For some members, we’ll be targeting a single lump sum, so we could see lifecycles that focus on cash,” says Towers Watson’s Senior DC Consultant Will Aitken. “But for many people, they’ll be targeting a long-term income stream and possibly even an annuity purchase at a far later date than we’ve traditionally seen. This may be the end of one-size-fits-all lifecycles, not lifecycles themselves,” he adds.

“We’ll increasingly see some sort of pot-size division, where part of the pot is de-risked to cash, and the rest to something with duration and probably investment risk,” Aitken continues. “Most members taking drawdown will take advice and not rely on the default, so the amount of risk at retirement will only be moderately more than now.”

Tim Banks, managing director of the pension strategy group at AllianceBernstein, argues that the presumption that individuals will retire on a specific day and immediately annuitise on retirement, will become a redundant concept.

“Target-date funds’ [TDFs’] investment strategies recognise that members may prefer to keep their funds invested while they decide what to do with them,” Banks says. “As a result, we expect TDFs to continue increasing in popularity as the default strategy of choice.”

But Nigel Aston, head of UK DC at State Street Global Advisors, believes the industry will need to go beyond offering decent TDFs. “Workplace savers crave the security of income that annuities provide, but with the access flexibility that drawdown products offer,” he says. “The industry must now create innovative products that intuitively blend these customer aspirations.”

And Laith Khalaf, head of corporate research at savings provider Hargreaves Lansdown, also warns that the days of the default fund could be numbered.

“Default funds work on the basis of what the average employee can be expected to do. Until now, that meant buying an annuity for 90% of pension savers. From now on there are any number of pension withdrawal options,” he says. “Default funds have always been a blunt tool, but investing in one of these now looks like trying to eat a steak with a spoon.”