Life insurers seeking higher returns from illiquid assets such as equity release mortgages or student housing must properly understand the underlying risks, the UK’s insurance supervisor has warned.

In the face of low interest rates and declining yields, many insurers have sought to back their annuity books with increasingly risky forms of investments, said David Rule, executive director of insurance supervision at the Prudential Regulation Authority (PRA), said in a speech last week.

“Illiquid assets can be a good match for annuities,” he said. “Diversification may lower overall portfolio risks. And long-term infrastructure investment has wider economic benefits.

“But these assets bring a wider range of risks than those familiar to bond investors. Insurers need to ensure they have the skills to understand and manage them.”

PRA estimates suggest that illiquid fixed income assets – defined as those “other than traded debt securities” – currently account for “more than 25% of the assets backing annuities across UK insurers”.

“Insurers’ business plans suggest this proportion might increase to around 40% by 2020,” Rule added.

Issues have arisen following a spate of high-profile bankruptcies in the UK, including the January collapse of Carillion, formerly the UK’s second-largest construction company.

“The failure of Carillion left some insurers needing to replace a contractor on construction projects,” said Rule.

He also cited other recent investment trends and their associated risks: “Financing student accommodation exposes insurers to the risk of changing UK student numbers; and financing railway stock creates a risk at the point when a new train operator wins a franchise.”

Alternative strategies have risen in popularity in recent years as falling bond yields and low interest rates in many developed countries have led investors – both institutional and retail – to seek higher returns elsewhere.

According to Preqin, the data provider: “The proportion of investors with a preference for higher-risk strategies such as special situations and distressed debt vehicles has increased from Q1 2017 to Q1 2018, with the largest share (52%) of investors now showing a preference for distressed debt.”

Sourcing the best and most appropriate assets was critical, said Duncan Hale, portfolio manager of Willis Towers Watsons’ Secure Income Fund.

“Good sourcing not only means that you can access assets to generate strong returns, but good sourcing is critical to managing the risk as a well,” he said. “Liquid assets can be bought or sold, but a poorly-structured illiquid project is likely to be a big drag on returns.”

Hale added: “You want significant diversification to manage the idiosyncratic risks seen across the spectrum, but you want to be selective and work with the best partners in each area. It is hard to do, but the benefits for those willing to do the hard work are quite attractive.”

For Andrew Epsom, principal at Mercer’s insurance investment team, more illiquid types of assets “do seem like a good fit”.

“In terms of understanding the risk, there is definitely lots of due diligence that insurers would go through before they invest in these types of instruments,” he said.

“Given the size of the life insurers – their high profile, and the fundamental [role] they play within the UK economy – the [PRA] is paying close attention,” Epsom added.

“A lot of life insurers have upgraded their internal processes to be able to cope with this fact.”

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