Alternative investments for insurers: Adhering to compliance in a higher risk environment
November 08, 2016
The Prudential Regulation Authority’s (PRA) focus on valuation uncertainty might take on a wider remit in the near future. Given last month’s resurgence in insurers’ infrastructure investments in secondary markets across the globe, regulators are keen to protect shareholders’ interest by reviewing companies’ asset financial risk frameworks.
Under the PRA Rulebook and SS9/14 Direction, insurers need to quantify the uncertainty ranges around fair value for illiquid assets including real estate, private equity and IFRS level 3 debt securities. During last few months the PRA has given companies feedback on their assessments of asset valuation risk for largest insurers operating in UK – both P&C and Life markets.
With recent trends in alternative asset investments, including infrastructure projects in undeveloped countries, regulators are looking for insurers to improve their frameworks for identifying, measuring, managing, controlling and reporting valuation risk.
Secondary infrastructure markets in Latin America, Easter Europe, Argentina and Brazil in particular are attracting some interest amongst investors. It looks like returns might be promising. However there might be challenges around compliance and regulation covering poor transparency of projects, lack of scale, shaky operational models and political instability. These will need to be reflected in companies’ policy for control and governance of asset valuations including documented assumptions for valuation models and their transparency.
Insurers with a bigger risk appetite are keen to chase higher returns, and don’t seem to be too overly concerned with increased investment risks and compliance burden. Recent investment examples include:
- the Canadian Pension Plan Investment Board, who made its first infrastructure investment in Mexico in a partnership with the Ontario Teachers’ Pension Plan and Latin American infrastructure group IDEAL in July 2016, is kicking in a combined $1.35 billion to acquire a 49 per cent stake in a new company formed by the partners to house one of the largest toll road concessions in Mexico.
- Cubico Sustainable Investments has won a large purchase agreement in Mexico’s second long-term electricity auction. The renewables investment vehicle, owned by Canadian Pensions Public Sector Pension Investment Board and the Ontario Teachers’ Pension Plan, has secured the rights to build a 250MW wind project and a 290MW solar project - with total investments around $700m.
- IFC, the investment arm of the World Bank Group, has launched a $5 billion managed co-lending portfolio program (MCPP) infrastructure project to finance infrastructure development in undeveloped markets. The first partnership under the programme was signed with Allianz insurance who will invest $500m into IFC debt financing for infrastructure projects. IFC is also securing partnerships with Eastspring Investments, the Asian asset management business of Prudential and AXA, for a commitment of $500m each.
If you’re looking to satisfy PRA requirements in relation to valuation uncertainty with regards to illiquid assets make sure you bear the following three points in mind:
- Inclusion in governance framework – while strengthening asset valuation controls across the business, focus should be given to independent price verifications, robust valuation uncertainty & prudent valuation adjustments (including their quantification), and client supplied prices - all of which should be part of an overall company’s governance framework;
- Documenting unobservable valuation model inputs – assessment of the appropriateness of unobservable valuation model inputs such as discounts for illiquidity and credit ratings (in the absence of public ratings) should be particularly properly documented. This also should be included in the overall process of an appropriate approach to assessment of valuation risk and its materiality;
- Asset specific and regular review of valuation model inputs – valuation model inputs should be asset specific and regularly reviewed. Where assets are not managed by the business, transparent group procedures should be in place to ensure that sufficient due diligence is performed on the internal governance of external asset managers with respect to asset valuation.
In addition, insurers need to consider the capital treatment of alternative investments. This introduces additional complexity, since it is necessary to consider asset portfolio conditions under an appropriate range of stress scenarios, where asset values may be significantly reduced, and discounts for illiquidity may be heightened.
Do get in touch if you’d like to discuss any of the issues I’ve raised here.