UK insurers’ uptake of CFOs will take time

UK solvency II reforms are unlikely to trigger an evolution in insurers’ investment approaches, experts have said.

In June 2024, the Prudential Regulation Authority (PRA) implemented a new matching adjustment mechanism (under UK Solvency II), which reduces insurers’ capital requirements for investing in longer-term, illiquid assets as long as they can demonstrate “highly predictable” cashflows.

Some industry onlookers expected that this would trigger increased investment in structured assets such as collateralised fund obligations (CFOs) – a type of securitisation that is backed by alternative investments, such as private equity, hedge funds, and real estate funds – without facing disproportionate capital penalties.

However, it appears that this has not materialised yet.

“We have not observed a notable increase in exposure to structured assets, such as CFOs,” said Rishi Sivakumar, a director in the insurance team at Fitch Ratings. He expects progress to be gradual as, so far, only a limited set of new asset types has been put forward.

Robert Cannon, partner in the capital markets group of law firm Cadwalader, agrees. He considers the changes introduced by the UK regulator as “more of an evolution than a revolution”, with material impacts only to become visible “over the next several years”.

There are some constraints that will prevent a speedy uptake of CFOs by insurers.

Cannon notes the reforms primarily benefit life insurers with long term liabilities as matching adjustment is much less relevant for non-life insurers, who typically have much shorter-term liabilities.

He also emphasises that it will take time for insurers to become familiar with determining the overall risk capital charge for such assets and weighing it against the increased yield of these assets.

While UK life insurers are exploring ways to use the additional flexibility under the new matching adjustment mechanism, “we do not anticipate firms materially changing their investment risk profiles,” said Fitch’s Sivakumar.

When UK insurers do consider CFOs, he expects them to focus on the most highly-rated tranches and, where necessary, to structure them to deliver highly predictable cash flows as is required under the new rules. Consequently, shorter-dated, lower-rated, or cashflow-uncertain CFO tranches are unlikely to be favoured by insurers.

To achieve higher predictable cash flows, CFOs are being redrawn to make them more attractive to UK insurers. According to Cannon, common features include extended maturities and fixed repayment schedules, longer reinvestment periods, stronger reserve funds and liquidity facilities, as well as the incorporation of stable asset buckets.

Despite the challenges, some asset managers offering CFO vehicles are already making inroads with insurers. Churchill Asset Management said its recent $750m (£579.4m) CFO, focused on a range of US and European private capital strategies, was particularly well-received by insurance investors.

“We believe the structure’s long duration strongly resonated with insurers and other investors focused on long duration investment grade rated debt, especially as they look to capture attractive yield enhancement,” the firm said.