The illiquid (or alternative) asset investment market continues to develop, according to our recent 2023 Illiquid Asset Survey. At the same time, Solvency II reforms in the UK are in focus, with most firms having started work to consider the implications.

Introduction

Across the life insurance industry in the UK, interest in illiquid assets continues to develop, even as market and economic conditions have changed. Illiquid assets are a particular focus of Solvency II reforms in the UK, as referenced in a February speech by Sam Woods, “Fundamental Spreads,”¹ which talked about plans to “widen the range of assets that are eligible for the matching adjustment,” and other changes.

We recently conducted Milliman’s 2023 Illiquid Asset Survey. This was a private and industry-wide survey in respect of the market practice adopted by insurers investing materially in illiquid asset classes.

With our survey participants being very active players in the UK’s bulk purchase annuity (BPA) market, we were able to cover most of the activity in UK insurers’ illiquid asset investments. The survey also enabled us to explore whether there was any consensus from the participants on several key topics.

As part of the survey, we developed a tailored report for each participant and conducted one-to-one sessions to discuss the results and share our key observations.

In the rest of this memo, we summarise several key observations from Milliman’s 2023 Illiquid Asset Survey.

Key observations

The survey focused on four areas of particular interest—approaches to illiquid asset origination, valuation methodology and approach, implications of Solvency II reform and finally the impact of current market and economic conditions.

Illiquid assets origination

• Asset types: While asset mixes varied considerably among participants, the overall picture is of a relatively stable core group of asset types held broadly across the range of insurers. Origination of new asset types is limited and focused on commercial ground rents, commercial real estate loans and some other asset classes.
• Exposure: Many participants aim to increase exposure to illiquid assets via higher target allocations for new business. This points to a possible convergence over time towards higher typical illiquid asset backing ratios—a positive indicator for future demand of illiquids. Firms’ target illiquid asset backing ratio was also anticipated to be stable over the next 12 months.
• Rationale: All respondents suggested that improving risk-adjusted investment return was the top priority for investment in illiquid assets, followed by improved diversification. Environmental, social and corporate governance (ESG) investing has become a less important driver for many firms compared with last year.
• Origination: Direct origination was the most common approach noted by participants. Participants were most likely to seek support or use third-party asset managers for commercial real estate loans, local authority loans, commercial and residential ground rents and private equity. Generally, firms anticipated making greater use of specialist external services or asset management in 12 months’ time.

Valuation

• Approach: Firms tend to use internally developed models to value most illiquid asset classes, typically based on discounted cash flow approaches. Valuations at outset are not always consistent with transaction values, though the latter term is not uniquely defined, which can account for some of the differences.
• Variation by asset type: There is a dispersion in the approaches used, and also different approaches are used by firms for illiquidity premia and recovery rates, even when discounted cash flow approaches are used.
• Factors prompting a methodology review: Reviews were more likely to be driven by a significant change in credit conditions, or a change in insurance regulations or legislation than anything else.
• Reviews: Mostly conducted by internal or a combination of internal and external teams. One participant said they would use a fully external team for ad hoc reviews.

Solvency II reform

• Benefit vs. detriment: Overall, the reforms are expected to be beneficial, though mostly of modest benefit. There is expected to be a broadly neutral impact on the size of the matching adjustment.
• Notching: Most respondents indicated that their current internal rating methodology for illiquid assets includes ”notching” within the rating, albeit a minority indicated that it did not. Some firms predicted that rating notching would be of modest detriment as a Solvency II reform.
• Eligibility: The majority of firms felt the changes had the potential to expand the range of illiquid assets they invest in. However, firms also need a clearer picture of what “highly predictable” means, and what additional risk management is expected.
• Attestation: Most firms were content in principle to give the attestation in relation to fundamental spread (FS) but not in relation to the matching adjustment (MA). While they may look like similar statements given the technical relationship between FS and MA under Solvency II, it shows that firms acknowledge a theoretical difference.
• Analysis: Most participants have started to analyse or scope the work required. We are not surprised by this—the impact on insurers will potentially be significant, though of course further clarity on the proposals is eagerly awaited.
• PRA scrutiny: There was generally a wide dispersion in views regarding the significance of expected areas of Prudential Regulation Authority (PRA) scrutiny.² This may suggest that different firms are already at different stages in their development and embedding of processes in these areas.

Market conditions

• Attractiveness of illiquids: Views varied around the implications of current market conditions with this, depending to some extent on the particular areas the market participants were focused on. Some participants indicated illiquid assets were relatively less attractive and that there was likely to be a reduction in availability due to increased cost for borrowers of raising debt finance. However, others took a more positive view.
• Actions: Given the recent substantial changes in economic conditions, it is not surprising that many insurers are reassessing their asset allocations. However, fewer insurers are looking at their liquidity framework, risk calibrations or dependencies, which seems a little surprising, unless this has already been carried out.

Conclusion

Insurers, in particular those writing BPA business, continue to invest an increasing proportion of their balance sheets into illiquid assets, even under current market and economic conditions. At the same time, insurers are prepared to change their valuation approach in response to changes in credit conditions or insurance regulations. Insurers are also starting work on the implications of Solvency II reform, which vary from expanding the range of MA-eligible assets to internal model approval, notching and the Senior Manager Regime changes.

We look forward to running the Illiquid Asset Survey again in 2024 to explore other areas of the topic.

How Milliman can help

As the illiquid (alternative) investment market becomes more and more competitive and widespread, insurers must continue to develop their skill sets in managing those types of assets on their balance sheets through better alignment across various frameworks related to origination and management. Examples of such frameworks include investment origination (and risk management), liquidity risk management and credit research frameworks, as well as any overarching objectives in association with transitioning to net-zero investment portfolios.

Milliman consultants have extensive market experience in helping clients understand the appropriate treatment of different types of illiquid and unrated assets across various purposes. Together with our risk management experts on climate risk or complex risks in general, we are well placed to help our clients address a broad range of questions and challenges, for example:

• Setting up and independently reviewing credit quality assessment frameworks for different types of illiquid and unrated assets
• The potential treatment of novel assets within internal models and Standard Formula frameworks
• Benchmarking market practice
• Developing investment strategies and investment risk management frameworks involving illiquid assets and ESG considerations
• Independently reviewing market risk management frameworks, such as liquidity risk
• Modelling illiquid assets using stochastic techniques, including producing real-world stochastic investment return scenarios and much more

To discuss this note or any related topics please contact your usual Milliman consultants.

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¹ Bank of England (20 February 2023). Fundamental Spreads − speech by Sam Woods. Retrieved 18 July 2023 from https://www.bankofengland.co.uk/speech/2023/february/sam-woods-keynote-speech-association-british-insurers-dinner.

² As set out in the “Dear CEO” letter of January 2023 from Charlotte Gerken and Shoib Khan.