The illiquid asset investment market continues to develop, according to our recent 2024 Illiquid Asset Survey. As well as increased usage and demand for illiquids, insurers continue to adapt their approach for Solvency UK reform and embedding the approach for sustainable investments.

Introduction

Across the bulk purchase annuity (BPA) insurance sector in the UK, usage of illiquid assets continues to develop, supporting the increased premium volumes which the sector is seeing. Illiquid assets remain a particular focus of the Solvency UK reforms, with Lisa Leaman of the PRA recently noting that internally rated assets now provide more matching adjustment (MA) benefit than externally rated assets.¹

We recently conducted Milliman’s 2024 Illiquid Asset Survey. This was a private and industry-wide survey regarding insurers’ market practice for investing in illiquid asset classes. The survey is carried out on an annual basis, with this being our third survey on the topic.

All of the survey participants were UK BPA insurers and in aggregate gave a broad market coverage. The survey also enabled us to explore the degree of consensus on several key topics. In the rest of this note, we summarise some of the key observations from our 2024 Illiquid Asset Survey.

Key observations

The survey focused on three areas of particular interest: namely, approaches to illiquid asset allocation and origination, the impact of Solvency UK reform and sustainable investing. We also extended beyond illiquid assets and covered how firms manage short-term and long-term liquidity, given the current importance of this for BPA insurers.

Illiquid assets allocation and origination

• Asset types: Similarly to our finding in last year’s survey, while asset mixes varied considerably between participants, the overall picture continues to be of a relatively stable core group of asset types held broadly across the range of insurers. Moving into new asset classes is limited and focused on commercial ground rents and infrastructure debt (construction phase). Some insurers invest in USD- or EUR-denominated assets for certain illiquid classes.
• Allocation to illiquid assets: Most participants aim to increase overall illiquid asset exposure via a higher target allocation on new business, with this target being similar across the survey participants. Different approaches are used to set the upper bound for the proportion of illiquid assets, including benchmarking and forward projection. Different constraints bite for different firms.
• Rationale to invest: Unsurprisingly, improving the risk-adjusted investment yield is the most important investment driver for all survey participants, followed by improved portfolio diversification and better duration matching. Compared to our 2023 survey, using illiquid assets to improve inflation matching has become more important.
• Origination: Firms use a mixture of in-house, partial in-house or fully outsourced approaches to originate illiquid assets.
• Asset constraints: Some firms believe that there are asset constraints on meeting their target allocation to illiquids, primarily from an insufficient supply of attractive MA-approved and GBP-denominated illiquid assets.
• Additional execution spread: Firms do require additional yield or execution spread on illiquid assets compared to a similar externally rated asset. For shorter duration assets the required spread falls in a quite narrow range, but this range appears wider at longer durations.
• Assessment metrics: Survey participants use multiple metrics to assess the efficiency, value or relative economic attractiveness of different fixed-income assets. The most common metric is MA spread less SCR spread cost (that is, the cost of locking in the additional SCR).

Impact of Solvency UK reform

• Reform of the MA - CP19/23: Overall, insurers consider the MA proposals in CP19/23 to have a neutral or moderately beneficial impact for illiquid assets. However, some firms consider that there could be a modest detriment to the overall size of MA.
• MA application changes: One respondent is expecting to update their MA application, with the other respondents uncertain whether this would have to be done. One factor driving this would be the intention or not of using assets with highly predictable cash flows. Firms may be waiting to understand the final details, including the process for revising the MA application, before reaching a conclusion.
• Impact of highly predictable cash-flow assets: The proposals may enable firms to invest in additional asset types that either include prepayment terms or have pre-construction and construction phases.
• Removal of MA cap on sub-investment grade (SIG) assets: The removal of the MA cap on SIG assets will likely lead to some increase in the resulting SIG assets held, primarily from increased retention of downgraded assets. It will be interesting to see what levels of MA and fundamental spread are assigned to SIG assets.
• Funded reinsurance - CP24/23: If the proposals in CP24/23 are implemented, this is not expected to result in much change to the asset range or asset mix limits applied to illiquids in the collateral policy compared to directly held illiquids.

The details of the matching adjustment changes will be settled when the resulting policy statement is issued by the PRA, expected in June, though of course the impacts and resulting practice will emerge over time.

Sustainable investing

• Sectors: For most of the firms surveyed, investment-grade (IG) debt is, or will soon be, held across a wide range of sustainable illiquid investments—including renewable energy, non-energy climate, social housing, social infrastructure and other infrastructure.
• Investment capability: Most of the firms surveyed have the full capabilities needed to invest across a wide range of sustainable IG debt. Social housing is the class where all firms had capability.
• Allowance for ESG risks and impacts: All firms consider ESG risks and impacts when determining whether to invest, particularly regarding climate factors. However, there are a wide range of approaches, reflecting levels of embedding at the different firms.
• Risk thresholds and returns assessment: There is a wide variation in how ESG risks are considered for individual assets, ranging from all new investments having to meet certain thresholds through to actively seeking assets with positive ESG impacts in some areas. When considering the required returns on an asset, some firms make allowance for the risk and return benefits on assets with better ESG criteria.

Managing short-term and long-term liquidity

• Short-term liquidity assessment: Not surprisingly, firms assess liquidity over multiple periods, generally from one day to one year. However, there is a variation in the number of periods used between survey participants.
• Collateral: The proportion of posted collateral that is cash or gilts does vary between the firms. The responses indicate that participants have in place 'dirty' CSAs (the credit supported annex allows corporate bonds to be posted as collateral), but the relative proportion of these varies significantly.
• Illiquid assets and use of derivatives: Overall, the inclusion of illiquid assets has had a limited impact on the use of derivatives or the complexity of managing and monitoring collateral. Some participants indicated no change while others indicated some increase in the use of interest rate and foreign exchange derivatives and a modest decrease in the use of inflation derivatives.
• Managing and monitoring collateral: Overall, most firms have faced an increase in the complexity of managing and monitoring collateral, reflecting BPA business volume and more complex hedging and reinsurance strategies.
• Currency hedging and liquidity risk: We asked whether firms made an allowance for the cost of liquidity on assets requiring a currency hedge. The responses varied, depending on the overall level of liquidity of the firm.

Conclusion

BPA writers continue to invest an increasing proportion into illiquid assets, primarily to achieve a greater expected risk-adjusted yield.

The proposed MA reforms are expected to be of neutral or moderately beneficial impact, although the overall MA may reduce, and it is possible that insurers will want to update their MA applications.

There is quite a wide variety between firms in their approaches to sustainable investing, although most invest in a wide range of sustainable debt.

Short-term liquidity is assessed across multiple time periods and firms are using dirty CSAs to manage collateral, though the proportion used varies.

All the areas covered in the survey questions are undoubtedly of strategic importance, and this year the industry will see other areas in the spotlight, such as Funded Reinsurance and Life Insurance Stress Test 2025 guidelines, expected to be published later in the year.

How Milliman can help

As the illiquid investment market continues to grow in scale and importance as a driver behind new business pricing, insurers must continue to develop their capability and frameworks for originating and managing these assets.

Milliman consultants have extensive market experience in these areas and we are well placed to help our clients address a broad range of questions and challenges, for example:

• Developing asset allocation strategies and investment risk management frameworks for illiquid assets
• Independently reviewing market risk and liquidity risk management frameworks
• Independently reviewing credit quality assessment frameworks and their application
• Sustainable investment frameworks and implementation
• The potential treatment of novel assets within internal models and Standard Formula frameworks
• Modelling illiquid assets using stochastic techniques, including real-world stochastic investment return scenarios

To discuss this note or any related topics, please contact your usual Milliman consultants or the paper authors.

¹ Lisa Leaman, Head of Division Insurance Supervision (April 2024). What's next? Bulk annuity insurers — Regulatory developments. https://www.bankofengland.co.uk/speech/2024/april/lisa-leaman-speech-21st-conference-on-bulk-annuities.