Regulators branded mad over capital rules

Europe's new capital-adequacy rules for insurers show regulators are mad, although they give Asian firms the chance to buy cheap assets, said the chief executive of fixed income at UK-based M&G Investments at a forum yesterday.

Simon Pilcher also criticised the investment policy of many Asian insurers regarding duration mismatch, which he said amounted to keeping their fingers crossed and hoping rates would rise.

Speaking at AsianInvestor’s third annual Insurance Investment Forum in Hong Kong, Pilcher said the introduction of Solvency II in Europe this year had led to a sea change in how insurers invest.

Solvency II is a European Union directive setting out the capital insurers must hold to reduce risk of insolvency. Implementation was pushed back many times and comes on the back of the post-2008 crisis regulatory clampdown on banks.

Pilcher noted that Prudential pulled out of the market for its largest product (annuities) in the UK because capital requirements for the business shot up by 50% on January 1 due to Solvency II. (M&G is the European fund management arm of Prudential and manages more than $100 billion of its assets.)

He also pointed to huge structural changes in the way derivatives now operated and consequently the capital requirements of the people who use them.

“Generally these changes are designed to make us use derivatives less to make the world a safer place, because apparently if you do not hedge your risks with derivatives you are safer than if you were to do that,” Pilcher said.

“Regulators are sometimes mad," he added. "Apologies if you are a regulator. You are mad.”

He said asset-backed securities had become “horrific” to invest in due to the increased capital requirements, even though they offer high risk-adjusted returns "under any sane model of risk”.

Still, there are opportunities for Asian insurers, unregulated by Solvency II, to buy cheap assets. Pilcher pointed to senior commercial mortgage and real estate debt as attractive investment options.

He noted how the commercial mortgage market globally had been exclusively bank-financed until 2011, but that insurance companies and money-managers now accounted for about a quarter of it.

“Increasingly this is the way of the world,” Pilcher said. "Those of us with real, long-term capital are going to be replacing banks, because we are the natural providers of finance."

He added that he had seen a trend globally towards greater use of private debt, as borrowers could no longer source the required financing from banks.

Private debt generally offers higher returns than corporate bonds due to its illiquidity premium, said Pilcher, and such investments could be easily tailored.

“If you are structuring your own transactions, you can end up as senior [in the debt capital structure], secured with decent covenants to protect you, so you get higher returns for less risk,” he added. “Often you can access markets you could not previously and thus get better diversification to boot.”

Private debt accounted for about 25% of the assets in Prudential’s annuity business last year, he noted, but the challenge is finite supply. “We have more demand from our clients than we can source in the market,” he said.

Asked about trends he was seeing among Asian insurers, Pilcher made two points.

Firstly, insurers in Japan have historically dealt with asset-liability mismatches by investing short versus long liabilities. As a result they have ended up with portfolios that are extremely low-yielding and substantially invested in government bonds.

“So they are looking to take more credit risk, but the amount of credit risk they would end up taking is tiny relative to the duration risk they used to have, or perhaps still have,” he said.

Meanwhile, insurers elsewhere in Asia are looking to rebalance the dramatic overweighting of interest-rate risk in their portfolios, said Pilcher.

“Many insurers’ current investment policy regarding duration mismatch is this,” he noted, holding up his hand and crossing his fingers. “This is not a great strategy and certainly not a diversified strategy.

“So we are seeing people looking to reduce that huge interest-rate risk and exchanging it for more credit risk, which is better rewarded over time.”