INVESTMENT FUNDS: Funds investments. KPMG Business DialogueS November 4 th 2011

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1 INVESTMENT FUNDS: Impact of Solvency II Directive on Funds investments KPMG Business DialogueS November 4 th 2011

2 Map of the presentation Introduction The first consequences for asset managers and investors The risk modules structure The market risk How will the funds be treated in the market risk? Example of actuarial calculation Q&A

3 Introduction: What is Solvency 2? - Solvency 2 is the European regulation for insurance, reinsurance and captive firms - It is based on economic principles for the measurement of the assets and liabilities. - Contrary to Solvency 1, Solvency 2 a risk-based system. Capital requirements will depend on risk modules which includes the market risk. - Like Basel 2, it is structured in 3 Pillars: Pillar 1 Quantitative capital requirements Three-pillar approach Pillar 2 Qualitative supervisory review Pillar 3 Market discipline Market-consistent valuation Own funds Economic risk based capital requirements MCR = VaR 85% ( NAV) SCR = VR VaR 99.5% ( NAV) Internal control and risk management Required functions Own risk and solvency assessment (ORSA) Supervisory review Capital add-ons Transparency Disclosure Solvency and financial condition report (SFCR) Solo Group Groups

4 Introduction: Solvency -1 balance sheet / The lack of risk management Excess of capital ASSETS In book value Solvency Margin Required (SMR) Technical Provisions Capital In non-life: SMR In life: Max ( 18 %. P M 16 %. P 50 M ;26 %. P 35 M 23 %. P 35 SMR 4%. P 2%. Riskycapit 50 M al ) NO RISK MANAGEMENT The type of investments had NO impact on the solvency margin Solvency 2 reforms this approach

5 The first consequences for asset managers and investors - Under Solvency II, the type of investments will be taken into account - Some investments may be preferred comparing to others which are too capital consuming - Solvency II enters in force in January 2014, but the regulation must be implemented in January The calculation of the Solvency Capital Requirement (SCR) will have to be done by the actuaries of the companies on a quarterly basis. To do so, the investors will have to provide updated data every quarter (amounts of stocks, bonds, property etc ) - The European regulator (EIOPA) and the insurers calibrated the calculation of the SCR in 5 Quantitative Impact Surveys - From QIS4 to QIS5, the treatment of funds in the market risk calculation has changed. It will lead to negative consequences for the insurers in terms of capital consuming

6 The risk structure SCR Adj BSCR Operational Market Health Default Life Non-life Intangible

7 The risk structure SCR Adj BSCR Operational Market Health Default Life Non-life Intangible The risks are not summed! They are aggregated with specific matrix which h are provided d by the EIOPA

8 The risk structure: Focus on the market risk SCR Adj BSCR Operational Market Health Default Life Non-life Intangible Interest rate Equity Property Spread Concentration Illiquidity

9 The risk structure: Focus on the market risk SCR Adj BSCR Operational Market Health Default Life Non-life Intangible Interest rate Equity Property Spread Concentration Capital charge = Shocks on IR curves Capital charge = Shock on the MV of the stocks Capital charge = Shock on the MV of the properties Capital Charge = Shock on the bonds spread depending of the rating Capital charge = Shock on the amounts invested in currencies Illiquidity Capital Charge = Shock on the illiquidity premium added to discount liabilities Cash Flows

10 The risk structure: Focus on the market risk SCR Adj BSCR Operational Market Health Df Default Life Non life Intangible Interest rate Equity Capital charge = 100 Capital charge = 100 Market Risk = 600 Property Capital charge = 100 Spread Capital charge = 100 Concentration Capital charge = 100 The market risk will aggregate those amounts with a correlation matrix and a root square. The result will ALWAYS be lower than the sum Illiquidity Capital charge = 100

11 The market risk: what will be the impacts on the assets from the insurer side? Interest rate Up and down shocks by duration specified (max +70%, -75%)

12 The market risk: what will be the impacts on the assets from the insurer side? Interest rate Up and down shocks by duration specified (max +70%, -75%) Equity Global equities: -39% (listed in regular markets in the countries which are members of EEA or OECD) Other equities: -49% (listed only in emerging markets, non listed equity, hedge funds) Participations : 0% for participations in Financial institutions, -22% otherwise

13 The market risk: what will be the impacts on the assets from the insurer side? Interest rate Up and down shocks by duration specified (max +70%, -75%) Equity Global equities: -39% (listed in regular markets in the countries which are members of EEA or OECD) Other equities: -49% (listed only in emerging markets, non listed equity, hedge funds) Participations : 0% for participations in Financial institutions, -22% otherwise Property 25% fall (no differentiation between City and non-city properties). If the investment is not leveraged (otherwise, must be considered as equity)

14 The market risk: what will be the impacts on the assets from the insurer side? Interest rate Up and down shocks by duration specified (max +70%, -75%) Equity Global equities: -39% (listed in regular markets in the countries which are members of EEA or OECD) Other equities: -49% (listed only in emerging markets, non listed equity, hedge funds) Participations : 0% for participations in Financial institutions, -22% otherwise Property 25% fall (no differentiation between City and non-city properties). If the investment is not leveraged (otherwise, must be considered as equity) Currency 25% change versus reporting currency

15 The market risk: what will be the impacts on the assets from the insurer side? Interest rate Up and down shocks by duration specified (max +70%, -75%) Equity Global equities: -39% (listed in regular markets in the countries which are members of EEA or OECD) Other equities: -49% (listed only in emerging markets, non listed equity, hedge funds) Participations : 0% for participations in Financial institutions, -22% otherwise Property 25% fall (no differentiation between City and non-city properties). If the investment is not leveraged (otherwise, must be considered as equity) Currency 25% change versus reporting currency Illiquidity New to QIS5 : impact of 65% on the illiquidity premium

16 The market risk: How will the funds be treated? To estimate the impact of Solvency 2 in a fund, their economic substance must be examined: If it is possible, this should be achieved applying the Look Thru approach Otherwise, the reference should be made to the investment mandate of the scheme. Last choice: we consider the fund as an equity investment and apply global equity stress. Fund Look thru approach Mandate based Equity like

17 The market risk: How will the funds be treated? investment Leverage Real Estate Funds Look Through approach Mandate based Equity like Investment: Land, building, participation in real estate companies generating periodic incomes, property investment for the own use of the insurance undertaking... Mkt prop =Max(0; NAV shock = 25%) Leverage : Investment in a company which took out loans from non insurance enterprises in order to leverage its property investments. Such investment is considered as equity. Mkt = Max(0 ; NAV shock = 39% or 49% if the equity is whether in the OECD or in the Emerging Markets)

18 Example of actuarial calculation: We consider a fund with a global market value of 6 M EUR (including 4 M EUR in OECD countries and 2 M EUR in Emerging Markets). We suppose 3 cases. From the insurer side, they lead to different capital charges for the market risk. CASE 1 : We know the economic substance (stocks, bonds, real estate) and we can look thru. In this example we suppose that the fund is not leveraged CASE 2 : Same case, but the fun is leveraged CASE 3 : We suppose that we cannot look thru: we choose the Equity like approach

19 Example of actuarial calculation: The look thru approach We consider the following investment in a fund (unleveraged) for which the Look Thru Approach is possible (The amounts in bold are converted from other currencies than EUR) STOCKS BONDS REAL ESTATE 1 M EUR in OECD countries 1 M EUR outside OECD Capital charge for: 1 M EUR in OECD government bonds 1 M EUR in corporate bonds : - AAA 600 k EUR - AA 100 k EUR - A.300 k EUR 1 M EUR in properties in OECD 1 M EUR in properties outside OECD Interest rate Equity Property Spread Concentrati ti Currency on Illiquidity??????

20 Example of actuarial calculation Case 1 : The real estate is not leveraged STOCKS BONDS REAL ESTATE 1 M EUR in OECD countries 1 M EUR outside OECD Capital charge for: Interest rate Equity Property Spread Currency 1 M EUR in OECD government bonds 1 M EUR in corporate bonds : AAA 600 k EUR AA 100 k EUR A 300 k EUR 1 M EUR in properties in OECD 1 M EUR in properties outside OECD Illiquidity

21 Example of actuarial calculation Case 2: The real estate is leveraged STOCKS BONDS REAL ESTATE 1 M EUR in OECD countries 1 M EUR outside OECD Capital charge for: Interest rate Equity Property Spread Currency 1 M EUR in OECD government bonds 1 M EUR in corporate bonds : AAA 600 k EUR AA 100 k EUR A 300 k EUR 1 M EUR in properties in OECD 1 M EUR in properties outside OECD Illiquidity

22 Example of actuarial calculation : Example on Excel sheet CASE 1: Isreal estate investment leveraged? NO Capital charge for the risks: Interest rates Equity Property Market risk / capital charge Spread Currency Illiquidity premium CASE 2: Is real estate investment leveraged? Capital charge for the risks: YES Interest rates Equity Property 0 Market risk / capital charge Spread Currency Illiquidity premium

23 Example of actuarial calculation Case 3: We assume that the «Look Thru Approach» is impossible. If the Equity like approach is chosen, we consider the global fund as equity investment. t In our case, OECD Equity represents 4 M EUR and non OECD Equity represents 2 M EUR The application of the impacts gives us a capital charge of 2,54 M EUR The possibility to look thru becomes essential for the insurers (the incapacity to do so will be synonym of penalty). The asset managers will be required to provide accurate data to the insurers to allow the actuaries to make the capital charge calculations.

24 KPMG Financial Risk Management and Actuaries Dr. Sven Mühlenbrock Director KPMG Luxembourg S.a.r.l. Financial Risk Management and Actuaries Phone Mobile Fax Mr. Bertrand Segui Senior Adviser, Actuary KPMG Luxembourg S.a.r.l. Financial Risk Management and Actuaries Phone Mobile Fax

25 Presentation by Bertrand SEGUI

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