Solvency II is Causing a Paradigm Shift. Regulation

Transcription

1 Regulation Solvency II is Causing a Paradigm Shift Long-term institutional investors, such as insurance companies and pension vehicles, manage approximately EUR 7.7 trillion in assets in Europe 1. Their investment behaviour influences the capital markets quite substantially in some cases. It is therefore interesting to look at the interrelationship between the low interest environment and the planned Solvency II Directive. AUTHORS: DENNIS NACKEN & DR. CHRISTIAN SCHMITT 6

2 Solvency II Although the introduction of the new insurance supervision rules in Europe known as Solvency II has now been postponed from its original start date of 1 January 2014 to the beginning of 2016, it can be assumed that many larger insurance companies will continue their preparations for the start of Solvency II, and use the extra time for fine-tuning. In addition, the European Insurance and Occupational Pensions Authority (EIOPA) plans to introduce rules derived from Solvency II for institutions for occupational retirement provision (EbAV) as part of its HBS (Holistic Balance Sheet) approach. Although similarities to, and deviations from, Solvency II are still being discussed, and the rules governing the first (quantitative) pillar have been put on hold for the time being, the regulator still sees a need to ensure competitive parity over the long term among the various providers of occupational retirement provision in terms of solvency rules 2. As part of a holistic system, Solvency II aims to audit the overall solvency of an insurer. In particular, the newly planned solvency capital requirement (SCR), which must be sufficient in relation to eligible own funds, could sometimes influence the investment decisions of the cover pools of European insurance companies. As a result, the current investment policies will have to be supplemented to the extent that in future companies will need to support their investments with equity, the amount of which is determined according to the risk of each investment 3. [1] ECB, Euro area insurance corporation and pension fund statistics, December [2] The initial results of the Quantitative Impact Study (QIS) were published in April [3] Solvency II requires insurance companies to have sufficient funding so that they can withstand an extreme 200-year scenario (calculated using value-at-risk with a confidence level of 99.5% over a holding period of one year). 7

3 REGULATION As part of a holistic system, Solvency II aims to audit the overall solvency of an insurer policy. In an isolated consideration of asset classes (before diversification effects), government bonds of European Economic Area states are considered to be risk-free in the standard model of the Solvency II regulation, so that investments in these instruments have a 0 % equity backing requirement. By contrast, the ratio for equities in OECD countries is 39 %, and for emerging market equities it is even 49 %. The SCR for other high-risk asset classes such as commodities, infrastructure investments (equity), private equity and hedge funds is also 49 % 4. In the case of corporate bonds, risk factors graded according to the rating are multiplied by the average length of capital commitment (duration) 5. Generally the following applies: the worse the rating and the higher the duration of a bond, the more capital must be deposited. The ratios are lower for real estate investments (25 %) and infrastructure loans with 20-year duration and a good A-rating (15.5 %) than they are for equities. Investment behaviour is likely to change The aforementioned capital requirements of the draft Solvency II regulation could have both direct and indirect effects on the investment behaviour of the institutional investor groups affected. Under Solvency II, insurance companies will have to be even more concerned about the risk-return profile of their investments and duration management in future. The basic question will be whether the individual asset classes generate a sufficient expected return bearing in mind the specified capital requirements to cover the return requirements, in particular the guarantees issued, because equity is expensive and in short supply. In this respect, insurers will have to optimally distribute their solvency capital across the different risk classes. Using risklab s Economic Scenario Generator 6, we derived and compared the expected long-term returns with the solvency capital requirements for different asset classes (see Chart 01). [4] No diversification effects were taken into account in the consideration of the Solvency II capital requirements. [5] According to the Solvency II standard formula in QIS 5, EIOPA Technical Specifications for the Solvency II valuation and Solvency Capital Requirements calculations, Oct [6] The risklab Economic Scenario Generator produces consistent simulations and integrates scenarios for individual asset classes in terms of the relevant risk factors. The model is calibrated to current market conditions and long-term assumptions. The resulting scenarios can be used to derive risk and return figures for the asset classes. 8

4 01 LONG-TERM RETURN EXPECTATIONS AND SOLVENCY CAPITAL REQUIREMENTS IN COMPARISON OVER DIFFERENT ASSET CLASSES Solvency II: Preferential Treatment for European Government Bonds 10 % 50 % 9 % 45 % 8 % 40 % 7 % 35 % 6 % 30 % 5 % 25 % 4 % 20 % 3 % 15 % 2 % 10 % 1 % 5 % Europe (Core) Europe (Overall) Emerging Markets (BBB, 5 Years) Europe Emerging Markets AA (5 Years) AA (10 Years) A (5 Years) A (10 Years) BBB (5 Years) BBB (10 Years) BB (5 Years) BB (10 years) AA (5 Years) A (20 Years) Government Bonds Equities Corporate Bonds High-Yield Bonds Covered (with respect to Rating and Duration) Bonds Infrastructure Loans Infrastructure Equity Private Equity Commodities Real Estate Expected long-term return (p. a. left scale) Solvency capital requirement (p. a. right scale) Source: EIOPA Technical Specifications for the Solvency II valuation and Solvency Capital Requirements calculations, October 2012, risklab (Allianz Global Investors Portfolio Health Check, Date: February 2013), Allianz Global Investors Capital Markets & Thematic Research. 9

5 REGULATION 02 LONG-TERM EXPECTED EXCESS RETURN VERSUS EUROPEAN GOVERNMENT BONDS (IN % P.A.) IN RELATION TO SOLVENCY CAPITAL REQUIREMENTS (EROSC) Risk Premiums should offset Solvency capital requirement Corporate Bonds AA (5 Years) Commodities Covered Bonds AA (5 Years) Corporate Bonds AA (10 Years) Corporate Bonds BBB (10 Years) High-Yield Bonds BB (10 Years) Corporate Bonds A (5 Years) Real Estate Corporate Bonds BBB (5 Years) Infrastructure Equity Corporate Bonds A (10 Years) High-Yield Bonds BB (5 Years) Equities Emerging Markets Equities Europe Infrastructure Loans A (20 Years) Private Equity Government Bonds Emerging Markets BBB (5 Years) Source: EIOPA Technical Specifications for the Solvency II valuation and Solvency Capital Requirements calculations, October 2012, risklab (Allianz Global Investors Portfolio Health Check, Date: February 2013), Allianz Global Investors Capital Markets & Thematic Research. 10

6 Under Solvency II, insurance companies will have to be even more concerned about the risk-return profile of their investments and duration management. At first glance, asset classes with low solvency capital requirements such as European government bonds appear interesting under the Solvency II rules. However, the expected return of 2 % p. a. for European government bonds is usually not adequate to meet income requirements. To assess the attractiveness of each asset class, the excess returns over European sovereign debt are compared with the (additional) capital requirement. We call this return benchmark, which is adjusted by 2 %, the Excess Return on Solvency Capital (ERoSC). It indicates which asset class can be expected to generate how much additional return per unit of risk capital. Figure 2 shows that although high-risk asset classes, such as private equity or stocks, are subject to comparatively high solvency capital requirements, they nevertheless do not sacrifice attractiveness relative to government bonds. In this regard, the expected higher risk premiums compared to European government bonds are likely to compensate for the additional capital requirements. However, the leaders in this analysis are government bonds of emerging countries, which have the highest expected excess return per unit of additional risk capital (ERoSC). The comparatively low capital deposit is also evident in infrastructure loans with better credit ratings, which are treated like corporate bonds in regulatory terms. In this asset class, the illiquidity premium to be collected should significantly overcompensate for the relatively high capital deposit (due to the long duration). This also applies to the Infrastructure Equity segment, which, despite the high SCR (49 %), should generate comparatively attractive excess returns. The corporate and covered bonds segments lie in the middle in the comparison of asset classes. It is interesting to observe here that high-yield medium-term bonds in particular appear attractive because of the risk premiums collected (Chart 02). However, it should be taken into account in the overall assessment that diversification effects as well as internal models reviewed by the supervisory authorities may have a significant impact on how advantageous individual assets are in the context of the portfolio. In addition, the regulatory risk parameters presented may at times differ significantly from the economic risks. For example, the question arises as to whether insurance companies might invest their money only in government bonds on the European periphery because doing so is not counted towards the required solvency capital and ignore the potential default risk. 11

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8 Outlook Overall, the following developments are relevant for the investment decisions and risk management of (life) insurance companies and institutions for occupational retirement provision: 7 1. Risk-return considerations in investment decisions should be reconsidered in part. For example, although the economic risks associated with investing in government and corporate bonds with better credit ratings should increase in view of the asymmetric risk-return profile in the low interest rate environment, under Solvency II these asset classes appear relatively more advantageous than other asset classes. Equity or private equity investments are indeed in a worse regulatory position, but as investments by institutional investors, their higher risk premiums should still generate promising capitaladjusted returns. 2. Optimisation of asset-liability management is likely to be more important than ever for both pension funds and insurance companies. First, the volatility of balance sheets based on market value is likely to increase, making efficient and dynamic control necessary. In addition, it is becoming increasingly more challenging to better harmonise regulatory risk parameters with economic risks. For example, a reduction of the chronic duration mismatch of asset positions and liabilities, and improved synchronisation of cash flows on both sides of the balance sheet, can be achieved by investing in longer-term infrastructure projects. 3. Broader diversification of investments may minimise overall risk, and also reduce the requirements of additional solvency capital. As a result, the risk-return profile of the overall portfolio should improve by means of diversification into various asset classes. 4. Risk management with the use of derivatives and dynamic risk control can help to make investment risks more manageable, and ultimately improve asset-liability management. Dennis Nacken is Vice President of Global Capital Markets & Thematic Research, the think tank of Allianz Global Investors. As a capital market strategist, he analyses current perspectives on the international capital markets. His particular areas of focus include long-term trends in capital investments and strategic portfolio optimisation. He worked previously for Helaba Trust, where he spent six years as a senior securities analyst responsible for the chemicals and oil sectors. Dennis Nacken studied economics at Hamburg University, and business management at Wirtschaftsakademie Hamburg, and holds degrees in both areas. He is also a qualified Chartered Financial Analyst (CFA). Dr. Christian Schmitt is head of the Asset Liability Management division at risklab GmbH, the experts in investment and risk consulting at AllianzGI Global Solutions. Before joining risklab in 2002 as Head of Portfolio Analytics, he worked for Deutsche Bank AG as Chief Market Risk Officer and Vice President Risk Management Services. Dr. Christian Schmitt holds a degree in business engineering from Karlsruhe Technical University. After university, he worked as an associate at the Centre for European Economic Research (Zentrum für Europäische Wirtschafts forschung, ZEW) and completed his PhD at Mannheim University. Dr. Christian Schmitt is a CFA Charterholder, and lectures on asset liability management in the Certified International Investment Analyst (CIIA) programme of the German Association for Financial Analysis and Asset Management (DVFA Deutsche Vereinigung für Finanzanalyse und Asset Management). [7] See also: OECD, The Effect of Solvency Regulations and Accounting Standards on Long-Term Investing,