Of no fixed abode - PART IV: ACE-ing it – the importance of appetite, culture and expertise

Not surprisingly, the most common fears echoed about a successful resolution to Parts I-III are whether insurers have the organisational culture to embrace changeNot surprisingly, the most common fears echoed about a successful resolution to the above issues are whether insurers have the organisational culture to embrace change; whether investment and risk committees really have the appetite for embracing the new (or greater, depending on your perspective) risks these new asset classes represent; whether firms have the actual expertise to assess and monitor these new strategies; and whether these can be structured to fit within the strictures of regulation. These are all valid concerns and point to the need for innovation beyond just evolving the investment strategy. With the value likely to be found in highly specialised, sometimes esoteric, assets, many of which require detailed fundamental credit analysis or have to be directly owned to get significant enough payback – solar panels, wind farms, social housing schemes, infrastructure projects and their like – expertise will be at a premium. The fear of many insurers and managers is that this will be the major constraining factor, alongside organisational caution at the senior level. 7 15 30 14 14 14 6 Direct lending strategies Infrastructure debt Property related debt Bank loans and CLOs Liquid alternative credit Public fixed income None of the above Figure 4: Where insurers’ fixed income allocations are expected to flow in the next two years Source: Insurance Investment Exchange survey, March 2015 24 40 4 12 20 Multi-asset solutions Equities New uncorrelated sources of risk (eg smart beta) Property Real assets (eg farmland, timber, plantations etc) Derivative overlays 0 Figure 5: Where insurers expect to allocate over the next two years outside of fixed income Source: Insurance Investment Exchange survey, March 2015 5 The size of institution will also be a key factor in the type of assets they can manage. Some fear that too few institutions are large enough to understand and embrace the diversity of assets required to make up a quality fixed income portfolio in 2015. Only the very largest could contemplate direct investment in something like the Paddington Central development, a high-risk scheme split into six phases over 10 years, or the recent acquisition of stakes in Associated British Ports and Eurostar by Canadian-UK consortiums. Smaller institutions will instead be attracted to the range of open and closed funds, as well as mandate offerings that are emerging to give them access to these asset classes. But here, their emphasis will need to shift to assessing the manager’s own abilities to originate, analyse and monitor assets. Internal teams are also small and often made of generalists rather than specialists. They have few means of keeping apprised on the changing dynamics across these diverse asset classes, and comparing them both to each other as well as to traditional staples to reach the best decisions. Traditionally conservative investment and risk committees will have to be coaxed gently into this new world, although many felt this could be a serious blockage. Overcoming that will require a well balanced approach to governance, with good quality data and metrics put alongside intelligent qualitative and quantitative analysis. The challenge will be to develop a risk culture appropriate to the size and position of the business, and then to put the appropriate risk models and policies in place. While the search for quality and value goes on, other pressing challenges cannot be ignored. From a regulatory perspective, capital is not the binding constraint surprisingly. Many feel they have sufficient capital to deploy intelligently. Equally, modelling capital charges is not the issue, given the huge investment that has been made across the industry in developing internal models and upgrading the risk architecture. Rather, the key problem is one of ensuring that an attractive yield or risk premium translates also into a healthy return on capital deployed. Insurers are businesses first and foremost, and so return on capital as well as profitability are paramount. The leverage inherent in the business model coupled with the sympathetic regulatory treatment of traditional fixed income means that even at these minute spreads, there is a return on capital to be extracted. This is a barrier to allocation for many of the new emerging asset classes, as they are not in the first instance often in the right form or structure for the insurance balance sheet. The detailed implementation of Solvency II remains a concern for many insurers and is likely to remain so for a while. Life insurers, for example, are hostage to the matching adjustment, which mandates fixed and ideally investment grade rated cashflows to maximise the benefit. Even where this may not be a constraint, the ability to structure cashflows and manage credit risks will make significant differences to both the embedded risk as well as the capital deployed. That requires more alternatives expertise, particularly on the structuring side, which currently is in short supply for both managers and insurers.