Take cover: Insurers and private credit

As fixed income flags, insurers are turning to private credit in their search for Solvency II-approved yield. Kathryn Gaw reports…

Insurers are unusual amongst institutional investors. They have phenomenally deep pockets, with approximately $26tn (£20.02tn) in funds under management, and this money has to be invested. However, they are also subject to strict regulations and scrutiny which can drastically limit their investment options.

Under Solvency II rules, insurers must maintain certain capital requirements so that they are able to meet any payout claims. This means that for insurers, the priority is capital protection. And private credit can offer just that.

Solvency II has identified private credit as a lower-volatility asset class, given its lack of correlation to the main equity markets. Private credit can also provide diversification in investor portfolios, offsetting some of the ongoing macro-economic risks which are currently playing out on the public markets.

Of course, there is another key reason why insurers and other investors have been attracted to private credit investments – the returns.

A Goldman Sachs Asset Management survey carried out earlier this year found that insurers expect private credit to be one of the asset classes that delivers the highest returns over the next 12 months, beating private equity for the first time. A separate study by Moody’s confirmed that insurers are prioritising yield and diversification in their portfolios this year.

“Lower mark to market volatility is considered attractive, as private valuations tend to lag public markets, although from a credit perspective this could obscure underlying deterioration in such investments,” says William Keen-Tomlinson, a vice president and senior analyst at Moody’s Ratings in London.

“For longer term liabilities such as annuities, especially in the UK, asset liability management is a further factor. Private deals such as infrastructure and private placements can offer fixed cash flows over very long periods, and often include call protection which eliminates reinvestment risk.”

Insurers are funded by clients who pay premiums in exchange for protection from various risks. In order to keep pace with inflation and fund big pay-outs, insurers must invest these funds, ideally in long term assets which provide a fixed return. However, recent concerns about an economic slowdown have been weighing on the fixed income markets, forcing insurers to look at alternative asset classes which might be able to offer similar benefits.

“The private credit opportunity is particularly attractive in today’s market as it provides compelling absolute and risk-adjusted returns for an insurer’s portfolio,” says David Ross, head of private credit at Northleaf Capital Partners.

“With elevated base rates, senior secured loans to high quality mid-market companies are generating low-double-digit gross returns with strong downside protection from robust equity cushions and lender protections.”

Due to their preference for long-term, fixed income assets, it can take a while for any new trends in insurance investments to emerge. But there has been a visible shift towards private credit over the past year.

Earlier this year, SLC Management – the $277bn fixed income and alternatives asset manager – launched its own dedicated insurance group aimed at expanding its work with the insurance community. Just a couple of weeks prior, US-based alternative credit asset manager Invictus Capital Partners launched an insurance solutions business of its own.

Partnerships between insurers and private credit managers are also on the rise. Last year, KKR acquired the insurer Global Atlantic, and subsequently saw its assets under management increase by six per cent quarter-on-quarter. It said that new capital raised over the quarter was driven by inflows at Global Atlantic, as well as asset-based finance vehicles, evergreen US direct lending, Asia private credit and CLO formation.

Northleaf has also been reaching out to insurers.

“We continue to see strong demand from insurers for private credit because of the return and diversification benefits that the asset class can provide to their fixed income portfolio,” says Ross.

“It is important however for insurers to be able to invest in private credit in a regulatory capital efficient way, and we are speaking to insurance investors about the variety of private credit structuring solutions that are now available to them, such as rated feeder funds, separately managed accounts, and co-investments.”

There have been countless analyses about why insurers are favouring private debt at the moment. M&G believes that insurance investors have been seeking to increase their exposure to less liquid markets, such as private debt, over recent years. Neuberger Berman has claimed that private credit could be a particularly good fit for insurers due to the sector’s predictable cash flows, risk diversification and illiquidity premium relative to public markets. And Moody’s’ Keen-Tomlinson has pointed towards the sector’s diversification possibilities and higher credit spreads.

In recent years, there has been another compelling reason for insurers to consider private credit: the inflation-beating returns. Across the UK, US and EU, interest rates have remained persistently high, while stock market volatility has spooked the more risk-averse investors. The search for yield has sent institutions flocking to the private credit market, which is now said to be worth more than $1.8tn globally.

Last year, Morningstar DBRS data revealed that US-based private debt funds returned an average of 13.3 per cent, while European funds returned 13.4 per cent. This represented the highest annual return for such funds since the global financial crisis in 2008 and the second-strongest return ever recorded.

Read more: Institutions seek out investment-grade private credit

For most investors, the illiquidity of private credit is seen as a negative, but insurers often have liquidity to spare due to their liability profile, so private credit allows them to boost their portfolio returns while remaining compliant with their regulatory capital requirements.

However, in return for this illiquidity they tend to prefer investment grade assets, either with good quality counterparties or favourable loan-to-value ratios. They have traditionally shown a particular fondness for asset-based finance (ABF) and asset-based specialty finance (ABSF) which comes with in-built collateral to assuage any fears of capital loss.

While ABF typically relies on real estate as the underlying asset, ABSF is a growing segment of the financial market that covers almost every aspect of the economy, with one of the largest segments being the consumer and commercial space, such as credit card receivables or auto loans.

“As insurers have built their corporate direct lending exposure, we are increasingly seeing them look to add ABSF to their portfolios, which typically has low or no correlation to their direct lending or traditional fixed-income exposure and helps to mute overall volatility and reduce correlation across the portfolio,” explains Ross.

“At Northleaf, we focus on more niche asset classes within ABSF where the key characteristic is that they aren’t correlated to macro and market factors and also have high barriers to entry given the specialized skill set required.

“This provides enormous value to an insurance balance sheet, not just in terms of return, but also in terms of providing an investment opportunity that doesn’t correlate to what they are investing in on other places on the balance sheet.”

With such specific needs and long-term investment horizons, it makes sense that private credit fund managers seeking to attract insurance investors would opt to create dedicated insurer solutions, or enter into partnerships to streamline their mutual due diligence. However, as more and more insurers tilt their portfolios towards private credit, a few alarm bells are already being rung.

An upcoming maturity wall has inspired many discussions about the possibility of mass defaults across the sector, particularly for those loans which were originated during the low-rate era of the pandemic. This could result in lower returns for investors, or in some cases the risk of capital loss.

Just a few months ago, Citigroup chief executive Jane Fraser warned of the risk of arbitrage between banking and insurance, and said she intended to raise the issue at a committee meeting of Citigroup’s board.

“The piece I’ve noticed a lot of late that does worry me is there’s an arbitrage between banking and insurance that is going on,” Fraser said. “We all need to keep an eye on that one.”

A Citi representative confirmed to Alternative Credit Investor that this committee meeting took place, but would not share any details of the discussion or how it impacts Citi’s investment plans.

Furthermore, insurers’ preference for real estate-backed loans could make them vulnerable in the event of a property crash. Keen-Tomlinson said that he has already noticed a number of insurers are growing cautious on office and retail in real estate, while becoming more bullish on logistics and fulfilment opportunities.

“A number of insurers we spoke to invest thematically and are more agnostic on whether opportunities are public or private as long as investment fundamentals are strong,” he says.

With tightening credit conditions globally and a persistently high interest rate environment, many analysts have predicted a rise in defaults later this year. However, good private credit fund managers will be able to minimise the risk of losses using a range of strategies such as underwriting, due diligence, security and structuring capabilities.

As the private credit sector grows and becomes more competitive, it is very possible that we will see even more insurer tie-ins in the months and years ahead. These partnerships can be mutually beneficial. They allow fund managers to create confidentiality clauses which protect their investment strategies while giving insurers the transparency they require. For the insurers themselves, partnerships allow them to create bespoke portfolios which can be consistently managed by the same team over the long term.

There are clear opportunities for both parties, it is just a matter of navigating the regulatory nuance and risk factors.