UK life insurers are buying more illiquid assets to match their growing long term liabilities as they insure more pension risk through bulk purchase annuity (BPA) contracts, suggest analysts at Moody’s.
The rating agency notes that UK life insurers invested significantly in the asset class to boost returns when interest rates were low.
“The current weak economic outlook is eroding the credit quality of some illiquid assets, but we still see them as beneficial to insurers overall,” the analysts explain.
They continue, “Illiquid assets still deliver attractive returns and remain a good match for long-dated liabilities.
“Demand for the asset class could however outstrip supply as the BPA market keeps growing. This could reduce insurers’ investment yields, or push them to buy lower quality illiquid assets.”
Moody’s states that illiquid assets, such as commercial real estate loans, are not traded and therefore cannot be bought and sold as easily as bonds or shares but offer higher yields to compensate.
According to the analysts, UK life insurers’ combined illiquid investments have doubled since 2017, reflecting strong BPA sales and the sector’s search for yield, and because they qualify for capital efficiency benefits under Solvency II.
Rising rates have moderated demand for illiquids among European groups, say Moody’s, but UK life insurers will continue expanding their exposures on the back of strong BPA demand.
The analysts continue, “The asset class held up well as equity and bond markets fell in unison during 2022.
“However, the UK’s weak economic outlook is now eroding the quality of illiquid assets such as real estate and equity release mortgages (ERMs), with property prices and office occupancy rates expected to fall.
“Assessing these assets’ value and credit quality is also difficult, particularly in a stressed scenario, and the lack of ready buyers and sellers makes risk mitigation harder.”
Moody’s notes that replacing highly rated government bonds with illiquids is negative for insurers’ capitalisation, though, illiquids can be of high quality and match well against annuity liabilities, reducing reinvestment risk.
They also carry a profit-enhancing illiquidity premium that supports insurers’ ability to write new BPA deals.
The analysts state that UK life insurers’ strong overall liquidity, the high quality of their illiquid portfolios, and their good ability to originate and manage these assets underpin these benefits.
Moody’s concludes, “A growing BPA market, together with investors’ growing focus on environmental, social, and governance (ESG) considerations, will drive up competition for high-quality illiquid assets.
“This could create a temporary supply shortage, eroding yields and forcing insurers towards lower-quality investments.
“The UK’s proposed Solvency II reforms will also allow insurers to include riskier assets within their illiquid portfolios.”
