The loosening of matching adjustment restrictions in Solvency UK presents life insurers with new opportunities and the potential for greater diversification
The Solvency UK reforms are presenting UK insurers with new investment opportunities, unavailable under the preceding Solvency II regime, in sub-investment grade and private market assets.
Nicola Kenyon, head of insurance investment and ALM at Hymans Robinson, said the most significant change in Solvency UK was the removal of the cap on how much matching adjustment (MA) benefit a bulk purchase annuity provider gets from investing in sub-investment grade and illiquid assets.
She said: “In simple terms, insurers can now take the full benefit of the extra illiquidity or complexity premium that they can get from riskier assets, provided they can manage the risks appropriately.”
Before the Solvency UK changes, regulated insurers typically did not hold double-B, or sub-investment grade, assets. “The only sub-investment grade assets they held had been downgraded, fallen angels, because of the so-called triple-B cliff edge,” she said.
Insurers using the MA framework have an opportunity to rethink their investment strategies. “They can allocate to lower rated assets like double-B, or increase their allocation to triple-B minus where previously they were a nervous of downgrades. This can complement their investment approach, if they stay within the regulatory boundaries and prudent person principle.”
Hymans Robertson and Legal & General collaborated on a white paper that explored how insurers could take advantage of these opportunities. “The extra MA benefit now accessible is most pronounced for double-B private assets. The UK Government said this reform could encourage investment into innovative asset classes, which potentially sit just below the investment grade threshold,” she said.
Under Solvency II, MA was only available to bond-like cash flows from investment grade assets. Solvency UK introduced the category of ‘highly predictable assets’, which have contractual cash flows but are potentially sub-investment grade and therefore higher yielding.
Allocating to highly predictable assets facilitates greater diversification, allowing access to different sectors and sub-sectors that wouldn’t typically be rated investment grade. “There’s potentially diversification at different places in the capital stack,’ she said. “You potentially get more influence over your finance and structures [and access to more…] ESG-focused investments.”
Strengthening analysis
Kenyon predicted that insurers are likely to remain highly concentrated in investment grade assets and noted the prudent person principle still applies.
“If you want to go into such investments, you’d need to strengthen your risk management framework,” she said. “There would be a higher level of expected default in your portfolio, which you would need to prepare stakeholders for, so you need make sure you have processes to deal with that.”
She noted that insurers may never have experienced a default. “That wouldn’t be the case if you allocated to sub-investment grade – so you’d need better processes,” she said.
“Insurers are very good at managing credit – but they’ve always focused on investment grade credit. In sub-investment grade there are different risks to understand, and you’d have to make sure you were meeting regulatory requirements appropriately. There’re also capital implications, and you would probably need to have a greater understanding of the legal framework of the assets you’re investing in.”
She noted other challenges, such as insurers’ capabilities being concentrated in investment grade areas and the relative lack of data for sub-investment grade asset classes.
“You would need somebody who understands some of the nuances of the sub-investment grade assets. We would expect firms to run a greater amount of stress and scenario testing. We’d expect them to expand their skillsets, potentially rely more on external resources to fill their knowledge gaps, have more robust frameworks in place and communicate clearer strategies for governance.”
Geoff Bauar, partner, Aon, noted that moving down the capital stack would likely necessitate mandating new asset managers. “You might have a core fixed income manager that performs very well – but it may not be the best at private credit,” he said.
He added that it complicates portfolio construction as new asset classes such as private credit would need to be allocated into existing buckets, and this may have knock-on implications for other investments to avoid concentrating risk.
Sumit Mehta, head of strategy, Legal & General, noted that there are interesting opportunities, especially in infrastructure debt financing, including around the clean energy transition. He added that insurers could take a bit more risk by moving down the capital stack. He also noted that default rate assumptions can be improved when cash flows are backed by assets.
Kenyon added: “The limiting factor probably comes down to the prudent person principle… We’re probably talking about a mid-to-low single-digit percentage of the portfolio.”