Solvency II In: Risky Assets Out?

Transcription

1 October 2014 Solvency II In: Risky Assets Out? Efficient Asset Management under the Solvency II Framework Jérôme Malaise * Koris International *Institutional Client Solutions at Koris International. jerome.malaise@koris-intl.com; Address: Koris International, 46 New Broad Street, London EC2M 1JH, United Kingdom.

2 Abstract The Solvency II Directive forthcoming implementation 1 January 2016 poses serious challenges to insurance companies despite a laudable objective of ensuring financial stability in the sector. This article first establishes a picture of insurers readiness to implement the Directive and recalls the capital requirements included in the Pillar I. We then investigate the Solvency Capital Requirement (SCR) market risk module and emphasise on the resulting asset allocation conundrum faced by insurance companies. Given the burdensome cost of investing in risky assets, some institutions have decided to cut their equity and alternatives holdings. As insurance firms need to both generate returns (at least) matching the liability discount rate and diminish their SCR, we review the potential capital reliefs offered by hedging risky exposures via derivatives. Finally, we discuss how dynamic asset allocation strategies supplemented with a formal risk transfer can provide an option for insurers to access to capital intensive assets while benefiting from a much reduced SCR. 1

3 1 January 2016: The Solvency II Directive 2009/138/EC application date is definitive and this time it will not be postponed 1. Commissioner Michel Barnier official announcement last October 2013 sounded the death knell of Solvency II sceptic hopes 2. The countdown has started, ready? The fast approaching deadline leaves European insurance firms little time to comply with the Solvency II regulatory requirements. According to Ernst & Young European Solvency ll Survey 2014 they were almost 80% to expect fully addressing all requirements by then though their readiness greatly differ by country 3. British, Dutch and Nordic country insurance companies are quite confident in their ability to meet the targets while their counterparts from France, Germany and Eastern Europe are much less. Among the three Solvency II pillars, insurers level of preparedness is also heterogeneous. They mostly feel ready to implement all components of Pillar 1 (quantitative capital requirements) and most of Pillar 2 (risk assessment and control) but express serious concerns over Pillar 3 (transparency and disclosure requirements). The first pillar, which comprises the Minimum Capital Requirement (MCR) and the Solvency Capital Requirement (SCR), is at the heart of this discussion. As a reminder, an insurance firm can determine its SCR either by using the standard formula or developing an internal model. The latter can be further separated in two categories: full model (all risk categories are quantified using the internal model) and partial model (one or more modules of the SCR use the standard formula). Adopting an internal model only makes sense for an organisation should it believe the resulting capital charges would be significantly diminished with regards to the standard model. Moreover, it remains very costly to run an internal model hence only an available option for sizeable players. 2

4 Efficient asset allocation conundrum The SCR market risk module imposes capital charges on financial assets held by insurance companies based on their riskiness. Consequently, most insurers have started to adjust the risk profile of their investment portfolios in order to align it with their current reserves. Given the burdensome cost of investing in risky assets, some institutions have decided to cut their equity and alternatives holdings. Solvency II capital standards favour European government bonds and low-duration corporate debt. Conversely, insurers invested in long-duration corporate bonds, unhedged equities and alternatives (structured credit, private equity etc.) have to put aside large amounts of capital. Holding European sovereign bonds is free of any capital charges while Global Equities (OECD listed shares) bear a 39% SCR and Other Equities (emerging market shares and alternatives) face a 49% SCR, excluding strategic participations. Unfortunately, most insurance companies must not only invest in cash related assets, sovereign bonds and low-duration corporate debt to meet their obligations to policyholders. Generating returns at least matching the liability discount rate in a rock-bottom yield environment, and under the Solvency II capital adequacy rules, requires CIOs optimising the asset side of their organisations balance sheets. Solvency II rewards institutions for diversifying the risk of their financial assets. As insurers reassess their asset allocation, identifying investment opportunities that generate adequate returns and reduce global capital requirements through efficient diversification must be their first priority. To this end, (re)allocation to capital-intensive asset classes such as equity or infrastructure has to improve the overall portfolio s return on SCR ratio. Derivatives to limit capital requirements How can insurance companies diminish their capital charges? Reaching this desirable outcome implies working on the asset side and / or liability side of the balance sheet. Leaving apart the 3

5 latter, institutions aiming at reducing the capital requirements incurred by their investment portfolios have two main options available: increasing their allocation to SCR favoured asset classes or hedging their investments in capital intensive assets. As discussed before, the Solvency II Directive gives a clear advantage to sovereign and, to a lesser extent, corporate debts (excluding structured credit) at the expense of equity and alternatives. Allocating to fixed income is vital for insurance firms owing to their specific business nature. Obviously, companies with short duration liabilities (e.g. health or P&C) have a stronger need to invest in such securities than those underwriting long duration contracts (e.g. life or annuity). However, significantly increasing allocation to Solvency favoured fixed-income while unloading risky assets could be detrimental for insurers: forthcoming interest rate rises would have far from negligible effects on the mark-to-market left side of their balance sheets, hence on pay-out promises to policy holders. Hopefully, investing in risky assets under Solvency II capital based rules is far from being an unrealisable wish. Using derivatives, instruments that have long been adopted by the insurance sector, leads to some potential answers. Indeed, the Directive recognises the potential role of derivatives as risk-mitigation instruments provided that they do not yield a material basis risk or induce any leverage. To this end, an insurance company seeking to hedge the tail risk of its equity portfolio with swaps or futures, for instance, would then benefit from lowered capital requirements. The regulator stance on hedging strategies employing derivatives nevertheless does not mean insurers should blindly mitigate the drawdown risk of their risky assets portfolio with such instruments. Instead, institutions should carefully weigh the potential advantages of using derivatives (i.e. capital reliefs on risky asset holdings) with the induced costs (fees and the addition of a counterparty risk). Enhancing the return on SCR with innovative strategies Controlling the drawdown and tail risks of a portfolio has gained considerable popularity among the investment industry lately. Disenchanted investors no longer want to suffer substantial losses 4

6 such as those experienced in 2008 and are increasingly looking at dynamic risk control strategies. In this regard, portfolio insurance techniques that appeared in the end of the eighties have intended to meet those needs 4 5. Obviously, some in the financial community have significantly improved the initial output of such systematic investment programs since then. One of the main drawbacks that has been addressed is the multiplier, which is fixed in the first portfolio insurance methods drafted. According to the available risk budget (NAV - Floor), it defines how much will be allocated to risky assets should a rebalancing be triggered. The lasted Dynamic Core-Satellite (DCS) innovation developed by Koris International (Mantilla-Garcia, 2014) extending the Dynamic Core-Satellite (Amenc, Malaise, and Martellini, 2004) and TPPI (Hamidi, Maillet and Prigent, 2008) approaches has enabled to calibrate a time-varying multiplier based on the Expected Shortfall (C-VaR) of the portfolio s underlying risky assets, further completed with market stress indicators DCS strategies aim at generating asymmetric payoffs by maximising the participation to the upside of risky assets (e.g. equity) while cutting the fat tails on the left end of the return distribution. Unfortunately, even though such an approach consists in a dynamic hedging strategy, this is not considered as a valid risk mitigation technique under the Solvency II standard formula. Assuming a DCS portfolio can theoretically allocate up to 100% emerging market equities, the SCR attributed would then be the worst: that of other equities. With a view to tackling this issue, DCS solutions supplemented with a put option whose cost fluctuates daily depending on the actual asset exposure of the underlying portfolio have been engineered. As the hedging strategy becomes formally compliant with the Pillars I and II thanks to the formal risk transfer, it leads to a substantial cut in capital requirements. Also, the insurance cost is optimal in comparison with a static put option that would not be re-priced according to the portfolio s allocation shifts. Finally, what investors would be most interested in is the optimised return on SCR ratio yielded (dynamic access to diverse risk premia within a formal protection framework). 5

7 References 1 Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II). 2 Directive 2013/58/EU of the European Parliament and of the Council of 11 December 2013 amending Directive 2009/138/EC (Solvency II) as regards the date for its transposition and the date of its application, and the date of repeal of certain Directives (Solvency I). 3 European Solvency II Survey Ernst & Young. 4 Perold, A. (1986). Constant proportion portfolio insurance. Technical report, Harvard Business School. 5 Estep, T. and M. Kritzman (1988). TIPP: Insurance without complexity. The Journal of Portfolio Management 14 (4), Mantilla-Garcia, D. (2014). Dynamic Allocation Strategies for Absolute and Relative Loss Control. Working Paper, EDHEC Risk and Asset Management Research Center. 7 Amenc, N., P. Malaise, and L. Martellini (2004). Revisiting core-satellite investing: a dynamic model of relative risk management. Journal of Portfolio Management 31 (1), Hamidi, B., B. Maillet, and J.-L. Prigent (2008). A Time-varying Proportion Portfolio Insurance Strategy based on a CAViaR Approach. Working paper, University of Cergy-THEMA. 6