Insurers 'must understand risk on non-traditional assets'

Modelling and regulatory impact of new asset classes must be considered in search for higher yield

Insurers must carefully manage the risks of investing in non-traditional asset classes, as they look for ways to increase yield on their investment portfolios, according to insurers and investment managers.

Incorporating new asset classes into existing investment portfolios could pose significant risks to firms that do not have a good knowledge of how they work, said speakers at a panel discussion at Insurance Risk's Solvency II & Insurance Risk conference in London. Insurers need to consider the modelling, data and regulatory implications of investing in new and potentially higher risk assets.

Emerging market debt, loans to small- and medium-sized enterprises (SMEs) and collateralised loan obligations (CLOs) were highlighted as potential providing above-average yields in the current low interest rate environment.

Charles Pears, head of insurance products at asset manager Insight Investments in London, said: "We are really seeing insurance clients push away from their more traditional investment heartland and asking investment managers, ‘Can you deliver return without taking on undue risk?' And that is taking them into all sorts of new areas."

Insurers, Pears said, must consider the capital charge that will attach to assets under Solvency II, as well as the modelling requirements. "However well-rewarded an investment position may be, if the regulatory capital attached to that risk is such that you can't afford it, than that's it - you can't afford to take that risk," Pears said.

We are really seeing insurance clients push away from their more traditional investment heartland

"Also, look at what sort of modelling requirements would be attached to that sort of investment instrument to enable you to realise what sort of data is needed and how it will fit into your asset-liability modelling, both now but more specifically under Solvency II," he added.

Tom Rogers, head of strategy implementation at Zurich Insurance, said his firm is looking at opportunities to invest in structured assets, as well as opportunities to provide direct finance to companies.

"We've specifically looked to CLOs and collateralised debt obligations (CDOs), because we have done CLOs in the past. We did some following on from the crisis as there were more opportunities and some bank deleveraging was occurring in the US and there were some loans that were being passed into CLO structures, so we took the opportunity then. Similar opportunities are arising now," Rogers said.

"But [we are] also [looking at] the opportunities that are being created in direct lending to SMEs where the banks are showing less interest," he added.

Branching out from traditional investments may require a company to reassess its risk framework, said Jorg Sauren, senior adviser on internal models and Solvency II for Dutch group ING. For a firm to input new types of asset in its internal model, the so-called ‘three lines of defence' in the internal control framework need to operate in concert, he said.

"You have to go back to the guys in the first line and ask how they know about a particular asset. If they say, ‘We just ask for the broker's report', then you don't understand the risks in the first line and it's no use the second line trying to solve it," he said.

Having adequate data on asset risk will enable an insurer to determine how a certain investment will affect a firm's regulatory capital. At present, Solvency II's standard formula puts a punitive charge on structured products such as CDOs and CLOs.

Zurich views the regulatory charges as a constraint, but takes an economic view of the merits of an investment, Rogers said. "We look at the problem [of low yields] in economic terms and we view the regulatory capital models as a constraint within that. So long as we can meet that restraint, we will go ahead and invest in asset classes that on a standalone basis would not look attractive, but on an aggregate basis fit into the overall portfolio and make the economics work," he said.

Many insurers' appetite for investment risk had so far not been curtailed by Solvency II, because of the levels of regulatory capital they hold, said Insight Investments' Pears.

"Yes, the standard formula will drive up high capital charges. But as investors, they're driving their business more by their view of economic risk and return. They will still look at certain asset classes that under the standard formula look expensive. But if it looks attractive on economic grounds, then they will take some of those investment positions anyway," Pears said.

While the risks associated with investing in new asset classes could be adequately managed by insurers, few have made substantial changes to their portfolios at present.

"We haven't made any major shifts in our asset allocation, as we want to fully understand [new investments] before we step into that area," said Zurich's Rogers.