Navigating the Risks of Illiquid Assets in a Shifting Market

For a sustainable life insurance business model, creating the right asset mix is equally important to the managing of insurance commitments. While the assets held are intended to be chosen in the best interest of all stakeholders, the evolving macroeconomic landscape and shifting investment strategies continue to pose significant challenges. In recent years allocations to illiquid assets have increased - particularly private loans – raising new concerns. Do these investments provide sustainable excess returns while enhancing portfolio diversification as a prudent strategy, or do they introduce unnecessary risks?

Over the past decades, private investments have gained traction as insurers sought higher yields in a persistently low-interest rate environment. These allocations were often justified by the promise of stable returns, enhanced portfolio diversification, and better asset-liability matching (ALM) in line with the insurer’s risk profile having long term liabilities. However, with changing macroeconomic conditions and interest rate hikes, these strategies that strengthened insurers' portfolios could now become sources of concern. A substantial increase in exposure to illiquid assets can create systemic vulnerabilities. Should interest rates rise sharply, the business models built on such floating rate loans may lose their appeal, leaving insurers exposed to adverse market shifts.

The valuation of illiquid assets, particularly private loans, is highly dependent on internal expertise, models, and judgment. Unlike listed securities, these assets lack readily available market prices, making their assessment subjective and reliant on approximations and benchmarks. This inherent uncertainty presents risks that insurers must carefully manage.

First, the consequences of inadequate valuation can be significant, especially when these assets are managed by external parties who may have incentives to target the higher end of the valuation uncertainty range. Overstating asset quality may lead to misaligned capital reserves, while underestimating risk could result in financial instability when unexpected market conditions arise. Moreover, valuations of illiquid assets often lag behind, sometimes by a month or even a quarter. Beyond the operational challenges this creates in reporting, such delays can significantly impact risk management, as substantial shifts in value may not be immediately apparent. Strong internal governance, well-calibrated valuation models, and experienced professionals are crucial to ensuring that insurers remain in control of their portfolios.

Secondly, from a regulatory standpoint, the Standard Formula under Solvency II currently categorizes private loans within spread risk. While this approach provides a standardized measure of capital requirements, it may not fully capture the nuances of these investments. Insurers using internal models have an opportunity to refine their valuation methods, potentially leading to a more accurate reflection of the risk exposure. However, this also introduces additional scrutiny and dialogue with regulators, particularly regarding the assumptions embedded in the models.

Finally, when introducing further illiquidity in the balance sheet, liquidity risk requires care and attention, also considering potential regulatory implications. While liquidity risk is addressed under Pillar 2, it currently does not carry any capital requirements.  The EU agency that supervises the insurance and occupational pensions sectors (hereinafter: EIOPA) has recently introduced a set of Regulatory Technical Standards (RTS) on liquidity risk management plans, developed as part of the Solvency II 2020 review. This aims to standardize and strengthen how insurers manage and report on liquidity risk. The consultation on the RTS closed in January 2025, and the final standards are expected to be adopted and implemented  in the near future. The RTS define which insurance and reinsurance undertakings and groups must include medium-term and long-term liquidity analyses in their plans, with the goal to enhance comparability and supervisory convergence across the EU. The criteria are designed to ensure that entities with more complex or risk-prone profiles are subject to more detailed planning requirements, including identification of liquidity sources and uses, stress testing under adverse scenarios, contingency funding plans and governance and escalation procedures.

For life insurers, the growing exposure to illiquid assets represents both promise and peril. While private loans and other alternative investments can enhance portfolio returns and offer diversification, they also introduce complexities in valuation, capital requirements, liquidity management, and regulatory scrutiny. This presents two distinct risks that require careful management:

First, there is a risk in the business model itself, particularly in a rising interest rate environment. The widespread adoption of private investments was largely driven by a prolonged era of low interest rates, where floating rate loans provided reliable returns. However, as rates rise, the fundamental dynamics supporting these investments could shift unfavorably. History has shown that a sudden influx into specific asset classes can trigger systemic vulnerabilities, leading to sharp corrections when market conditions turn. If insurers fail to reassess their strategies in light of changing macroeconomic trends, they risk being caught in an asset bubble that could disrupt balance sheet stability. This challenge is further compounded by exit risk, as illiquid assets are often difficult to sell quickly without incurring substantial losses. In times of market stress, insurers may struggle to unwind their positions, exacerbating financial instability and limiting their ability to react effectively to valuation shifts. Without proactive risk management and strategic portfolio adjustments, these factors can severely impact an insurer’s resilience.

Second, a valuation risk stems from the inherent uncertainty in pricing these assets. Unlike publicly traded securities, illiquid investments lack transparent market pricing, making their valuation highly dependent on internal models, assumptions, and expertise. The subjectivity involved in these assessments can lead to significant discrepancies, increasing the risk of misaligned capital reserves and regulatory scrutiny. Without strong in-house capabilities, insurers may struggle to accurately gauge their exposure, potentially leading to financial instability during periods of stress.

The challenge lies not in avoiding illiquid assets altogether, but in integrating them prudently within a well-calibrated investment strategy. Navigating this landscape requires more than traditional risk assessments - it demands deeper in-house expertise, stronger internal governance, and proactive engagement with regulators. With interest rates shifting and market dynamics evolving, insurers must remain agile, ensuring that their capital buffers and asset liability management strategies are robust enough to withstand stress scenarios.

Ultimately, illiquid assets are neither inherently risky nor unequivocally beneficial. Their role in a life insurer’s balance sheet depends on the firm’s ability to strike the right balance - leveraging opportunities while maintaining financial resilience. As market conditions continue to transform, the dialogue on these investments will remain central to industry discussions, shaping the future of risk management and regulatory frameworks.

If you would like to engage in a discussion about the implications of macroeconomic shifts, asset liability challenges, or the intricacies of valuation and regulatory considerations, do not hesitate to contact us.