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Direct lending and alternatives: the future of investment?

European insurers' investment portfolios will become more diversified in the coming months, as low returns and non-investment profits come under pressure, according to AM Best.

A report released on 29 July predicted that insurers would increase their allocations to alternative investments - including private equity, real assets and direct lending - in the coming months, as the impact of Solvency II's regulations comes to fruition.

Despite its relatively penal capital treatment under Solvency II as the rules stand today, AM Best felt direct lending would become more attractive as the European regulators come under pressure to make allowances for certain types of infrastructure assets.

Allianz and UK life and pensions insurer Legal & General (L&G) have already made progress in building significant direct lending and real asset portfolios.

In February 2015, Allianz reported real asset financing totalling some EUR110bn at year-end 2014, up by EUR30bn on a year earlier.

L&G built its portfolio in part through developing a strategic partnership with Pemberton Asset Management Holdings, a mid-market lending manager in which it holds a 40 percent interest.

The firm reported direct investments totalling £5.7bn at year-end 2014, an increase of 98 percent over the year.

So should chief investment officers at non-life carriers reconsider direct lending as part of their portfolios?

"There's enormous interest from the P&C industry and a number of the larger participants are working on direct lending strategies," said Gareth Haslip, global head of strategy and analytics at JP Morgan Asset Management.

"Within Lloyd's there is interest, but there are more constraints. The trust fund rules and the funds at Lloyd's rules mean you have to work to find where the best place is to hold these sorts of funds in the portfolio."

Solvency II actually makes it easier to invest in direct lending too, he continued. Under UK regulator the Prudential Regulation Authority's guidance, non-UCITS funds are often limited to 1 percent of the overall portfolio, but under Solvency II that requirement is replaced by the prudent person principle, meaning there's more scope for Lloyd's insurers to move into direct lending from 2016.

There are dangers to be aware of, however.

"With direct lending for insurers you need two sorts of expertise; there's the expertise in the asset class itself (and related areas such as trade finance, auxiliary debt etc.) and the expertise to know how to structure the investment to ensure that it is efficient from a regulatory capital perspective," said Simon Richards, head of insurance solutions at Insight Investment.

Being aware of the regulations is key, he added, because of the risk of developing an apparently attractive investment that structurally doesn't work for an insurance company.

"If you were, for example, to structure one of these deals inappropriately you could end up having to treat it as a securitisation, which would be very unattractive. There are some approaches which provide appropriate collateral to mitigate the counterparty risk, but if it does not meet the exact requirements of Solvency II, the insurer will not get that preferential treatment."

Other alternatives could start to appear on the radar too. Stephen Oxley, managing director at Paamco, said that Solvency II presented European insurers with the opportunity reconsider hedge funds if they're transparent enough to satisfy the regulator's demands.

"Because of the way we manage money there are ways for insurers to increase their holdings in hedge funds. We manage all our assets through managed accounts, which gives us transparency to the underlying positions, and that transparency can be aggregated and passed on to the client so they can build that into their internal models," he explained.

"Where hedge funds are treated as other equities with a high capital charge, if you can look through to the underlying holdings a multi-manager hedge fund portfolio consists of equities, credit, bonds and other instruments, and by breaking it down, we estimate you can typically reduce the Solvency II capital charge by about half."

Equities are also garnering more interest than before, with high dividend yielding stocks becoming more popular with insurers on both sides of the Atlantic, according to Payden & Rygel.

The firm's managing principal Jim Sarni noted that as the world enters a rising rates environment, assets such as high dividend yielding equities, preferred stocks and master limited partnerships were gaining more attention.

"While in general the equity markets could be described as overheating, these income-focused stocks are performing quite well in this volatile market," he said.

He also predicted that as a result of the Volcker Rule and Dodd-Frank in the US, we could see more direct trading, given that the traditional broker dealer role has been put under pressure from the advance of electronic trading and platforms.

"That is the future of this market - less reliance on broker dealers and more direct trading - we are the liquidity now - mutual funds, exchange-traded funds, that's where the biggest holders are now."

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