Insurance
Income strips for insurers: A natural fit?
3 min read 27 Feb 24
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With many UK defined-benefit pension schemes considering de-risking options in the wake of higher interest rates, their appetite for private assets, such as income strips, has reduced thus leaving significant opportunities for other institutional investors. Given their high quality and inflation-linked nature, income strips have always been a popular asset class with insurers but current market dynamics make the opportunity particularly attractive, in our opinion. Here, we explore how income strips – which are backed by prime real estate – could provide insurance companies access to an alternative source of credit risk and illiquidity premium, as well as the opportunity currently available.
What are income strips?
As the name suggests, these transactions ‘strip’ or separate the stream of cash generated by a lease from the underlying real estate asset. This means that the income stream an investor receives represents 100% of the value of the investment.
“Income strips could provide long-dated, investment grade, inflation-linked cashflows with an attractive yield, secured against business-critical UK real estate.”
In an income strip transaction, the owner sells the underlying real estate to the investor and enters into a lease agreement, with the option to buy the asset back for a nominal sum (e.g. £1) when the lease ends. This effectively means income strips have an amortising repayment profile of the underlying real estate where the remaining future cashflows are secured against the property.
For tenants, income strips offer the benefit of raising long-term affordable financing against their strategic real estate holdings, while retaining ownership of the freehold when the lease ends (so long as all lease payments are fulfilled).
For investors, income strips could provide long-dated (c.40 year), investment grade, inflation-linked cashflows with an attractive yield, secured against business-critical UK real estate. This investment profile can be attractive to different types of institutional clients such as pension funds and insurers seeking to generate long term inflation-linked cashflows.
Why are they suitable for insurers?
Given their long-dated, bond-like, inflation-linked cashflows, income strips seem a natural fit for Life insurers looking for suitable assets to match their longer-term liability cashflows. Traditionally, insurers have bought lower-yielding government bonds to match their long-term liabilities, whereas income strips offer the potential for a higher-yielding alternative with enhanced returns through not only a credit spread, but also an illiquidity premium.
Income strips are an ideal match for Life insurers’ core portfolios, in our view, but these assets could also be a good fit for the surplus non-core portfolios of both Life and General insurers. With more stable valuations than equivalently rated fixed income instruments, zero exposure to residual property values, and less volatility than other asset classes often seen in non-core portfolios such as equities, income strips offer good diversification within insurance portfolios. Their bond-like nature also minimises the red tape required to gain internal investment approval for the asset class and does not warrant significant Prudent Person Principle concerns – this means it is a simple asset class to allocate to from a Governance perspective.
Although longer-dated credit can lead to higher Solvency II Spread SCR charges under the Standard Formula, the pick-up in yield can compensate for the higher capital requirement which could lead to an attractive Return on Capital when compared to corporate bonds. On top of this, the RoC has the potential to be increased significantly given the underlying collateral (typically prime UK real estate) can be eligible for Solvency II regulatory capital relief, thus reducing the Spread SCR charge.
Why invest now?
Historically, UK defined-benefit pension schemes have been large investors in the asset class given their long-term liabilities. However, higher rates, fuelled by the September 2022 UK mini-budget, have boosted scheme funding levels leaving many schemes looking at options for de-risking over the next 5 years. More illiquid assets, such as income strips, are generally seen as less preferable in these de-risking programs meaning demand from DB schemes has slowed, with some schemes looking to exit otherwise sound positions.
This has created a unique opportunity for other institutional investors such as insurers to pick up these high-quality assets at a higher spread than previously available in this new interest rate environment.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.
