REGULATORY IMPACT ON BANKS AND INSURERS INVESTMENTS

Transcription

1 REGULATORY IMPACT ON BANKS AND INSURERS INVESTMENTS VLERICK CENTRE FOR FINANCIAL SERVICES PART OF THE AGEAS CHAIR: THE ROLE OF INSURERS FINANCING THE ECONOMY PROF. DR. ANDRE THIBEAULT MATHIAS WAMBEKE SEPTEMBER

2 We would like to extend particular thanks to our research chair partner, Ageas, for their support.

3 TABLE OF CONTENTS Executive summary... 2 Introduction Basel III implications for banks Basel III impact on banks asset allocation Solvency I vs. Solvency II Solvency II impact on insurer s asset allocation Basel III vs. Solvency II Differences in capital requirements for banks and insurers Conclusion Annex I - Basel II vs. Basel III Annex II List of interviewees Annex III Product cost increase due to Basel III Annex IV Solvency II capital charge calculations Annex V Comparison between efficient frontier and the average life insurers portfolio Sources Corresponding author: mathias.wambeke@vlerick.com or mathias.wambeke@assuralia.be, Tel:

4 EXECUTIVE SUMMARY This report identifies how two major regulatory changes in the financial industry, Basel III and Solvency II, will impact asset allocation decisions of banks and insurers. We study the Basel III implications for banks asset management through interviews with lending experts, calculations of funding costs and market data on banks asset allocation. We furthermore construct an efficient frontier based on 15 asset indices and discuss to which extend Solvency II calibrations influence portfolio selection. We also compare Basel III and Solvency II capital charges and measure to which extent insurers can benefit from regulatory arbitrage opportunities compared to banks for different asset classes. We find that the incentives provided by Basel III and Solvency II are largely consistent with the business model of banks and insurers. As such, Solvency II directs insurers towards long-term fixed income investments, which match the long-term liabilities of insurance companies. Basel III, on the other hand, favours investments with a shorter maturity. As an example, we find that insurers, from a regulatory capital viewpoint, have a very clear advantage over banks for residential mortgage loans. This is especially the case for mortgages with a long maturity and mortgages with a low loan-to-value ratio. We also find that Solvency II calibrations are advantageous compared to Basel III for other long-term loan segments, such as infrastructure loans, long-term export loans and long-term loans to public sector entities. These are granted a beneficial treatment under Solvency II, since insurers are better able to cover their interest rate risk with such long-term loans. This reduced interest rate risk leads to lower regulatory capital requirements for insurers. We find that sovereign debt is treated favourably under both Basel III and Solvency II. Indeed, sovereign debt rated AA or higher requires no capital under Basel III. Solvency II takes this even a step further, requiring no capital for any sovereign debt exposure from the entire European Union. The treatment of other, shorter term asset classes is often similar under both regulatory frameworks. As such, we find that capital charges for short- and medium-term corporate exposures are largely comparable under both Basel III and Solvency II. Securitised assets are an exception to this rule: capital charges for securitisations are highly unattractive for insurers compared to banks. The transactions and partnerships between banks and insurers observed recently in financial markets often corroborate our findings on regulatory incentives provided by Basel III and Solvency II. Furthermore, we see additional potential for insurers to become active in the market for residential mortgage loans. 2

5 INTRODUCTION The regulatory landscape is changing for the European financial sector. On the banks side, the capital requirements regulation (CRR) and capital requirements directive (CRD IV) are being introduced. CRR and CRD IV implement the global Basel III framework, imposing stronger capital and liquidity requirements for banks. Insurers, on the other hand, also face changing capital requirements with the introduction of Solvency II. These changing regulations can influence how banks and insurers compete or cooperate in certain markets. More specifically, this report studies the influence of Basel III and Solvency II on the investment behaviour of banks and insurers, respectively. We provide an overview of the Basel III framework and assess the implications for banks asset management decisions through interviews with lending experts, calculations of funding costs and market data on banks asset allocation. We also provide an overview of Solvency II regulations and verify to which extent Solvency II may affect insurers asset allocation. We furthermore ask whether Basel III capital requirements for certain asset classes are similar to capital requirements under Solvency II. As such, we check whether insurers may have regulatory arbitrage opportunities over banks for certain asset classes. The first chapter analyses how Basel III affects banks lending activities. We find that the pricing of loans will be highly influenced by capital and liquidity requirements, even to an extent that bank may become uncompetitive for certain products. Certain banks may also face constraints in their lending capacity due to Basel III, which reinforces the trends for deleveraging and disintermediation. The second chapter of this report identifies how specific assets classes are impacted by new Basel III requirements. We find that banks have clearly reduced their allocation towards securitisations, inter-bank loans and infrastructure loans. We show that several banks have taken steps to reduce the maturity of their portfolio of infrastructure debt. We also find evidence for disintermediation in a wide range of lending segments. The third chapter assesses the new regulatory framework for the European insurance sector: Solvency II. We present an overview of Solvency II regulations and compare these to the previous Solvency I regime. We show that Solvency II takes into account all relevant risks related to the insurer s investments, whereas Solvency I did not provide any risk measure for the insurer s asset side. We also provide an overview of capital charges under the Solvency II standard formula for a range of asset classes. The fourth chapter assesses the implications of Solvency II on the asset allocation of insurance companies. We build an efficient frontier based on 15 asset indices and calculate the market risk 3

6 capital charges for the portfolios of this efficient frontier. We furthermore calculate the market risk capital for the portfolio of an average European life insurer and assess whether this portfolio complies with a likely budget for market risk capital. The fifth chapter compares the Basel III and Solvency II framework, focussing on regulations for the investment side of banks and insurers. We find that Solvency II allows for a more diverse range of capital instruments and puts more emphasis on the matching of assets and liabilities. Furthermore, Solvency II is absent of any charge for liquidity risk. We also compare the specific capital charge calculation methods under Basel III and Solvency II and find that both frameworks have a very different approach in terms of diversification benefits, interest rate risk and loss absorbing capacity of liabilities. The sixth chapter presents an overview of different asset classes and measures to which extent insurers can benefit from regulatory arbitrage opportunities compared to banks. To this end, we assess the Solvency II and Basel III capital charges for several asset classes. We find that the incentives provided by Basel III and Solvency II are largely consistent with the business model of banks and insurers, i.e. Solvency II directs insurers towards long-term fixed income investments, while Basel III favours investments with a shorter maturity. The final chapter concludes and graphically represents the attractiveness of Basel III and Solvency II capital charges for different asset classes. 4

7 1. BASEL III IMPLICATIONS FOR BANKS This chapter provides an overview of different implications of Basel III on banks lending behaviour. This chapter is based on a theoretical review of Basel III implications and also provides outcomes of interviews with lending experts at 10 major European banks 1. We start by giving a view on the influences of Basel III on loan pricing, followed by a discussion of reduced lending capacity, deleveraging and disintermediation. A detailed review of Basel III specifications can be found in Annex I. Pricing Basel III will considerably increase costs for a wide range of lending activities. The combined effect of capital requirements and liquidity ratios will highly influence banks cost of funding, which in turn will influence banks pricing behaviour. Different elements in Basel III will increase the capital costs for banks lending activities: - Higher capital ratios for common equity Tier 1 and Tier 1 capital - The introduction of the capital conservation buffer, countercyclical buffer and a capital surcharge for systemically important financial institutions - Stronger requirements for capital quality: phasing out of step-up hybrid capital previously included under Tier 1, elimination of Tier 3 capital and the deduction of several balance sheet items (e.g. goodwill, other intangibles and deferred tax assets) from CET1. - Increased risk weights for interbank exposures and resecuritisations Furthermore, liquidity requirements notably the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) influence costs through different channels: - Increasing allocation to high quality liquid assets (e.g. government bonds or high rated corporate bonds) or increasing allocation to assets with a low required stable funding factor (i.e. high rated assets or assets with a residual maturity of less than one year). This will inevitably lower the yield of banks asset base. - Increased funding from liabilities with low outflow assumptions (in order to optimise the LCR) or high available stable funding factors (in order to optimise the NSFR). Such liabilities include capital instruments, retail deposits, or generally liabilities with residual maturities of one year or more. Such liabilities are inevitably more expensive compared to e.g. short term wholesale funding. 1 Annex II presents a list of interviewees. 5

8 Table 1 displays the funding cost increases due to Basel III for investing in a specific product, measured in basis points. This table distinguishes between the increase in capital costs (related to Basel III capital ratios, capital quality requirements and risk weights) and the increase in liquidity costs (related to the Basel III LCR and NSFR). Assumptions underlying these calculations can be found in Annex III. This table will be presented in more detail for each asset class in the next chapter. Asset rating Table 1 - Funding costs increase due to Basel III (basis points) Change capital cost Change liquidity costs Consumer loans Residential mortgage loans Corporate loans A Government bonds AA or higher Securitisations A 3 year maturity Change total costs Resecuritisations A Table 1 indicates that the change in capital costs is the predominant component for most asset classes. Changes in liquidity costs are relatively low. This can be partly explained by the low interest rates at which banks can currently gather long-term stable funding, i.e. the cost of complying with the NSFR is relatively low. Our interviews with 10 European banks also confirmed that pricing increased due to the combined effect of the LCR, NSFR and capital ratios introduced under Basel III. However, our interviewees noted that pricing is generally not conducted on a product basis (i.e. for individual loans) but on a relationship basis. All possible revenues (loans, payment services, bank accounts ) and all possible costs (including costs due to Basel III) are taken into account to determine the profitability of a relationship. Hence, the increased capital and liquidity costs introduced by Basel III do not necessarily have to reflect directly in higher margins for a particular loan. Our interviewees generally observe that most customers are capable of accepting higher margins, since reference rates are historically low: i.e. even though margins may increase, total (nominal) rates still remain very low. Nevertheless, our interviews showed that, for certain lending segments, banks have become uncompetitive due to their increased funding costs. As an example, several banks also noted that large corporates can find cheaper funding through bond issuance compared to bank loans. Our interviews also revealed that the markets for long-term infrastructure loans and long-term loans to public sector entities are seeing increased competition from institutional investors. Indeed, institutional investors, such as insurers and pension funds, operate on a different cost basis compared to banks and can therefore provide a tighter pricing for certain niche lending segments. 6

9 Basel III also introduced a non-risk based leverage ratio of 3%. Our interviews generally indicated that this leverage ratio does affect pricing behaviour since most banks have always maintained a leverage ratio above this strict minimum. The leverage ratio might nevertheless affect specific items which bear a low risk weighting but can take up a large part of a banks balance sheet. As such, our interviewees indicated that derivatives, securities lending and repos are highly affected by the leverage ratio. Reduced lending capacity, deleveraging and disintermediation Banks facing a shortfall in capital or stable funding will have to take significant mitigating steps in order to comply with Basel III requirements. Table 2 shows the evolution of CET1 shortfall and stable funding deficits as presented in the monitoring reports of the Basel Committee. Table 2 Capital and stable funding shortfall in Basel III monitoring reports (billions) Monitoring exercise date CET1 shortfall Stable funding shortfall 30 June , December , June , December , June (not disclosed) Our interviews with 10 European banks have shown many possibilities of how to reduce a potential shortfall in capital or stable funding. Banks can e.g. choose to place non-core assets in bad banks, divest portfolios in non-strategic countries, reduce trading activities, increase longer term funding or issue shares. Another possible trend, advocated by many of our interviewees, is for banks to move towards an originate and distribute model. Indeed, many of the interviewed banks indicated that, due to funding constraints, activities such as corporate bond issuance, securitizations and cofinancing agreements with institutional investors will play a more prominent role. Banks can thus leverage their knowledge in sourcing credits and can acquire RWA-free fee income instead of RWAheavy net interest income. The next chapters will highlight for some particular asset classes and their potential of co-financing with institutional investors. Figure 1 illustrates the importance of disintermediation for credit to non-financial corporations in the Euro area. While the amount of bank loans has been declining since 2009, debt securities have continued to rise in recent years. Several interviewees noted that this trend towards bond issuance in Europe is likely to continue in the future: not only large corporates, but also mid-corp clients and in a later stage, larger SMEs might be pushed towards bonds issuance. 7

10 Figure 1 - Funding sources of Euro area non-financial corporations Source: ECB. In trillion euros. Bank loans Securities other than shares This trend towards disintermediation is nevertheless highly dependent on the funding characteristics of banks. As an example, banks which have abundant access to retail deposits are generally better capable of answering all loan demands from their clients. Table 3 displays funding characteristics for banking sectors across countries. Table 3 - Banks' funding characteristics Source: ECB customer deposits Loan-to-deposit (capital + reserves) Country / assets ratio / assets Belgium 60% 78% 5.74% Germany 60% 98% 5.82% France 48% 112% 6.39% Netherlands 45% 121% 4.91% United Kingdom 42% 107% 8.87% This table, as well as our interviews with 10 European banks, show some interesting findings: - Belgium and Germany have abundant access to cheap, long-term retail deposits. This funding base also entails that these banks can easily comply with the LCR and NSFR. Our interviews with Belgian banks even showed that, due to this access to retail deposits, banks have surplus liquidity on their balance sheet: Belgian banks do not see enough investment opportunities to put their liquidity to work. Hence, their need for disintermediation has disappeared. Our interviewees did note that, once the economy picks up again, banks may not have enough capital to absorb all the demand for loans: this could be a new pulse for disintermediation. - In France, the UK and the Netherlands, bank cannot heavily rely on retail deposits and have to finance themselves more through e.g. short-term wholesale funding. For these banks, the LCR and NSFR can put constraints on lending activities. Disintermediation is therefore an 8

11 important trend in these countries. The Netherlands faces additional problems due to their large amount of long-term mortgages, as depicted by the loan-to-deposit ratio of 121%. Preliminary conclusion Basel III is definitely not the only factor for the allocation or pricing decisions of banks seen over the past years. Other factors such as funding constraints experienced during the financial crisis, the low demand for loans in the current cycle of the economy, the strategy of certain banks to keep servicing certain customers, the potential for cross selling certain products etc. can also be important drivers of making certain allocation or pricing decisions for loans. Nevertheless, this chapter has indicated several important trends influenced by Basel III. The new regulatory framework influences pricing for a wide range of assets, even to an extent that bank may become uncompetitive for certain products. NSFR and capital requirements may put lending constraints on certain banks, which enhances the trends for deleveraging and disintermediation. The next chapters will provide details on the regulatory effects on specific asset classes. 9

12 2. BASEL III IMPACT ON BANKS ASSET ALLOCATION The previous chapter discussed banks higher funding costs introduced by Basel III. These higher funding costs may introduce a repricing for different lending segments, or when such a repricing is impossible, will lead to a divestment from banks of the businesses with an insufficient ROE. Banks facing a shortfall in capital or stable funding will be required to adapt their funding base, or reduce investments which consume the most capital and liquidity. In this section, we discuss to which extent banks main asset classes will be affected by Basel III. Our focus is towards assets held in the banking book and not in the trading book. We consider securitisations, inter-bank loans, corporate loans, residential mortgages, long-term lending (e.g. infrastructure loans) and commercial real estate loans. This chapter is partly based on a theoretical review of Basel III. Our theoretical findings are compared with outcomes of interviews with lending experts of 10 major European banks and market data on banks asset allocation. (Re)securitisations Basel III risk weights for (re)securitisations have considerably risen compared to Basel II, as demonstrated in Annex I. Furthermore, higher capital ratios, capital quality requirements and liquidity ratios will considerably increase funding costs for holding (re)securitisations. In general, (re)securitisations require 85% of stable funding are not considered as high-quality liquid assets (HQLA). One exception are qualifying RMBS which only require 50% of stable funding and are considered to be HQLA for 75% of their value. Table 4 summarizes the increase in funding costs for (re)securitisations due to Basel III. Table 4 - Funding costs increase for (re)securitisations due to Basel III (basis points) Asset rating maturity Risk weight LCR factor RSF Factor Change capital cost Change liquidity costs Change total costs RMBS AAA 3 years 20% 75% 50% RMBS AA 3 years 37.5% 75% 50% Securitisations AAA 3 years 20% 0% 85% Securitisations AA 3 years 37.5% 0% 85% Securitisations A 3 years 62.5% 0% 85% Securitisations BBB 3 years 110% 0% 85% Securitisations BB 3 years 195% 0% 85% Securitisations B 3 years 365% 0% 85% Securitisations CCC 3 years 495% 0% 85% Securitisations below CCC- 3 years 1250% 0% 85%

13 Resecuritisations AAA 69% 0% 85% Resecuritisations AA 693% 0% 85% Resecuritisations A 1111% 0% 85% Resecuritisations BBB or lower 1250% 0% 85% The Basel III regulatory reforms, together with the general sub-prime considerations surrounding securitisations, have been an incentive for banks to divest such assets. This trend is likely to continue, particularly for the low rated or complex securitisation segments. On the other hand, the relative importance of plain vanilla or pass through securitisations might increase compared to the reduced attractiveness of securitisations in general. Our interviews with 10 European banks confirm these findings. All of the interviewed banks which previously invested in securitisations have considerably reduced such activities. These banks indeed confirmed that Basel III regulations are not favourable towards securitisations. Some banks still use ABS or MBS for liquidity purposes. In line with the above reflections, a study by Fitch Ratings (2013) confirmed that securitisation exposures of European systemically important banks decreased by 29% during Similarly, figure 2 shows a declining trend in the amount of outstanding securitisations in Europe Figure 2 - European outstanding securitisations In billions. Source: AFME Interbank lending Inter-bank lending will be largely affected by the amended risk weights on financial institution exposures. Basel III introduces the so-called asset value correlation multiplier, which increases correlation assumptions for large financial institutions by 25%. Such correlation assumptions heavily impact risk-weighted asset calculations, and will therefore effectively discourage interbank lending. Having interbank loans on the liabilities side is also highly unattractive due the LCR calibration: interbank funding of less than 30 days bears a run-off factor of 100%. Overall, European systemically important banks have decreased their exposures to the financial sector by 9% (see Fitch Ratings, 2013), and Basel III requirements are likely to have contributed to this reduction. Our interviews with 10 European banks largely confirm these findings: none of the banks see interbank lending as a strategic activity, and a majority of banks has materially reduced 11

14 their interbank exposures. Our interviewees noted that interbank exposure of longer maturities (e.g. 6 months or more) are the most affected. Even though repurchase agreements generally have lower risk weights compared to unsecured interbank lending, the leverage ratio introduced by Basel III might significantly reduce the potential of the repo market. After all, the leverage ratio effectively discourages lower risk exposures which take up a large part of the banks balance sheet. A report by Barclays (2013) indeed predicts a decline by 10 to 15% based on current leverage proposals. Sovereign debt High rated sovereign debt is given a beneficial treatment under Basel III. Risk weights, LCR factors as well as required stable funding (RSF) factors are inclined towards sovereign bonds. Furthermore, government bills and bonds form a substantial part of the high quality liquid assets (HQLA) required in the liquidity coverage ratio: at least 60% of HQLA needs to consist out of bank notes, central bank reserves or sovereign debt with a 0% risk weight. Table 5 provides the risk weights, LCR factors, RSF factors and funding cost increases for sovereign bonds under Basel III. Table 5 - Funding costs increase for sovereign bonds due to Basel III (basis points) Asset rating Risk weight LCR factor RSF Factor Change capital cost Change liquidity costs Change total costs Government bonds AA or higher 0% 100% 5% Government bonds A 20% 85% 15% Government bonds BBB 50% 0% 85% Government bonds BB or B 100% 0% 85% Government bonds below B- 150% 0% 85% In order to comply with the stringent Basel III liquidity requirements, banks have been increasing their holdings of sovereign debt considerably over the past years. Indeed, a study by Fitch Ratings (2013) shows that European systemically important banks have increased their exposure to sovereigns by 26% over the period Similarly, figure 3 shows a rising trend in government lending for euro area banks 2 over the past years. Hence, these numbers clearly validate the beneficial capital and liquidity treatment of sovereign exposures under Basel III. 2 Figures 3, 4 and 7 provide aggregated investments of Monetary Financial Institutions (MFIs) excluding central banks as defined under the regulations ECB/2008/32 and ECB/2011/12. 12

15 7,0% Figure 3 - Government loans as a share of total lending Source: ECB 6,5% 6,0% 5,5% 5,0% Our interviews with 10 major European Banks confirm the attractiveness of sovereign bonds due to their beneficial treatment under Basel III. A majority of interviewees confirmed they have increased their allocation towards sovereign exposures. One interviewee also noted that the ECB s LTRO program provided an additional incentive to invest in sovereign debt. Nevertheless, most banks do not see sovereign debt as a strategic investment and only use such assets for their liquidity buffer. Corporate exposures Basel III will considerably increase the costs for holding corporate loans. Even though Basel III did not change the risk weights for corporate exposures, table 6 clearly shows that capital requirements, capital quality regulations and liquidity ratios will increase the funding costs for this asset class. Table 6 - Funding costs increase due to Basel III/CRD IV for corporate exposures (basis points) Asset rating Risk weight LCR factor NSFR factor Change capital costs Change liquidity costs Change total costs Corporate loans AA or higher 20% 0% 65% Corporate loans A 50% 0% 85% Corporate loans BBB or BB 100% 0% 85% Corporate loans below BB- 150% 0% 85% Corporate loans unrated 100% 0% 85% SME loans unrated 3 57% 0% 85% These higher funding costs can be an incentive towards disintermediation. Indeed, our interviews with 10 European banks have shown that large corporates may find cheaper funding in capital markets compared to ordinary bank loans. Banks which are not able to secure enough capital and stable funding in order to comply with Basel III can also be pushed towards disintermediation. Our interviews with 10 European banks have 3 CRR/CRD IV Regulation (EU) No 575/2013 article 501 specifies a factor of (this is the so called SME "supporting factor") to be applied to capital requirements for SME loans. We assume SME loans to be weighted at 75% under the standard weight for retail exposures, not taking into account the supporting factor. 13

16 shown a great difference between Belgian and foreign banks in this respect. Whereas Belgian banks often have enough stable funding in order to satisfy loan demand, foreign banks often more inclined to issue bonds for their clients or to transfer loans to institutional investors. Several interviewees even see a potential for bond issues for larger SMEs. This trend towards disintermediation is clearly reflected in the amount of corporate loans on banks balance sheets. A study by Fitch Ratings (2013) has indeed shown that European systemically important financial institutions reduced their corporate exposure by 9% over the years Similarly, figure 4 shows a decline in loans to non-financial corporations since Our interviews with 10 European banks generally show the strategic importance of corporate loans due to the potential of cross selling ancillary services. Interviewees generally indicate a constant or slight decrease in allocation to corporate and SME loans over the past years. Interviewees who admit a decreasing exposure point out that this is mainly due to the lower demand for loans from their clients. Indeed, ECB lending surveys show that demand for loans was particularly low over (see figure 5), whereas supply credit standards (figure 6) have broadly remained at their historical average. Figure 4 - Loans to non-financial corporations as a share of total bank lending Source: ECB 27,5% 27,0% 26,5% 26,0% 25,5% 25,0% 24,5% 24,0% Figure 5 - Loan demand Measured as the difference between the share of banks reporting an increase in loan demand and the share of banks reporting a decline. Source: ECB bank lending survey Figure 6 - Supply credit standards Measurd as the difference between the share of banks reporting that credit standards have been tightened and the share of banks reporting that they have eased. Source: ECB bank lending survey 14

17 Residential mortgages Basel III reforms only have a minor impact on residential mortgage lending. The risk weight for mortgage loans under Basel II/Basel III is relatively low at 35%. Furthermore, under NSFR, residential mortgage loans are granted an RSF factor of only 65%. Table 7 shows that Basel III reforms do not heavily affect funding costs for residential mortgage loans. These funding costs can be further reduced through the use of covered bonds, which exist already for a long period in most jurisdictions and are allowed in Belgium under recent regulatory reforms. Asset Table 7 - Funding costs increase for residential mortgages due to Basel III (basis points) Risk weight LCR factor RSF factor Change capital cost Change liquidity costs Change total costs Residential mortgage loans 35% 0% 65% It appears that mortgage loans are still an attractive asset class for banks: a report by Fitch Ratings (2013) has shown that exposures to residential mortgages have increased by 12% over the period Similarly, figure 7 clearly shows that euro area banks have increased their holding of retail mortgage loans. 24% 23% 22% 21% 20% 19% 18% Our interviews with 10 European banks show that most banks have kept a stable or increasing allocation towards residential mortgage loans over the past years. The Belgian banks we interviewed, for example, have generally remained stable in their allocation towards residential mortgages, although they often have decreased the maturity and loan-to-value (LTV) of their portfolio. The interviewed Belgian banks note that loans with an exceptionally high maturity (30 years or more) or an LTV of 110% had an excessive credit risk and therefore are not issued anymore. The Dutch banks we interviewed have broadly decreased their allocation over the past years, often due to a lack of stable funding. Another interesting outcome of our interviews is that all banks viewed residential mortgage loans as a strategic activity, due to their potential of cross-selling other products and services. Figure 7 - Retail mortgage loans as a share of total bank lending Source: ECB 15

18 Long-term lending: infrastructure loans and export loans Certain lending segments, such as infrastructure loans or long-term export loans, typically have very long maturities. Basel III particularly affects such long-term lending due to the introduction of the NSFR. This liquidity ratio asks to fund long-term lending with long-term liabilities, which are typically more expensive. Furthermore, the specific NSFR calibration is not specified yet: hence, banks who now grant long-term loans do not know exactly which liabilities will be allowed to cover such loans. This regulatory uncertainty is an additional burden for long-term lending. Now that Basel III is being phased-in, banks rarely provide loans with a maturity longer than 10 years. Figure 8 indeed shows that the average maturity of European infrastructure loans has decreased significantly in the past decade: the maturity of loans in recent infrastructure projects is 7 years, whereas 15 year maturities were the norm in Figure 8 - Average maturity of loans in infrastructure projects Compiled from the Infrastructure Journal database. Average of greenfield and brownfield projects The funding costs for infrastructure loans and export financings are broadly similar to the costs presented in table 6. However, an important difference with general, shorter term corporate lending is that infrastructure loans and export loans are priced on a stand-alone basis. Indeed, our interviews with 10 European banks have shown that such loans are often one-off deals which do not provide any potential of cross-selling other products. Hence, the pricing for such loans is highly sensitive to new regulations, such as the NSFR. Our interviewees generally admit they are facing difficulties in competing with institutional investors for long-term lending, especially in the segment for long dated, fixed rated infrastructure projects with stable cash flows. Banks are on the other hand more competitive for floating rate financing, assets with construction risk, or assets with refinancing in the future. Our interviews with 10 European banks show that a majority have reduced their allocation towards infrastructure loans. Banks also often admit that the infrastructure loans which they granted recently are of a relatively short maturity. Some Belgian banks however are facing an excess liquidity 16

19 position, hence they cannot be selective in their loan policy: some interviewees therefore note that their excess liquidity forced them back into the long-term infrastructure market. Commercial real estate loans Commercial real estate loans are risk weighted at 100% under Basel II/Basel III. This relatively high risk weight, together with stringent liquidity requirements, induces substantially higher funding costs under Basel III, as shown in table 8. Table 8 - Funding costs increase due to Basel III for commercial real estate (basis points) Asset Risk weight LCR factor RSF Factor Change capital cost Change liquidity costs Change total costs Commercial real estate 100.0% 0% 85% Our interviews with 10 European banks have shown that a minority of interviewees admit a lower allocation to CRE loans over the past years. However, such allocation decisions are often inspired by general risk considerations and are as such unrelated to Basel III. Indeed, our interviews have shown that market and credit factors are predominant when assessing CRE loans: the risk cost in this segment can be very important, and this often has a bigger impact than the capital and liquidity costs introduced by Basel III. Preliminary conclusion Basel III capital and liquidity requirements severely affect a wide range of lending segments. We show that securitisations, inter-bank loans, corporate loans, long-term lending and commercial real estate experience substantially higher funding costs as a consequence of Basel III. Our interviews demonstrate that banks have taken substantial mitigating actions to counter the effects of Basel III. Indeed, this report shows that banks have clearly reduced their allocation towards securitisations, inter-bank loans and infrastructure loans. Several banks have also taken steps to reduce the maturity of their portfolio of infrastructure debt. Our interviewees furthermore confirm a trend towards disintermediation for several lending segments. 17

20 3. SOLVENCY I VS. SOLVENCY II SOLVENCY I The current framework on capital requirements for insurance companies, Solvency I, was introduced in The Solvency I framework amends the original insurance directives dating from 1973 and However, the overall structure of the original directives remained essentially unchanged. A summary of the capital requirements for life and non-life insurers under Solvency I can be found in table 9. Table 9 - Solvency I capital requirements Life insurance The sum of: 4% of technical provisions where the insurer runs investment risk 1% of technical provisions of unit-linked products (i.e. technical provisions where the insurer does not run investment risk) where the management fee is settled for a period of more than 5 years 25% of management fees for unit-linked products where the management fee is settled for a period of less than 5 years A charge for capital at risk (i.e. the amount payable on death less the technical provision of the life insurance policy) o 0.1% of risk capital where the remaining term is less than 3 years o 0.15% of risk capital where the remaining term is between 3 and 5 years o 0.3% of risk capital where the remaining term is more than 5 years Non-life insurance The maximum of: 18% of premiums under 50 million and 16% of premiums above 50 million o Premiums for aircraft liability, liability for ships and general liability should be increased by 50 % 26% of average claims under 35 million and 23% of average claims above 35 million o Premiums for aircraft liability, liability for ships and general liability should be increased by 50 % In order to obtain the Solvency I capital requirement for non-life insurers, this maximum should be multiplied by the ratio of net claims (i.e. claims after reinsurance) to gross claims (i.e. claims before reinsurance). The ratio should be at least be 50%. Solvency I also asks insurers to set up a minimum guarantee fund as an absolute minimum level of capital. This minimum guarantee fund is set to be at a minimum of 3 million, with some minor changes depending on the type of insurer. Given this low amount of the minimum guarantee fund, it is only relevant for the smallest European insurance companies. Under Solvency I, investment risks are merely addressed by setting certain asset limits. These limits can apply either to the total investment portfolio or to exposures against a single counterparty. These limits are provided in table

21 Asset class Table 10 - Asset limits under Solvency I Any one piece of land or building 10 Total shares and negotiable instruments of one company Total shares and debt securities not dealt in on a regulated market Total unsecured loans 5 Any single unsecured loan, other than 1 unsecured loans to financial institutions Cash 3 Concentration limit (% of gross technical provisions) Solvency I has been heavily criticised. The main disadvantages of Solvency I include: 5 10 Solvency I capital requirements are essentially not risk based. There is no relationship between the riskiness of an insurer and its Solvency I capital requirements. The riskiness of the insurer s investments are not taken into account for the Solvency I capital requirement. Indeed, the investment limits mentioned under table 10 are definitely not sufficient to account for market or credit risks. Solvency I includes some adverse incentives. Risk-reducing measures, such as increasing non-life premiums, or adding layers of prudence in the life technical provisions, result in rising capital requirements. Solvency I is merely an update of directives dating back from the 1970s. The overall structure of the original directives remained essentially unchanged, which results in the fact that Solvency I is essentially not risk based. In the process of drafting the Solvency I requirements, it became clear that a more wide-ranging reform was required hence Solvency II. 19

22 SOLVENCY II The solvency II project has been launched in 2002 with the aim of making truly risk based solvency requirements. The current timeline specifies that the Solvency II regime will be applied as of 1 January Solvency II, just like Basel II and Basel III, is focussed around 3 pillars, as shown in table 11. The next paragraphs will focus on pillar 1 specifications. Table 11 - Three pillar structure of Solvency II Pillar 1: financial requirements Pillar 2: supervisory review Pillar 3: market discipline Valuation of technical provisions Solvency requirements: solvency capital requirement (SCR) and minimum capital requirement (MCR) Powers of supervisory authorities: supervisory review process (SRP) Governance guidelines Own risk and solvency assessment (ORSA) Solvency capital requirement (SCR): different modules Disclosure requirements The Solvency II capital requirement (SCR) is designed to meet all quantifiable risks on an existing portfolio plus one year s expected new business. It is calibrated at a one year 99.5% VaR. The SCR aims for a comprehensive approach, including all relevant risks, taking into account diversification between the different risk classes. The different modules of the SCR are depicted under figure 9. Whereas Solvency I did not include capital charges for the insurers investment side, Solvency II now explicitly takes into account market risks. This explains the high importance of Solvency II for insurers investment activities. Figure 9 - SCR modules and sub-modules Solvency Capital Requirement (SCR) Adjustment for the risk absorbing effect of technical provisions and deferred taxes Basic Solvency Capital Requirement (BSCR) Capital requirement for operational risk Life underwriting risk Non-life underwriting risk Health underwriting risk Counterparty default risk Market risk Intangible assets risk Mortality Longevity Disabilitymorbidity Lapse Expense Revision Catastrophe Premium reserve Lapse Catastrophe cf. life cf. non-life Catastrophe Interest rate Equity Property Currency Spread Concentration 20

23 The specific stress calibrations and calculation methods used to determine the amount of the solvency capital requirement (SCR) are detailed under table 12. Table 12 - SCR calculation methods Risk module Sub-module Methodology for calculating SCR Operational risk Operational risk Factor * premiums or factor * reserves. This amount is capped at 30% of the basic SCR. 25% of expenses related to unit-linked products are added. Intangible asset risk Intangible assets 80% of the value of intangible assets Market risk Interest rate Maximum loss due to upward and downward interest rate shocks Equity Property Currency Spread Concentration 39% decrease in value for equities listed in regulated markets of the EEA or the OECD. 22% decrease in strategic participations. 49% decrease in other equity exposures. Subject to a symmetric adjustment 25% decrease in the value of land, buildings and immovable-property rights Maximum loss due to a 25% upward and downward shock in foreign exchange rates Market value * duration * shock factor, depending on the rating of the fixed income instrument Adjustment to address the risk regarding the accumulation of exposures with the same counterparty Counterparty Counterparty This module covers risk-mitigating contracts, default risk default receivables from intermediaries, as well as any other credit exposures which are not covered in the spread risk sub-module. Different approach for rated and unrated counterparties. Calculations are based on shocks in LGD and PD. Life risk Mortality Loss due to a 15% increase in mortality rates Non-life risk Longevity Disability-morbidity Lapse Loss due to a 20% decrease in mortality rates Loss due to a 35% increase in disability and morbidity rates in next year, 25% in the year afterwards; 20% for all years thereafter Maximum of 50% increase and decrease of lapse rates and a mass lapse shock of 40% (retail), 70% (nonretail) Expense Loss due to a 10% increase in expenses and a 1% increase in inflation rates used for the calculation of technical provisions Revision Catastrophe Premium and reserve Lapse Loss due to a 3% increase in annual annuity payments Loss due to a 0.15 percentage point increase of mortality rates in next year Premium * factor plus reserves * factor, different factors per line of business Loss due to a 40% discontinuance of insurance policies and a 40 % decrease of future insurance contracts 21

24 Health risk Catastrophe Health similar to life techniques Health non-similar to life techniques Catastrophe Losses due to natural catastrophes, man-made catastrophes and other non-life catastrophes Similar to life calculation methods, with different factors for disability-morbidity and lapse risk Similar to non-life calculation methods, with different factors for premium and reserve risk Losses for mass accidents, accident concentrations and pandemic events, calculated by ratio of people affected * amounts insured An insurance company can choose whether to calculate the SCR through the standard formula, i.e. using calculation methods detailed under table 12, or whether to develop its own internal model reflecting the specific risks the insurance company faces. If the insurer wishes to develop its own internal model, it needs to gain approval from the supervisor. As an illustration, figures 10 and 11 provide insight into the relative importance of the risk modules and sub-modules of Solvency II. Figure 10 clearly shows that market risks are predominant in the calculation of the Basic Solvency Capital Requirement (BSCR). Figure 10 furthermore demonstrates the importance of diversification and the loss absorbing capacity of technical provisions and DTA in order to reduce the SCR. Figure 11 shows that the biggest components of market risk are spread risk, equity risk and interest rate risk. Figure 11 also demonstrates the importance of diversification benefits in order to reduce the market risk charge. 250% Figure 10 - BSCR structure Group structure. Source: QIS 5. "Adj TP & DTA" stands for the loss absorbing capacity of technical provisions and deferred tax assets 200% 150% 100% 8% 34% 10% 31% 46% 0% 10% 60% 3% 50% 113% 149% 100% 0% 22

25 160% 140% 120% 100% 80% 60% 40% 20% 0% 21% 37% Figure 11 - Market risk structure Group structure. Source: QIS5. 15% 45% 14% 5% 37% 100% Minimum capital requirement (MCR) Besides the SCR, the Solvency II framework also specifies a Minimum Capital Requirement (MCR). The MCR indicates an absolute minimum level of capital. If the available capital drops below this threshold, supervisors are likely to intervene firmly. The MCR is calculated taking into account the following steps: - Life risk: technical provisions or capital at risk times a certain factor, depending on the line of business - Non-life risk: technical provisions or premium times a certain factor, depending on the line of business - The MCR must be minimum 25% and maximum 45% of the SCR - The MCR must be minimum 2.2 million for non-life insurers and 3.2 million for life insurers. The reason why Solvency II has introduced the SCR as well as the MCR is to enable the so-called supervisory ladder of intervention. If an insurer s own-funds fall below the SCR, then supervisors are required to take action in order to restore the insurer s own-funds back to the SCR as soon as possible. If, however, the financial health of the insurer continues to deteriorate, then the level of supervisory intervention will be progressively intensified. The breach of the MCR triggers a very strict recovery plan, which, if not complied with, will result in the insurance company being closed down. Hence, the insurer's liabilities will be transferred to another insurance company and the license of the insurer will be withdrawn. 23

26 Capital instruments and their importance The Solvency II framework divides capital instruments into basic own-funds and ancillary ownfunds. Basic own-funds are subdivided into Tier 1, Tier 2 and Tier 3 basic own-funds. Ancillary ownfunds are subdivided into Tier 2 and Tier 3 ancillary own-funds. The three basic own-fund tiers may include the following Items: - ordinary share capital and the related share premium account - initial funds and members' contributions - subordinated mutual member accounts - preference shares and the related share premium account - subordinated liabilities For a basic own-fund item to be included in a specific tier, it has to comply with the specific requirements of that tier in terms of subordination, duration, discretion over distributions and absence of encumbrances, among others. Other important differences between the basic own-fund tiers include the following: - Tier 1 basic own-fund items need to be paid in - Tier 2 basic own-fund items include called upon but unpaid items - Tier 3 basic own-funds include any capital item which do not comply with the requirements for Tier 1 or Tier 2 - Tier 3 basic own-funds particularly include deferred tax assets - Tier 1 basic own-funds particularly include a reconciliation reserve. This reconciliation reserve demonstrates the effect of moving from the accounting balance sheet to the Solvency II balance sheet. It ensures that the basic own-funds can be reconciled back to the excess of assets over liabilities. An important part of the reconciliation reserve are the expected profits included in future premiums (EPIFP). These EPIFP result from the inclusion in technical provisions of premiums on existing (in-force) business that will be received in the future, but that have not yet been received. Tier 1 basic own-funds are further subdivided into: - Tier 1 unrestricted basic own-funds, including ordinary share capital and the related share premium account, initial funds and members' contributions and the reconciliation reserve - Tier 1 restricted basic own-funds, including subordinated mutual member accounts, preference shares and the related share premium account and subordinated liabilities Table 13 details the composition of basic own-funds of European insurers: 24

27 Table 13 - Composition of basic own-funds Solo undertakings. Source: QIS 5. Basic own-fund instrument % Ordinary share capital (net of own shares) 14.07% The initial fund (less item of the same type held) 1.26% Share premium account 13.14% Retained earnings including profits from the year net of foreseeable dividends 25.53% Other reserves from accounting balance sheet 12.06% Reconciliation reserve 11.62% Surplus funds 7.26% Expected profit in future premiums 8.87% Preference shares 0.10% Subordinated liabilities 5.05% Subordinated mutual member accounts 0.03% Other items not specified above 1.01% Besides basic own-funds, Solvency II also allows insurers to include capital instruments called ancillary own-funds. These ancillary own-funds are subdivided into Tier 2 and Tier 3 ancillary ownfunds. Definitions of these own-fund tranches are given under table 14. Tier 2 ancillary own-funds Tier 3 ancillary own-funds Table 14 - Ancillary own-funds Items of capital other than basic own-funds which can be called up to absorb losses. Includes items such as unpaid share capital that has not been called up, letters of credit or guarantees, or any other legally binding commitments received by insurance and reinsurance undertakings. These items are subject to prior supervisory approval. Items or arrangements which currently exist but which do not count towards the available solvency margin, subject to supervisory approval. Table 15 details the composition of ancillary own-funds of European insurers: Table 15 - Composition of ancillary own-funds Solo undertakings. Source: QIS 5. Ancillary own-fund instruments Tier 2 Tier 3 Unpaid share capital or initial fund that has not been paid up 8.56% 0.63% Letters of credit and guarantees held in trust 70.32% 0.00% of which letters of credit 65.98% 0.00% of which guarantees held in trust 4.34% 0.00% Mutual calls for supplementary contributions 9.34% 0.53% Mutual calls for supplementary contributions 8.61% 0.07% Other items currently eligible to meet requirements under Solvency I 0.01% 1.95% Total ancillary own-funds 96.83% 3.17% 25

28 In order to ensure a sufficient quality of capital, Solvency II sets limits to the different own-fund tiers, as detailed under table 16: Own-funds item Tier 1 basic own-funds Table 16 - Solvency II weights of capital tiers Tier 1 restricted own-funds Tier 2 & 3 basic own-funds + Tier 2 &3 ancillary own-funds Tier 3 basic own-funds + Tier 3 ancillary own-funds Limit 50% of the SCR < 20% of all Tier 1 items < 50% of the SCR < 15% of the SCR Table 17 shows the relative shares of the different own-fund tiers for European insurers: Table 17 - Structure of available own-funds Solo undertakings. Source: QIS 5. Own-fund tier % Tier 1 unrestricted 91.94% Tier 1 restricted 0.72% Tier 2 basic own-funds 4.22% Tier 2 ancillary own-funds 1.25% Tier 3 basic own-funds 1.85% Tier 3 ancillary own-funds 0.02% Total Tier % Total Tier % Total Tier % Capital requirements for assets The following elements of Solvency II have to be taken into account when calculating capital requirements for insurers investment activities: - Stress calibrations: the calculation of the SCR for a particular investment starts from the spread shock, property shock or equity shock detailed in the Solvency II technical specifications. We also denote these shocks as the stand-alone capital requirement. Some examples of these stand-alone SCR calibrations for different asset classes can be found in the second column of table Interest rate risk: Solvency II asks insurance companies to hold capital against interest rate risks. The interest rate risk sub-module of Solvency II is designed to account for changes in both assets and liabilities when an interest rate shock occurs. As such, the interest rate risk sub-module demands to hold more capital when assets and liabilities are not properly matched, i.e. when the duration of assets is different from the duration of liabilities. As life 26

29 insurers face long-term liabilities, the interest rate risk sub-module of Solvency II will impose higher capital charges for life insurers when they invest in assets with a shorter duration. - Diversification: Solvency II explicitly takes into account different types of diversification benefits when aggregating capital charges: (1) diversification within the same risk class and business line; (2) diversification within a risk class and across business lines; (3) diversification across risk classes; and (4) diversification at a group level. As an example, table 18 provides the correlation coefficients across risk classes under Solvency II. Correlation coefficients Market risk 1 Table 18 - Solvency II correlation factors across risk classes Market risk Counterparty default Counterparty default Life underwriting Life underwriting Health underwriting Health underwriting Non-life underwriting Non-life underwriting The table 19 shows correlation coefficients across risk classes for the market risk module under Solvency II. Table 19 - Solvency II correlation coefficients across market risk sub-classes Interest Equity Property Spread Currency Concentration Correlation coefficients Interest rate risk 1 Equity risk Property risk Spread risk Currency risk Concentration risk Loss absorbing capacity: Solvency II accounts for the loss absorbing capacity of technical provisions (TP) and deferred tax assets (DTA). This means that under Solvency II, overall capital requirements are reduced because the insurer can reduce payments of discretionary benefits (loss absorbing capacity of technical provisions) or because the insurer has to pay less tax than initially expected (loss absorbing capacity of deferred taxes) after an adverse event. The fifth quantitative impact study (QIS5) has shown that the loss absorbing capacity of technical provisions and deferred taxes results in an average reduction of 40% in solvency capital requirements (see figure 10). 27

30 By taking into account all the above considerations (stress calibrations, interest rate risk, diversification benefits, the loss absorbing capacity of TP and DTA) we obtain the so-called all-in capital charge. The full range of assumptions behind our calculation of this all-in capital charge is largely based on a recent report by EIOPA (2013). EIOPA modelled the investment portfolio and balance sheet of an average European life insurance company, for which the incremental change in SCR is calculated resulting from a small shift from cash into other assets. As such, EIOPA s model takes into account diversification, loss absorbing capacity and the matching of assets and liabilities (i.e. interest rate risk). We use this model as a basis for our own calculations, and we try to improve this model by adapting EIOPA s method of calculating capital charges for interest rate risk. The full range of assumptions behind our calculations can be found in Annex IV. Table 20 provides an overview of solvency capital requirements for different asset classes. The column Solvency II all-in capital charge provides the capital requirement for making a certain investment, taking into account diversification benefits, loss absorbing capacity, and the matching of assets and liabilities (i.e. interest rate risk). These capital charges can be compared to the standalone Solvency II capital charge. The latter is merely based on the spread risk, equity risk, property risk or counterparty default modules of Solvency II. Table 20 - The solvency II capital requirement (SCR) for different assets Asset class rating duration Solvency II standalone capital charge Corporate debt A 3 years 4.2% 3.73% Corporate debt A 5 years 7.0% 4.25% Corporate debt A 10 years 10.5% 3.86% Corporate debt A 15 years 13.0% 3.00% Corporate debt BB 3 years 13.5% 8.27% Solvency II allin capital charge Corporate debt BB 5 years 22.5% 11.84% Corporate debt BB 10 years 35.0% 15.90% EU Government debt A 10 years 0.0% -2.10% Non-EU Government debt A 10 years 8.4% 2.84% Residential mortgage loan 10 years, 80% LTV Residential mortgage loan 15 years, 80% LTV Residential mortgage loan 10 years, 100% LTV Residential mortgage loan 15 years, 100% LTV 0% -2.10% 0% -5.58% 3% -0.95% 3% -4.44% Covered bond AAA 5 years 3.5% 2.55% 28

31 Covered bonds AA 5 years 4.50% 3.03% Type 1 securitisation AA 3 years 12.6% 7.83% Type 1 securitisation A 3 years 22.2% 12.53% Type 2 securitisation AA 3 years 40.2% 21.40% Type 2 securitisation A 3 years 49.8% 26.16% Resecuritisation AA 2 years 80.0% 41.64% Real estate 25% 13.90% Type 1 equity (i.e. equity listed in regulated 39.0% 23.37% markets of EEA or OECD member states) Type 2 equity (i.e. equities other than type % 28.64% such as private equity, hedge funds, commodities) Table 20 shows how the stand-alone capital charges for fixed income investments rise considerably for longer durations. The all-in capital charges, however, are not necessarily higher for long-dated fixed income compared to short-dated exposures: the beneficial effects of asset-liability matching induce a lower interest rate risk charge, which also leads to a relatively low all-in capital charge. Table 20 also shows a remarkably low 0% stand-alone capital charge for EU government bonds. Due to diversification benefits and a reduced interest rate risk, the all-in capital charge for EU government bonds can even become negative. Table 20 also illustrates the generally very low capital charges for residential mortgage loans. Table 20 furthermore demonstrates the generally very high capital charges for securitisations. Solvency II has recently introduced a different approach for Type 1 and Type 2 securitisations, where the former have to comply with stringent requirements based on the quality of the underlying assets, underwriting processes, structural features, rating, seniority, listing and transparency for investors, among others. This higher quality of type 1 securitisations also leads to lower capital requirements under Solvency II. Some limitations with respect to our calculations in table 20 have to be noted: - Our calculations are based on the standard models of Solvency II, while larger insurers are likely to use an internal model. The use of internal models can have beneficial effects on solvency capital requirements: QIS5 has shown that the median (mean) SCR calculated via internal models is 91% (99%) of the equivalent SCR derived from the standard formula. - Our calculations assume a 100% SCR for insurers. However, insurers are likely to target a higher capital than this minimum imposed by Solvency II. - Solvency II requires significant amounts of capital for underwriting activities in addition to capital for asset risks. One could argue that a charge for underwriting risks needs to be taken into account when assessing the overall capital requirement for insurers investments. However, we have decided to only take into account market risk and counterparty default 29

32 risk when calculating the capital requirement for insurers investments. We advocate an imaginary separation of the investment side and underwriting side of an insurer: the investment side bears the capital charges for market risk and counterparty default risk, and is allocated all investment profits above the risk-free rate. The underwriting side bears the capital charge for all other risk modules (life, non-life, and health underwriting risk) and is allocated the underwriting income, added to the risk-free rate as an investment return for remunerating its policyholders. This approach is similar to the case study of Doff (2006). Valuation of assets and liabilities The valuation methods for assets and liabilities under Solvency II are based on fair value and are largely in line with IFRS Phase II. Figure 12 illustrates the most important valuation practices under Solvency II. Figure 12 - Valuation under Solvency II Assets Liabilities Capital requirements Assets are assigned their market value or, when market values are unavailable, are "marked to model" Present value of expected liability cash flows, including the value of embedded options and guarantees, discounted using the relevant risk-free rate. Fair value of assets Available own-funds Risk margin Best estimate of technical provisions Surplus SCR A risk margin, or market value margin is added for non-hedgeable technical provisions. This risk margin is calculated by cost of capital method. Hence, current and future capital requirements are calculated for the run-off of non-hedgeable technical provisions. The present value of these capital requirements is then calculated. The "risk margin" is then calculated by multiplying this present value by the costof-capital rate (6%). The risk-free rate used to calculate the best estimate of technical provisions is the swap rate, corrected for credit risk. This adjustment for credit risk is subject to a floor of 10 bps and a cap of 35 bps. It is widely recognised in academic literature that asset prices are more volatile than implied by their default rates. Multiple publications 4 furthermore demonstrate that interest rates do not only remunerate for credit risk, but also include an (often considerable) remuneration for illiquidity: the so-called illiquidity premium. As insurers are typically long-term investors, they are not affected by 4 A good overview is given by Moody s Analytics (2014), Illiquid Assets and Capital-Driven Investment Strategies. 30

33 the artificial volatility or illiquidity premiums inherent in market prices. These considerations are recognised under Solvency II: in order to correct for this excess volatility and/or illiquidity premium inherent in market prices, liabilities are discounted with an additional factor. As such, the risk-free rate, used to value liabilities, is corrected with either a volatility adjustment or a matching adjustment. Both are detailed in the paragraphs below. Volatility adjustment The volatility adjustment allows insurers to increase the risk-free interest rate used to value liabilities. The volatility adjustment is calculated by EIOPA based on a notional portfolio representing an insurer s typical portfolio of assets. It is calibrated to 65% of the portion of the spread of this reference portfolio that is not attributable to "a realistic assessment of expected losses or unexpected credit or other risk of the assets". The volatility adjustment, calculated by EIOPA for year-end 2013, equals 22 bps for a euro portfolio. A historical overview of volatility adjustments is given under table 21. Table 21 - Volatility adjustment (bps) under the LTGA specifications Note: this table is based on LTGA calibrations, i.e. calculated using a 20% risk-corrected spread, not the 65% risk-corrected spread as specified in the Omnibus II directive. Year Volatility adjustment (bps) The volatility adjustment may be increased for certain euro zone countries when this country faces a significantly higher risk-corrected spread. At year-end 2013, EIOPA specified a higher volatility adjustment for five euro zone countries: Table 22 - Volatility adjustments (bps) at year-end 2013 Eurozone standard volatility adjustment: 22 National adjustments: Cyprus Greece Italy Latvia Slovenia Insurers are not required to hold any specific assets in order to be allowed to apply the volatility adjustment. However, the effectiveness of the volatility adjustment may diminish when the assets actually held by the insurer differ from the assets in the reference portfolio calculated by EIOPA. In addition, the insurance industry has raised questions about the relatively low volatility adjustments calculated by EIOPA for year-end A joint letter by Insurance Europe, the CFO Forum and CRO 31

34 Forum 5 states: The volatility adjustment at the end of 2013 would be around 15 bps lower than industry estimations based on the latest draft for Delegated Acts. Additionally, against our expectations, national adjustments in a period of time where sovereign debt is still under stress were only to be applied in Italy and Greece and even in those cases, to a very limited degree. Matching adjustment The matching adjustment is an adjustment to the risk-free rate used to value predictable liabilities. The matching adjustment is equal to the spread over the risk-free rate on assets admissible to back these predictable liabilities, less an estimate of the costs of default and downgrade of these backing assets. Contrary to the volatility adjustment, the matching adjustment is company specific and is calculated by the insurance undertaking itself. The matching adjustment cannot be used together with the volatility adjustment. The size of the matching adjustment depends on: - the type of insurance obligations - the assets held against these insurance obligations - the degree of matching. The size of the matching adjustment is capped at 70% of the spread on EEA sovereign debt and 65% of the spread on other debt. The portfolio of backing assets must comply with various requirements in order for an insurance company to be allowed to apply the matching adjustment: - the portfolio consists of bonds and other assets with similar cash-flow characteristics - the expected cash-flows of the assigned portfolio replicate the expected cash-flows of the portfolio of insurance or reinsurance obligations - the cash-flows of the portfolio of assets are fixed and cannot be changed by the issuers of the assets or any third parties. In addition, the underlying insurance obligations also have to comply with a series of stringent requirements in order to be eligible for the matching adjustment. This however makes the matching adjustment impractical for most insurance undertakings. Figure 13 shows that the matching adjustment can only be applied for specific annuity products in some specific countries. Even though the matching adjustment, from a theoretical viewpoint, could incentivise long-term investing by life insurers, figure 13 shows that, due to the limited applicability of the matching adjustment, it is unlikely to influence insurers investment decisions. 5 See Joint Insurance Europe, CFO and CRO Forum letter on Solvency II Volatility adjustment, 32

35 35% 30% 25% 20% 15% 10% 5% 0% Figure 13 - Percentage of technical provisions eligible for the matching adjustment at year-end 2011 Source: QIS 5 UK Spain Netherlands Denmark Portugal Belgium Preliminary conclusion Solvency II has introduced major changes in the regulation of the European insurance sector. The main innovations of Solvency II include among others the three-pillar structure, risk-based supervision, the possibility for insurers to choose between standard approaches and internal models, and an increasing reliance on fair value. Solvency II also includes two adjustments to the risk-free rate used to value liabilities: the volatility adjustment and the matching adjustment. These two measures recognise that insurers are less exposed to short-term market volatility and illiquidity discounts related to asset pricing. Whereas Solvency I did not require any capital for insurers investment activities, Solvency II now imposes specific capital charges for a wide range of asset classes. This makes Solvency II a highly relevant topic for insurers asset management. The next chapter discusses the asset allocation implications of Solvency II. 33

36 4. SOLVENCY II IMPACT ON INSURER S ASSET ALLOCATION This chapter aims to test the impact of Solvency II on an insurance company s asset allocation. We first attempt to build a set of portfolios with optimal risk-return characteristics, the so-called efficient frontier. This chapter then describes the capital charges for these efficient portfolios under the Solvency II standard formula. We furthermore compare and analyse these capital charges with respect to a likely budget for market risk. We thus can determine whether the Solvency II standard formula impedes or enhances an efficient asset allocation. This chapter ends with a discussion of the asset allocation of an average European life insurer. We calculate the solvency capital requirement for the portfolio of this average life insurer and determine whether it complies with a conventional budget for market risk. We also compare the portfolio of an average life insurer to the efficient portfolios calculated in this chapter. Inputs for constructing the efficient frontier We choose the indices included in our efficient frontier to be similar to the indices described in the Solvency II calibration paper of CEIOPS (2010). We gather monthly return data for the period January 1996 July 2014 from Bloomberg. All indices are total return indices. We calculated the geometric mean of monthly returns and the corresponding standard deviations. The different indices and their risk-return characteristics are depicted in table 23. All indices are denominated in Euro. In order to proxy for money market fund returns, we use the Euribor, or, prior the the introduction of the Euro, the German Fibor. We do not include an equity index corresponding to the type 1 equity Solvency II calibration, since the most relevant equity index (MSCI total return) appears to be dominated, under the period considered, by the MSCI EM BRIC Local index and fixed income indices. We have chosen not to include illiquid assets such as infrastructure loans, export loans or residential mortgage loans due to a lack of sufficient data on risk-return characteristics. A caveat with respect to the IPD total return index is that it is based on appraised values rather than actual sales transactions. This leads to a degree of smoothing within the index data, as appraisal values tend to be backward-looking, depending on previous valuation prices as part of the current reported price. Therefore, in order to obtain a correct standard deviation of the IPD returns, we desmooth the return data, using the same approach as described in the QIS 3 calibration paper of CEIOPS (2007). 34

37 Table 23 - Descriptive statistics of asset classes Asset rating - maturity Full name (code) Monthly return Standard deviation of monthly returns Money market (Euribor) FIBOR DEM 1 Month (FD0001M Index) % % Corporate bonds AA 1-5 years The BofA Merrill Lynch 1-5 Year AA Euro Corporate Index ( ER2V) % % Corporate bonds A 1-5 years The BofA Merrill Lynch 1-5 Year Single-A Euro Corporate Index ( ER3V) % % Corporate bonds BBB 1-5 years The BofA Merrill Lynch 1-5 Year BBB Euro Corporate Index ( ER4V) % % Government bonds 1-5 years The BofA Merrill Lynch 1-5 Year Euro Government Index ( EG0V) % % Government bonds 5-10 years The BofA Merrill Lynch 5-10 Year Euro Government Index ( EG06) % % Government bonds 10+ years The BofA Merrill Lynch 10+ Year Euro Government Index ( EG09) % % Government bonds 15+ years The BofA Merrill Lynch 15+ Year Euro Government Index ( EG08) % % Government bonds 20+ years The BofA Merrill Lynch 20+ Year Euro Government Index ( EG0Y) % % Securitised/collateralized assets The BofA Merrill Lynch Euro Non-Periphery Securitized / Collateralized % % Index ( ELAX) Covered bonds 1-5 years The BofA Merrill Lynch 1-5 Year AAA Euro Covered Bond Index ( EC1V) % % Covered bonds 5-10 years The BofA Merrill Lynch 5-10 Year Euro Pfandbrief Index ( EP06) % % Covered bonds 10+ years The BofA Merrill Lynch 10+ Year Euro Covered Bond Index ( ECVH) % % Property UK IPD Total Return All Proper (IPDMPROP Index) % % Equity emerging markets MSCI EM BRIC Local (MSELBRIC Index) % % 35

38 The efficient frontier In order to calculate the efficient portfolios composing the efficient frontier, we solve the following, well-known optimization problem: (Minimise the portfolio variance. w is the vector of portfolio weights and Σ is the variance-covariance matrix) Subject to (The portfolio return must equal the target return, μ. M is a vector of average asset returns) (The portfolio weights must sum up to 1) (No short-selling) (The weights of corporate bonds, covered bonds, government bonds, securitisations and property investments must remain under 20% in order to avoid asset concentrations) 55 efficient portfolios were constructed. Figure 14 displays the efficient frontier and the individual asset indices which compose the efficient frontier. Figure 15 provides a breakdown of the efficient portfolios. Figure 15 shows that less risky portfolios load more on money market instruments and short term fixed income investments. Riskier portfolios, i.e. portfolios with a higher expected return, allocate more towards equity investments, property and long-term fixed income. The index of A rated corporate bonds is not used in the efficient frontier since, in this setting, the index is dominated by government bond portfolios with better risk-return characteristics. 36

39 Monthly return Figure 14 - Efficient frontier 0,90% 0,80% 0,70% 0,60% 0,50% 0,40% 0,30% 0,20% 0,10% 0,00% 0,00% 1,00% 2,00% 3,00% 4,00% 5,00% 6,00% 7,00% Standard deviation (monthly) Efficient frontier Equity emerging markets Property Government bonds 20+ years Government bonds 15+ years Government bonds 10+ years Government bonds 5-10 years Government bonds 1-5 years Corporate bonds AA 1-5 years Corporate bonds A 1-5 years Corporate bonds BBB 1-5 years Covered bonds 10+ years Covered bonds 5-10 years Covered bonds 1-5 years Securitised/collateralized assets Euribor 37

40 Allocation (% of total portfolio) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Figure 15 - Allocation of efficient portfolios Portfolio number Equity emerging markets Property Covered bonds 10+ years Covered bonds 5-10 years Covered bonds 1-5 years Securitised/collateralized assets Government bonds 20+ years Government bonds 15+ years Government bonds 10+ years Government bonds 5-10 years Government bonds 1-5 years Corporate bonds BBB 1-5 years Corporate bonds AA 1-5 years Euribor 38

41 Calculation of a budget for market risk and market risk capital charges In order to assess the eligibility of efficient portfolios under Solvency II, a budget for market risk is needed. The calculation details of our budget for market risk are detailed under table 24. All statistics are based on QIS 5. It remains an open question to which extent insurers will target a ratio of own-funds above the solvency capital requirement. We therefore calculate two market risk budgets: the first is based on a simple 100% SCR target ratio ( million). The second market risk budget ( million) assumes a 165% SCR target ratio, based on the QIS 5 statistic that insurers on average have 165% of own-funds compared to the SCR. Table 24 - Calculation of a budget for market risk Own-funds (% of balance sheet total) 12.8% (1) Basic solvency capital requirement (% of solvency capital requirement) 148% (2) Diversified market risk (% of basic solvency capital requirement) 56.5% (3) Budget for diversified market risk if the insurer targets a 100% SCR mio = (1)*(2)*(3) (based on a hypothetical balance sheet total of 1000 million) Average own-funds as a % of SCR 165% (4) Budget for diversified market risk if the insurer targets a 165% SCR = (1)*(2)*(3)/(4) (based on a hypothetical balance sheet total of 1000 million) mio We calculated capital charges for the market portfolios conform the method explained chapter 3. SCR stand-alone capital charges are based on the duration of the asset portfolios and their average rating, as displayed under table 25. These stand-alone capital charges are aggregated into an overall capital charge for the total market portfolio taking into account interest rate risk, diversification benefits and the loss absorbing capacity of technical provisions and deferred tax assets. We assume that the market portfolio constitutes 90% of the asset total of the hypothetical life insurer. We assume that another 5% of the asset total is allocated to cash with a 0 year duration and another 5% to mortgage loans with a 10 year duration. These assumptions on the balance sheet total of an average life insurer are based on balance sheet statistics of QIS 5. We assume a balance sheet total of 1000 million. We have assumed that the portfolio of securitised/collateralized assets follows the type 2 SCR calibration, leading to a significant stand-alone capital charge of 53.75%. Our choice for the type 2 calibration is justified since a major part of the securitised/collateralized portfolio includes assets issued some years ago and are therefore unlikely to be structured in a way that they comply to the numerous type 1 requirements set out by EIOPA. 39

42 Table 25 - SCR stand-alone capital charges under the standard formula Asset rating - maturity Modified duration (years) Average Rating Money market (Euribor) 1.0 AAA 0.90% SCR standalone capital charge Corporate bonds AA 1-5 years 2.7 AA 2.97% Corporate bonds A 1-5 years 2.8 A 3.92% Corporate bonds BBB 1-5 years 2.9 BBB 7.25% Government bonds 1-5 years 2.8 AA- 0.00% Government bonds 5-10 years 6.5 AA- 0.00% Government bonds 10+ years 13.1 AA- 0.00% Government bonds 15+ years 15.4 AA- 0.00% Government bonds 20+ years 16.9 AA 0.00% Securitised/collateralized assets 4.3 AAA 53.75% Covered bonds 1-5 years 2.8 AAA 1.96% Covered bonds 5-10 years 6.4 AAA 4.20% Covered bonds 10+ years 10.3 A % Property 25.00% Equity emerging markets 49.00% Analysis of capital charges for efficient frontier portfolios Figure 16 displays the market risk charge for the 55 portfolios on the efficient frontier. A breakdown into interest rate risk, spread risk, property risk and equity risk capital charges is provided. 39 out of 55 portfolios comply with the market risk budget if the life insurer targets a 100% SCR (black line in figure 16). 23 out of 55 portfolios comply with the market risk budget if the life insurer targets a 165% SCR (red line in figure 16). Portfolios complying with the 100% SCR market risk budget are characterised by a an average total asset duration of 4.6 years and a low allocation to equity and property investments. Portfolios complying with the 165% SCR market risk budget are in addition characterised by a low allocation to securitised/collateralised assets. Figure 17 displays the link between interest rate risk charge, total market risk charge and the duration of total assets. It is very clear that asset portfolios with a higher duration bear a lower interest rate risk charge, therefore also inducing a lower total market risk charge. For portfolios 39 until 44, the duration of assets becomes higher than the duration of liabilities, leading to a local peak for interest rate risk capital charges. 40

43 % of market risk budget 200% 180% 160% 140% Figure 16 - Market risk charge for efficient frontier portfolios Expressed as a share (%) of market risk budget for a 100% SCR target % equity charge % property charge % spread charge % interest rate risk 120% 100% 80% 60% 40% Market risk budget for a 100% SCR target Market risk budget for a 165% SCR target 20% 00% Portfolio number 41

44 Capital charge ( million) Modified duration (years) Figure 17 - Market risk charge, interest rate risk charge & asset duration Portfolio number interest rate risk capital charge (left scale) market risk capital charge (left scale) average duration of assets (right scale) Figure 16 displays how the spread charge increases sharply from portfolio 17 to 19. This is entirely due to a higher allocation towards securitised/collateralized assets. Similarly, the spread charge decreases sharply from portfolio 27 to 33, for which the exposure to securitisations decline. Portfolios which have a high allocation towards securitisations do not comply with the 100% SCR budget for market risk and are therefore unlikely to be selected by the life insurer. The high market risk charge for portfolios containing securitisations contradicts with the relatively low standard deviation of these portfolios. Even though the Solvency II standard formula aims not to drive insurers investment decisions 6, it is clear that the current SCR calibrations effectively incentivise insurers not to allocate towards securitised exposures. The efficient frontier portfolio which entails the lowest market risk capital charge is given by portfolio 13. Details of this portfolio composition are given under table Carlos Montalvo, Executive Director of EIOPA, recently claimed in an interview with Blackrock that Capital charges cannot be the same because risks are not the same, but if there were incentives to allocate assets in a given way, it would not be right. See Blackrock, 2013, Global insurance investment strategy at an inflection point, p

45 Table 26 - Characteristics of the minimum market risk charge portfolio Asset Allocation Return (monthly) % Money market (Euribor) 19.68% Standard deviation (monthly) % Corporate bonds AA 1-5 years 15.39% Duration fixed income Corporate bonds BBB 1-5 years 14.06% investments (years) Government bonds 1-5 years 20.00% Average duration of total Covered bonds 1-5 years 6.09% assets (years) Covered bonds 5-10 years 17.02% Market risk capital charge ( Property 6.46% million) Equity emerging markets 1.29% % of market risk budget 43.30% Portfolio 13 bears the lowest capital charge but is unlikely to be selected by the life insurer. Indeed, if the life insurer chooses to optimise the ratio of monthly return/market risk charge, depicted in figure 18, portfolio 36 should be preferred above portfolio 13. Portfolio 36 has a comparatively lower allocation to money market instruments, and a higher allocation towards long-term fixed income, property and equity ,00012 Figure 18 - Monthly return/market risk charge 0, , , , , , Portolio number We can conclude from the above paragraphs that the Solvency II standard formula is indeed riskbased. Solvency II charges a higher market risk capital when assets are not properly matched to liabilities and when the insurer allocates heavily towards risky exposures (e.g. property or equity). As an example, portfolios 44 until 54 have a relatively low duration and allocate heavily to property and emerging market equity, which induces high market risk capital charges and makes the portfolios inadmissible under the market risk budget. As Solvency II has an excessive stress calibration for type 2 securitisations, insurers are incentivised not to include these securitisations in their portfolio, even though such securitisations may enhance the portfolio s risk-return characteristics. 43

46 Does an average life insurer s market portfolio comply with the market risk budget? This section assesses whether an average European life insurer s asset portfolio complies with the market risk budget used in the previous sections. Data on the asset allocation of an average European life insurer are provided in recent publication of Höring (2013). This study based its data on a sample 7 of individual insurance companies annual reports and investor presentations from 2009 and The average allocation, rating and duration of the asset portfolio is described under tables 27 and 28. Table 27 - Asset allocation of an average life insurer Asset Allocation (%) Capital charge (%) Type 1 equity 4.50% 39.00% Type 2 equity 2.50% 49.00% Property 11.00% 25.00% Sovereign debt EEA 31.98% 0.00% Sovereign debt non-eea 8.04% 2.18% Corporate debt 29.52% 8.67% Covered bonds 12.46% 4.45% Average duration of asset portfolio (years) 5.1 The stand-alone Solvency II capital charges for each asset are also given in tables 27 and 28. The method for calculating the overall market risk capital charge is similar to the method used in the previous paragraphs. Again, we take into account interest rate risk, diversification benefits and the loss absorbing capacity of technical provisions and deferred tax assets. Similar to the calculations under the previous paragraphs, we assume that the market portfolio constitutes 90% of the asset total of the life insurer. Furthermore, we assume that another 5% of the asset total is allocated to cash with a 0 year duration and another 5% to mortgage loans with a 10 year duration. Our final results of the market risk capital charge calculations are given under table The sample consists of Allianz, AXA, Ageas, Aviva, Baloise, CNP Assurances, Fondaria SAI, Fortis, Generali, Helvetia, Legal & General, Swiss Life, Vienna Insurance and Zurich. 44

47 Table 28 - Rating and duration breakdown of fixed income portfolio sovereign debt EEA sovereign debt non-eea corporate debt covered bonds Allocation (%) Capital charge (%) Allocation (%) Capital charge (%) Allocation (%) Capital charge (%) Allocation (%) Capital charge (%) AAA 58.8% 0.00% 65.0% 0.00% 17.5% 4.70% 92.0% 4.10% AA 20.6% 0.00% 17.5% 0.00% 15.0% 5.74% 4.0% 5.10% A 18.1% 0.00% 2.5% 6.64% 40.0% 7.28% 2.0% 7.84% BBB 0.6% 0.00% 10.0% 8.33% 20.0% 13.10% 1.0% 14.30% BB 1.9% 0.00% 0.0% 15.35% 2.0% 23.50% 0.0% 25.50% B or lower 0.0% 0.00% 3.0% 27.25% 0.5% 39.18% 0.0% 42.54% Unrated 0.0% 0.00% 2.0% 18.23% 5.0% 15.68% 1.0% 17.04% Average duration (years) interest rate risk Spread charge Table 29 - Market risk capital charges for an average life insurer's portfolio (in million EUR) Equity charge Property charge Diversified market risk charge Budget for diversified market risk charge under a 165% SCR target Budget for diversified market risk charge under a 100% SCR target 45

48 Table 29 shows that the market portfolio of an average European life insurer induces a market risk capital charge of million. This is below the 165% SCR market risk budget of million. Hence, we can conclude that the Solvency II standard formula for market risk should not lead to significant reallocations of the market portfolio for the average life insurer. In order to test the relevance of the efficient frontier calculated under the previous paragraphs, it would be interesting to check whether a portfolio of this efficient frontier corresponds to the average European life insurer s portfolio. Annex V indeed shows that portfolio 38 on the efficient frontier is very similar to the average European life insurer s portfolio. This points out that 1) the average European life insurer is likely to hold a portfolio with optimal risk-return characteristics and/or 2) the efficient frontier calculated in the previous paragraphs is relevant in the real world as it is able to broadly capture the average life insurer s asset portfolio. Preliminary conclusion This chapter assessed the implications of Solvency II on the asset allocation of insurance companies. We built an efficient frontier based on 15 asset indices and calculated the market risk capital charges for the portfolios of this efficient frontier. We furthermore calculated the market risk capital for the portfolio of an average European life insurer and compared this portfolio to our efficient frontier. Our results showed that: - A considerable share of efficient portfolios (23 out of 55) comply with a stringent budget for market risk; - Portfolios with a higher duration will, on average, bear lower market risk capital requirements; - Portfolios which allocate heavily towards securitisations are likely to be inadmissible under a budget for market risk, even though the true spread risk of these portfolios remains reasonable; - Portfolios which allocate heavily towards equities and property investments are likely to be inadmissible under a budget for market risk; - A life insurer which chooses to optimize the return/market risk charge ratio, would select a market portfolio composed of 71.4% fixed income (average duration 10.1 years, 40% AAA, 31% AA, 2% A and 27% BBB) and 28.6% property and equity investments (i.e. portfolio 36 of the efficient frontier); - The market portfolio of an average European life insurer is likely to comply with a stringent budget for market risk. 46

49 5. BASEL III VS. SOLVENCY II Several similarities exist between the Basel III and Solvency II regulations. As an example, both frameworks are structured in three pillars, both frameworks allow for standardised as well as internal models, and both frameworks structure eligible capital items in different tiers. A detailed comparison of Solvency II and Basel III nevertheless shows important differences, and this for all three pillars of the regulatory frameworks. In this section, we will focus mainly on the differences between Solvency II and Basel III that could have an influence on investment decisions. This chapter compares Solvency II and Basel III with respect to requirements for the quality of capital, risk types included in both frameworks and the calibration of these risk types. We will focus on the banking book, and not on the trading book when comparing different regulations. The paragraphs below are based on the most recent technical specifications published by EIOPA. Quality of capital Basel III as well as Solvency II define various tiers of capital, but these tiers are not consistent with one another in terms of definition of the allowed capital instruments, nor in terms of the relative proportions of the different tiers. The most significant differences in capital tier characteristics are presented in table 30. Table 30 - Differences in capital instrument characteristics under Basel III and Solvency II Basel III capital Solvency II basic own-funds (BOF) Tier 1 Broadly similar characteristics under Basel III and Solvency II Tier 2 Items need to be paid in Includes called upon but unpaid items Original maturity of at least 5 years No mandatory suspension of repayment in the event of noncompliance with capital ratios Original maturity of at least 10 years Suspension of repayment in the event of non-compliance with the SCR Tier 3 Phased out Includes e.g. deferred tax assets Ancillary ownfunds Not included Includes items such as unpaid share capital that has not been called up, letters of credit or guarantees, or any other legally binding commitments received by insurance and reinsurance undertakings. These items are subject to prior supervisory approval. These differences in definitions of capital instruments seem to be in favour of insurers. Indeed, Solvency II seems to put less emphasis on quality of capital, as e.g. deferred tax assets (DTA) are allowed to be considered as basic own-funds (BOF) under Solvency II, while DTA are deducted from 47

50 capital under Basel III. Furthermore, all capital instruments under Basel III are included on the banks balance sheet, while this is not the case for the ancillary own-funds allowed under Solvency II. Moreover, the relative share of capital tiers differs heavily under Basel III and Solvency II. Table 31 provides weights of the capital tiers under both regulatory frameworks: Basel III Table 31 - Basel III and Solvency II weights of capital tiers Common Equity Tier 1: 4.5% of risk-weighted assets (RWA) + 2.5% RWA for the capital conservation buffer. Total Tier 1: 6% RWA + 2.5% RWA for the capital conservation buffer. Tier 1 + Tier 2: 8% RWA+ 2.5% RWA for the capital conservation buffer. Tier 3 capital is being phased out under Basel III. Countercyclical buffer: up to 2.5% in CET1. Capital surcharge for SIFIs: 1% to 2.5% in CET1 + an additional surcharge of 1% for certain banks. Solvency II Tier 1 basic own-funds must be at least 50% of the Solvency Capital Requirement (SCR). Tier 1 restricted own-funds: less than 20% of all Tier 1 items. Tier 2 &3 basic own-funds + Tier 2 &3 ancillary own-funds: less than 50% of the SCR. Tier 3 basic own-funds + Tier 3 ancillary ownfunds: less than 15% of the SCR. Not included Not included Table 31 clearly indicates that Basel III focuses more on the higher quality tier of capital compared to Solvency II. Indeed, Basel III requires 6% of RWA for Tier 1 capital, added to 2.5% for the capital conservation buffer. The countercyclical buffer and capital surcharge for SIFIs further emphasize the importance of CET1. Solvency II, on the other hand, allows to put significant weight for lower quality capital tiers: Tier 2 and Tier 3 can constitute up to 50% of the SCR under Solvency II. Risk types Basel III and Solvency II include different risk types into their respective pillars. Table 32 summarizes the main differences. Table 32 Differences in risk types included under pillar 1 of Basel III and Solvency II Risk type Basel III included under pillar 1? Solvency II included under pillar 1? Interest rate risk No Yes Concentration risk No Yes Liquidity risk Yes No Basel III focusses on market risk, credit risk, liquidity risk and operational risk. As depicted in figure 9, Solvency II has a somewhat more comprehensive approach by taking into account nearly all major risk types, i.e. underwriting risk, market risk (including e.g. interest rate risk and concentration risk), counterparty default risk and operational risk. Basel III addresses concentration risk and interest rate risk of the banking book under pillar 2 (the risk management and supervision pillar), while Solvency II addresses these risks in pillar 1 (the financial requirements pillar). 48

51 This differing treatment of interest rate risk under Basel III and Solvency II has important asset management implications. Indeed, the interest rate risk module of Solvency II effectively incentivises insurers to match the duration of assets with the duration of liabilities. As life insurer s liabilities are generally long-term, Solvency II effectively incentivises life insurers to hold more long-term assets. Banks, on the other hand, face no specific constraint on their asset-liability management, since interest rate risk is absent in pillar 1 of Basel III. However, implicitly the liquidity ratios will force banks to implement an ALM management. Another remarkable difference in the risk types considered under Basel III vs. Solvency II is liquidity risk. Basel III specifically aims at reducing liquidity risks with the introduction of the NSFR, LCR, and the publication of the Principles for Sound Liquidity Risk Management and Supervision. These enhanced liquidity risk measures were deemed necessary considering the various liquidity problems encountered by banks during the recent financial crisis. Additionally, liquidity risks are abundant in the business of issuing long-term loans financed with short term deposits. Solvency II does not include such liquidity risk measures, since the business model of insurers does not rely on maturity transformation whereas banks do. This absence of liquidity risk measurement under Solvency II again entails that insurers are incentivised to invest in long-term, illiquid investments. In other words, insurers can benefit more from the illiquidity premium embedded in certain long-term assets compared to banks. This fundamental insight is of critical importance in the discussion of asset allocation implications in the next chapter. Risk measure and calibration The method of calculating capital requirements for a particular asset differs substantially under Basel III and Solvency II. Table 33 summarizes the main differences. Table 33 - Differences in calculation steps under Basel III and Solvency II Calculation step Basel III Solvency II Diversification benefits Only includes diversification within a risk class Loss absorbing capacity of technical provisions (TP) and deferred tax assets (DTA) Not included Includes different types of diversification benefits Included Interest rate risk Not included Included Basel III addresses risks in a fairly simple way by giving a risk weight to different asset classes. Solvency II, on the other hand, requires to aggregate several modules and calculation steps for each asset class. As detailed under chapter 3, when calculating capital requirements for different asset 49

52 classes under Solvency II, one has to take into account the Solvency II stress calibrations, assetliability matching, diversification benefits, and the loss absorbing capacity of TP & DTA. Comparison of capital charges under Basel III and Solvency II Table 34 provides a first view on the differences between capital charges under Basel III and Solvency II for certain asset classes. This comparison of Basel III and Solvency II capital charges will be used in higher detail in the next chapter in order to assess insurers asset allocation implications. The column Solvency II all-in capital charge provides the capital requirement for making a certain investment, taking into account the Solvency II stress calibrations, diversification benefits, loss absorbing capacity, and the matching of assets and liabilities (i.e. interest rate risk). These capital charges can be compared to the stand-alone Solvency II capital charge. The latter is merely based on the spread risk or counterparty default modules of Solvency II. These capital charges for insurers are compared to Basel III capital charges under standard- and internal ratings-based approaches. The internal ratings-based data is derived from a study by the Institute of International Finance and Oliver Wyman (2011) 8. Asset class rating duration Table 34 - Comparison of Solvency II and Basel III capital charges Solvency II stand-alone capital charge Solvency II allin capital charge Basel III standard capital charge Corporate bond A 5 years 7% 4.25% 5.25% 4.46% Corporate bond A 10 years 10.5% 3.86% 5.25% 4.46% Corporate bond A 15 years 13% 3.00% 5.25% 4.46% Government bond AA % -2.10% 0% 1.95% years Residential mortgage loan A 0% -5.58% 3.68% 0.3% 15 years, 80% LTV Covered bond AAA 5 years 3.5% 2.55% 1.05% Type 1 securitisation A 3 years 22.20% 12.53% 5.25% Basel III internal capital charge An important finding deducted from our calculations is that Solvency II leads to a lower capital charge for a wide range of assets, the more so for longer term investments. However, some caution has to be taken into account when comparing Solvency II and Basel III capital charges based on the table above. The main limitations in our calculations are listed below: - Our calculations assume a capital ratio of 10.5% for banks and a 100% SCR for insurers. However, banks and insurers are likely to target a higher capital than this minimum imposed 8 This study calculates capital charges under the advanced internal ratings-based (IRB) approach, where the capital charge formula is given under the Basel II framework and the data for probability of default (PD) and loss given default (LGD) is given by Oliver Wyman benchmarks. 50

53 by Basel III or Solvency II. Insurers may target a higher or lower capital surplus compared to banks, and this may affect the interpretation of table Our Basel III capital charge calculations do not take into account the countercyclical buffer, nor the capital surcharge for SIFIs. Both of these capital requirements can affect capital charge calculations for certain banks in certain periods. - Solvency II generally has lower requirements for capital quality compared to Basel III. As an example, Solvency II allows to include deferred tax assets and ancillary own-funds as a part of capital. Solvency II also allows to hold a larger share of Tier 2 and Tier 3 capital compared to Basel III. Hence, even though Solvency II may charge more capital for some assets compared to Basel III, the overall capital cost can still be lower under Solvency II due to lower standards for capital quality. - Capital requirements are surely not the only factor that has to be assessed when making investment decisions. Other major issues are the risk-return characteristics, liquidity, complexity of the investments, accounting requirements etc. A recent study by Höring (2013) also pointed out that investment decisions are largely dependent on the rating which the insurance undertaking wants to achieve. Preliminary conclusion This chapter identified several differences between Basel III and Solvency II regulations that could have an impact on asset allocation decisions. First of all, this chapter identified lower capital quality standards for insurers compared to banks. Indeed, the definitions of the different capital tiers, together with the weights put on these capital tiers are both in the advantage for insurers. Our comparison of risk types included under Basel III and Solvency II shows that Basel III focuses heavily on liquidity risk, whereas it is absent of interest rate risk measures. The opposite holds for Solvency II. As such, insurers are incentivised to hold long-term, illiquid assets. A comparison of capital charges calibrations shows that Basel III and Solvency II have a very different approach towards diversification, interest rate risk and loss absorbing capacity of technical provisions and deferred tax assets. Furthermore, we show that Solvency II leads to a lower capital charge for a wide range of assets, the more so for longer term investments. This is due to the combined effect of diversification benefits, asset and liability matching, loss absorbing capacity of liabilities, and specific risk calibrations which are all in the benefit for insurers. This advantage over banks for certain investments is further enhanced by the fact that insurers face lower capital quality requirements, and that insurers do not face a countercyclical buffer, nor a capital surcharges for 51

54 SIFIs. These lower capital charges under Solvency II create possibilities for shifting assets from banks to insurers. The next chapter will go deeper into certain asset classes and their regulatory arbitrage potential for insurers. 52

55 6. DIFFERENCES IN CAPITAL REQUIREMENTS FOR BANKS AND INSURERS This chapter will identify whether insurers can benefit from differences in Basel III and Solvency II regulations when making investment decisions. We will compare the Basel III and Solvency II capital charges for the separate asset classes to see whether insurers have a comparative advantage over banks, from a regulatory perspective. We will also assess the pricing, risk, liquidity and insurers allocation to these investments, when applicable. However, it should be noted that relative capital charges for certain investments, and the corresponding risk, return and liquidity profile are not the only motives for making asset allocation decisions. As an example, a recent study by Höring (2013) shows that Solvency II capital charges are unlikely to influence asset allocation, since investment decisions are also driven by the need of achieving a certain rating for the insurance group. Other issues such as tax, accounting, or general strategic considerations can also play a significant role in making investment decisions. Securitisations 9 : insurers face prohibitively high capital charges Securitisations can provide a solution for banks lending constraints identified in the previous chapters. Insurers benefit from securitisations as they gain access to diversified loan portfolios which would have otherwise been the exclusive business of banks. As such, insurers can use banks expertise in performing loan underwriting, risk monitoring and resolution of non-performing loans. Previous chapters in this report have shown that banks are divesting their securitisations as a result of the higher risk weights introduced by Basel III. The origination of securitisations has also become more expensive as the skin in the game rule increases risk exposure to securitisations for originating banks. Insurers, just like banks, also face high capital charges for securitisations. Table 35 compares the capital charges for securitisations under Solvency II and Basel III: 9 In this report, securitisations are defined as investments such as asset backed securities (ABS) and mortgage backed securities (MBS). Covered bonds do not fall under our definition of securitisation and will be discussed later in this report. 53

56 Table 35 - Comparison of Solvency II and Basel III capital charges for securitisations Asset class rating - duration Solvency II standalone capital charge Solvency II all-in capital charge Securitisation AAA 1 year 12.50% 8.62% 1.58% Securitisation AAA 2 years 25.00% 14.33% 1.84% Securitisation AAA 3 years 37.50% 20.07% 2.10% Securitisation AAA 5 years 62.50% 31.64% 2.63% Securitisation AA 1 year 13.40% 9.06% 2.63% Securitisation AA 2 years 26.80% 15.21% 3.28% Securitisation AA 3 years 40.20% 21.40% 3.94% Securitisation AA 5 years 67.00% 33.88% 5.25% Securitisation A 1 year 16.60% 10.63% 5.25% Securitisation A 2 years 33.20% 18.37% 5.91% Securitisation A 3 years 49.80% 26.16% 6.56% Securitisation A 5 years 83.00% 41.90% 7.88% Securitisation BBB 1 year 19.70% 12.15% 9.45% Securitisation BBB 2 years 39.40% 21.43% 10.50% Securitisation BBB 3 years 59.10% 30.78% 11.55% Securitisation BBB 5 years 98.50% 49.70% 13.65% Securitisation BB 1 year 82.00% 43.06% 16.80% Securitisation BB 2 years % 51.71% 18.64% Securitisation BB 3 years % 51.29% 20.48% Securitisation BB 5 years % 50.46% 24.15% Securitisation B 1 year % 52.12% 32.55% Securitisation B 2 years % 51.71% 35.44% Securitisation B 3 years % 51.29% 38.33% Securitisation B 5 years % 50.46% 44.10% Basel III external ratings-based capital charge Table 35 demonstrates that, Solvency II all-in capital charges are often multiple times higher compared to the Basel III standard risk weights. However, Solvency II recently introduced a separate, less punitive calibration for so-called Type 1 securitisations. Such securitisations have to comply with stringent requirements based on the quality of the underlying assets, underwriting processes, structural features, rating, seniority, listing and transparency for investors. The capital charges for these type 1 securitisations are given in table

57 Table 36 - Comparison of Solvency II and Basel III capital charges for type A securitisations Asset class rating - duration Solvency II standalone capital charge Solvency II all-in capital charge Type 1 securitisation AAA 1Y 2.10% 3.55% 1.58% Type 1 securitisation AAA 2Y 4.20% 4.15% 1.84% Type 1 securitisation AAA 3Y 6.30% 4.75% 2.10% Type 1 securitisation AAA 5Y 10.50% 5.96% 2.63% Type 1 securitisation AA 1Y 4.20% 4.57% 2.63% Type 1 securitisation AA 2Y 8.40% 6.20% 3.28% Type 1 securitisation AA 3Y 12.60% 7.83% 3.94% Type 1 securitisation AA 5Y 21.00% 11.10% 5.25% Type 1 securitisation A 1Y 7.40% 6.13% 5.25% Type 1 securitisation A 2Y 14.80% 9.33% 5.91% Type 1 securitisation A 3Y 22.20% 12.53% 6.56% Type 1 securitisation A 5Y 37.00% 18.98% 7.88% Type 1 securitisation BBB 1 years 8.50% 6.67% 9.45% Type 1 securitisation BBB 2 years 17.00% 10.40% 10.50% Type 1 securitisation BBB 3 years 25.50% 14.16% 11.55% Type 1 securitisation BBB 5 years 42.50% 21.70% 13.65% Basel III external ratings-based capital charge Also these recently introduced capital charges displayed in table 36 are rather expensive for insurance companies, definitely when taking into account the wide range of requirements that type 1 securitisations have to comply with. Investing in securitisations is unattractive compared to the capital charges for other investments such as covered bonds (3.03% all-in charge for 5 year AA rated covered bonds) or corporate loans (3.52% all-in charge for 5 year AA rated corporate bonds). The Solvency II capital charges are often a multiple of the Basel III requirements for similar securitisations, even when taking diversification and loss absorbency into account. A possible solution to avoid high capital charges for securitisations is the use of internal models. However, it remains to be seen whether regulators will authorise calibrations which diverge significantly from the standard capital charges. A recent study by Fitch Ratings (2012) has shown that these Solvency II capital charges are largely unrelated to realised credit losses. As an example, the new Solvency II calibrations require a 62.5% (10.5%) stand-alone capital charge for 5 year AAA rated (type 1) securitisations. This is remarkably high compared to Fitch s ratings portfolios at end-july 2007 indicating a total loss of 6.5% for AAA US RMBS or a 0.8% loss for AAA EMEA RMBS portfolios. Empirical evidence also indicates a retreat of insurers from securitisations. A recent survey by the AFME (2012) of 27 Europe-based insurance companies and asset managers has shown that a 33% of 55

58 the insurers polled planned to stop securitisation investments, while the remaining 67% planned to drastically reduce investments in the securitisation sector. In sum, the Solvency II calibration of securitisations is prohibitively high compared to the Basel III calibration. Furthermore, the Solvency II capital charges for securitisations are a multiple of the Solvency II capital charges for similar investments such as covered bonds. From a regulatory capital perspective, securitisations do not represent an attractive asset class. Government bonds The previous chapters have pointed at the low capital charges for sovereign debt under Basel III: government debt with a rating of AA- or higher gets a risk weighting of 0%. This low risk weight, together with the beneficial liquidity treatment of sovereign debt under Basel III, has made banks increase their exposure to this asset class over the past years. Solvency II capital charges are equally skewed towards sovereign exposures. Bonds issued by EU member states are exempted from the credit spread sub-module. This exemption applies irrespective of the sovereign s credit rating. Non-EU government debt is also treated favourably under the credit risk sub-module, as exposures rated AA or higher have a 0% capital charge. Government bonds are often available at longer maturities, hence sovereign debt effectively enables matching with insurers long dated liabilities. The resulting low interest rate risk, combined with diversification benefits often result in a negative capital charge for sovereign bonds, as displayed in table 37. Table 37 - Solvency II capital charges for government bonds Asset class rating duration Solvency II standalone capital charge Sovereign debt 5 years 0.00% 0.84% Sovereign debt 10 years 0.00% -2.10% Sovereign debt 15 years 0.00% -5.58% Sovereign debt 20 years 0.00% -9.06% Solvency II all-in capital charge Sovereign debt 25 years 0.00% % Sovereign debt 30 years 0.00% % These low capital charges provide a strong incentive for insurers to invest in sovereign debt, even when it is below investment grade. This means that returns for sovereign exposures, and especially lower rated sovereign exposures, are attractive for insurers under Solvency II. Figure 19 below tracks interest rates of 10 year Euro zone sovereign bonds. 56

59 6 Figure 19 - Government bond yields In basis points. Source: Bloomberg Germany 10 years Belgium 10 years Avg 10 year Eurozone The sovereign debt crisis has shown that EU debt is not risk-free, and can be highly correlated. Larger insurers are likely to incorporate these findings in their internal models. Furthermore, EU member states and non-eu members rated AA or higher are exempt from the concentration risk module. Hence, large exposures to a single government are not penalised with a higher capital charge. The beneficial treatment of sovereign debt under Solvency II is also reflected in the asset holdings of insurers: QIS 5 has shown that government bonds constitute 25.3% of insurers total assets (excluding united linked assets). In sum, the low capital charges, exemption from concentration risk, and the long maturities available enhance the role which insurers historically have played in funding governments. Residential Mortgages The Basel III standardised approach applies a relatively low risk weight of only 35% for mortgage loans. The Basel III internal ratings based (IRB) approach generally results in even lower risk weights compared to standardised approach. We identified in previous chapters that, due to these low capital charges, banks were able to increase their exposure to residential mortgage loans over the past years. Figure 20 compares the Solvency II capital charges with the Basel III standard and IRB approach charges for residential mortgage loans as a function of their loan-to-value (LTV) ratio. 57

60 6,00% 5,00% 4,00% 3,00% 2,00% 1,00% Figure 20 - Residential morgage capital charges Source: IIF and Oliver Wyman (2011) and own calculations Basel III AAA Basel III AA Basel III A Basel III BBB Basel III BB Basel III standardised approach 0,00% 70% 75% 80% 85% 90% 95% 100% Loan-to-value Solvency II stand-alone charge Comparing and Basel III Solvency II stand-alone capital charges in figure 20 leads to some remarkable insights: - Solvency II imposes a 0% stand-alone capital charge for residential mortgage loans with a LTV ratio up to 80%. Taking into account diversification benefits and matching with longterm liabilities, marginal capital charges even are likely to be negative for such low LTV mortgages under Solvency II. - Large differences exist between the capital charges implied by Basel III standardised approach and the Basel III IRB method. This difference in capital charges is especially apparent for high rated mortgage exposures. - The Basel III IRB capital charges are significantly lower compared to Solvency II for high rated, high LTV mortgages. This implies that banks using the IRB approach have a comparative advantage over insurers for high rated, high LTV segment of the residential mortgage loan market. - Insurers have a comparative advantage over banks for loans with a low LTV ratio, irrespective of the mortgage loan rating. - This difference in Basel III and Solvency II capital charges could lead to a co-financing model where banks originate residential mortgage loans and transfer the low rated, high LTV loans to insurers. It should be noted that the Solvency II stand-alone capital charge displayed in the figure 20 is solely based on the counterparty default module, not taking into account any other risk module under Solvency II. Table 38 provides the all-in capital charge of residential mortgage loans under Solvency II, taking into account diversification benefits, loss absorbing capacity and interest rate risk charges: 58

61 Table 38 - Solvency II "all-in" capital charge for residential mortgage loans Loan-to-value (LTV) Duration 80% LTV 85% LTV 90% LTV 95% LTV 100% LTV 5 years 0.84% 1.04% 1.22% 1.38% 1.53% 10 years -2.10% -1.76% -1.46% -1.20% -0.95% 15 years -5.58% -5.25% -4.95% -4.68% -4.44% 20 years -9.06% -8.72% -8.42% -8.15% -7.91% 25 years % % % % % 30 years % % % % % Given that mortgage loans are available up to high durations, interest rate risk charges under Solvency II can be highly negative, resulting in negative all-in capital charges as displayed in Table 38. Residential mortgage loans could be seen as an attractive investment for insurers from a perspective of return on equity, given the very low capital charges as displayed in figure 20 and table 38. Figure 21 displays interest rates for retail mortgages in the euro zone. This graph shows that credit spreads have largely remained constant over the past years Figure 21 - Retail mortgage credit spread Euro zone retail mortgage credit yield in basis points over sovg bond yields. Source: ECB and Bloomberg spread over 10 year German govt bonds spread over average 10 year Eurozone govt bonds Valuation methods appear to be beneficial for residential mortgage loans. Indeed, illiquid investments such as mortgages do not have market prices available, hence less volatile appraisal values are likely to be used. This in turn can reduce the volatility of insurers own-funds. Our interviews with 10 European banks corroborate our findings above. Several interviewees explicitly noted that insurers are more suitable investors in certain segments of the residential mortgage market. Interviewees noted that insurers have an advantage over banks for long-term mortgages, fixed rate mortgages, and mortgages with a low LTV. Several interviewees see that in practice, insurers are becoming more active in the market for residential mortgage loans. Insurers can create a bilateral fund with a bank, invest in a fund of 59

62 mortgages, or source mortgages independently from banks through brokers. As an example, Belfius insurance has bought Elantis, a broker in mortgage loans, together with a 3.5 bn EUR mortgage loan portfolio from Belfius Bank in As such, mortgage loans comprised 19% of total assets of Belfius Insurance in Our interview with 10 European banks also showed that especially the Dutch mortgage loan market may be attractive for insurance companies. Dutch mortgage loans are particularly long term and repayments are few. Furthermore, Dutch banks are seeking disintermediation opportunities due to their high loan-to-deposit ratio, as identified in table 3. Figure 22 illustrates the mortgage loan holdings of euro zone insurers, which still appear to be quite low at 4% of total investments. Insurers therefore appear to have some potential to increase their allocation to retail mortgages loans. 6,00% 5,00% 4,00% 3,00% 2,00% 1,00% 0,00% Figure 22 - Mortgage loan share of total insurers' investments Euro zone life and non-life insurers. Source: OECD In sum, the inherently lower risk of mortgage loans (mortgages are per definition secured), the low capital charges under Solvency II and the spreads over government bonds make retail mortgages an attractive investment for insurers. Practice also shows that insurers are becoming more active in the market for residential mortgages. Corporate bonds and loans The previous chapters have indicated how Basel III negatively affects lending to corporates. Higher capital ratios, capital quality standards and liquidity ratios have increased the cost of holding corporate loans. Banks facing a shortage in stable funding may be inclined towards disintermediation of their corporate loans. Spread graphs (see figures 23 and 24) show how corporate lending was stressed during the period Nevertheless, spreads seem to have returned to their pre-crisis levels in recent months. 60

63 Figure 23 - Corporate bond credit spreads 10 year Euro zone corporate bond yield in basis points over 10 year German bond yields. Source: Bloomberg A 5 year corp spread BBB 5 year corp spread Figure 24 - Corporate loan spreads Euro zone corporate loan yield in basis points over sovg bond yields. Source: ECB and Bloomberg spread over average 5 year Eurozone govt bonds spread over 5 year German govt bonds Table 39 provides the capital charges for corporate debt under Solvency II and Basel III. The Solvency II capital charge generally increases with durations going up from 1 year to 5 years due to the higher capital charge of the spread sub-module. The all-in capital charge generally decreases for higher durations than 5 years due to improved asset-liability matching, where the decrease in interest rate risk charge offsets the increase in spread risk charge. Table 39 shows that the capital charges under Basel III and Solvency II are broadly similar. Solvency II only grants a lower capital charge compared to Basel III for low rated corporate debt for some specific durations. Table 39 - Comparison of Solvency II and Basel III capital charges for corporate debt Asset class rating duration Solvency II stand-alone capital charge Solvency II all-in capital charge Basel III standard capital charge Basel III internal capital charge Corporate debt AAA 1 years 0.90% 2.96% 2.1% 0.36% Corporate debt AAA 3 years 2.70% 3.00% 2.1% 0.86% Corporate debt AAA 5 years 4.50% 3.03% 2.1% 1.69% Corporate debt AAA 7 years 5.56% 2.71% 2.1% 1.69% Corporate debt AA 1 years 1.10% 3.06% 2.1% 0.63% Corporate debt AA 3 years 3.30% 3.29% 2.1% 1.30% 61

64 Corporate debt AA 5 years 5.50% 3.52% 2.1% 2.41% Corporate debt AA 7 years 6.66% 3.25% 2.1% 2.41% Corporate debt A 1 years 1.40% 3.21% 5.25% 1.59% Corporate debt A 3 years 4.20% 3.73% 5.25% 2.67% Corporate debt A 5 years 7.00% 4.25% 5.25% 4.46% Corporate debt A 7 years 8.40% 4.10% 5.25% 4.46% Corporate debt BBB 1 years 2.50% 3.74% 10.5% 4.07% Corporate debt BBB 3 years 7.50% 5.34% 10.5% 5.78% Corporate debt BBB 5 years 12.50% 6.94% 10.5% 8.63% Corporate debt BBB 7 years 15.50% 7.57% 10.5% 8.63% Corporate debt BB 1 years 4.50% 4.72% 10.5% 9.06% Corporate debt BB 3 years 13.50% 8.27% 10.5% 11.25% Corporate debt BB 5 years 22.50% 11.84% 10.5% 14.90% Corporate debt BB 7 years 27.52% 13.47% 10.5% 14.90% Corporate debt unrated 1 years 3.00% 3.99% 10.5% 4.07% Corporate debt unrated 3 years 9.00% 6.07% 10.5% 5.78% Corporate debt unrated 5 years 15.00% 8.16% 10.5% 8.63% Corporate debt unrated 7 years 18.36% 8.97% 10.5% 8.63% Table 40 provides the risk-adjusted return on capital (RAROC) for investments in corporate bonds, divided into their rating and duration characteristics. The RAROC is calculated using the following formula: ield 10 expected loss 11 funding cost 12 All in SCR (1 tax rate 13 ) Table 40 shows that the RAROC is the highest for A rated bonds and bonds with a low duration. The generally low RAROCs are a sign that the duration provided by corporate bonds is not high enough to provide significant benefits from asset-liability matching (i.e. reduced interest rate risk charges). The generally low RAROCs are also a sign of the current low yield environment. Table 40 RAROC for corporate debt investments under Solvency II Asset rating duration Yield All-in SCR RAROC Corporate debt AAA 1Y 0.32% 2.96% 3.08% Corporate debt AAA 3Y 0.56% 3.00% 3.72% Corporate debt AAA 5Y 0.98% 3.03% 3.07% 10 yields are derived from Bloomberg's Euro zone composite option-free fair market curves. Yields were gathered end of April Expected losses are derived from Altman E.I. and Keugne B.J., 2012, Special report on default and return in the high-yield bond and distressed debt market: the year 2011 in review and outlook. 12 We assume that the risk free rate, i.e. the rate on Belgian government bonds is transferred to the underwriting department as a remuneration for policyholders. 13 We assume the tax rate to be 25.8% This is the average tax rate of Ageas over FY2013 and FY

65 Corporate debt AAA 7Y 1.40% 2.71% 3.51% Corporate debt AA 1Y 0.41% 3.06% 5.29% Corporate debt AA 3Y 0.79% 3.29% 8.27% Corporate debt AA 5Y 1.21% 3.52% 7.27% Corporate debt AA 7Y 1.67% 3.25% 5.39% Corporate debt A 1Y 0.53% 3.21% 7.88% Corporate debt A 3Y 0.95% 3.73% 10.30% Corporate debt A 5Y 1.42% 4.25% 9.14% Corporate debt A 7Y 1.89% 4.10% 7.83% Corporate debt BBB 1Y 0.76% 3.74% 5.68% Corporate debt BBB 3Y 1.25% 5.34% -1.98% Corporate debt BBB 5Y 1.76% 6.94% 2.29% Corporate debt BBB 7Y 2.23% 7.57% 3.47% Corporate debt BB 1Y 1.05% 4.72% 4.39% Corporate debt BB 3Y 1.50% 8.27% -2.03% Corporate debt BB 5Y 2.00% 11.84% -0.13% Corporate debt BB 7Y 2.86% 13.47% 3.29% Our interviews with 10 European banks have generally shown an appetite of banks for disintermediation of corporate lending. Furthermore, our interviews also showed examples of how banks can transfer parts of corporate lending to insurers. As such, Axa has recently set up partnerships with SocGen and ING to co-finance longer term corporate loans. The targeted loans in these partnerships have a maturity between 5 and 10 years. Hence, AXA can benefit from the credit assessment expertise of banks and obtains loans with a sufficiently high maturity to match with AXA s longer term liabilities. Furthermore, insurers can obtain an illiquidity premium through such a co-financing structure, as illiquid loan should provide a premium above more liquid corporate bond investments. Banks can benefit from such a co-financing partnership as they do not have to hold large amounts of capital or stable funding for this type of loan origination. Furthermore, this partnership enables banks to offer their clients loans at longer maturities compared to standard loan contracts. Another example of a bank-insurer partnership is the recent deal between Pensioenfonds Zorg en Welzijn (PFZW) and Rabobank. In this deal, corporate loans remained on the balance sheet of Rabobank, but the first losses, up to a certain value, are transferred to the pension fund PFZW. This structure is therefore similar to a credit default swap. Rabobank benefits from this deal as it enables to significantly reduce the RWA of their corporate loan portfolio. PFZW, on the other hand, obtains a high expected return for such contracts. 63

66 Practice also shows a strong appetite of insurers for commercial real estate loans 14, due to their longer maturity compared to standard corporate debt. As an example, Aviva, UK s largest insurer, manages a portfolio of over 10 billion in commercial mortgages 15. As a preliminary conclusion, we have shown that banks corporate lending can be constraint due to higher capital ratios, capital quality requirements, and stringent liquidity ratios. Banks therefore often seek disintermediation through bond issuance or partnerships with institutional investors. Insurers can benefit from such a partnership trough banks superior credit assessment expertise and their long standing relationships with corporate clients. Through such co-financing partnerships, insurers can also capture the illiquidity premium inherent in corporate loan spreads. However, Solvency II capital charges for corporate exposures are not necessarily lower compared to banks Basel III capital requirements. Indeed, because standard corporate debt is not available for long durations, insurers cannot significantly reduce their interest rate risk charges trough corporate debt investments. This results in broadly the same capital charges for insurers under Solvency II compared to banks under Basel III. Mortgage covered bonds Mortgage covered bonds with a rating of AA or better are given lower capital charges under Solvency II compared to plain vanilla corporate bonds. Table 41 compares capital charges under Basel III/CRD IV and Solvency II for these AAA or AA rated mortgage covered bonds. Table 41 shows that, for covered bonds with very high durations, the Solvency II all-in capital charge can become lower compared to the Basel III/CRD IV standard capital charge. Table 41 - Comparison of Solvency II and Basel III capital charges for mortgage covered bonds Asset rating duration Solvency II stand-alone capital charge Solvency II all-in capital charge Covered bond AAA 5Y 3.50% 2.55% 1.05% Covered bond AAA 10Y 6.00% 1.67% 1.05% Covered bond AAA 15Y 8.50% 0.80% 1.05% Covered bond AA 5Y 4.50% 3.03% 1.05% Covered bond AA 10Y 7.00% 2.15% 1.05% Covered bond AA 15Y 9.50% 1.29% 1.05% Basel III/CRD IV standard capital charge 14 Commercial real estate loans are given the same capital charges under Solvency II compared to standard corporate debt. 15 See 64

67 Mortgage covered bonds are generally viewed as a very low risk investment. Multiple factors attribute to this finding: - Low credit risk: the credit risk of mortgage covered bonds is inherently lower compared to unsecured bonds as they have a double recourse to both the issuer and to the cover pool in case of issuer insolvency. - Low migration risk: the risk of downgrades is lower compared to the risk of downgrades for unsecured bonds of the same issuer (see ECBC, 2013). - Exempt from bail-in arrangements: covered bonds are exempted from bail-in arrangements due to their secured nature. Indeed, the latest version of the proposal for the recovery and resolution of credit institutions and investment firms by the European Commission excludes covered bonds from write down and conversion to equity to the extent that the value of the covered bonds does not exceed the value of the collateral. - Low spread volatility: covered bond spreads generally have a lower spread volatility compared to the spreads of their respective sovereigns (see ECBC, 2013). - Low risk compared to sovereign bonds: at certain points in the sovereign debt crisis, covered bonds were higher rated than their respective sovereign. This was mainly apparent in peripheral euro zone countries. Figure 25 provides information on the pricing of German covered bonds 16. It is apparent that pricing of covered bonds can become very tight compared to their respective sovereign yield in certain periods. 6 Figure 25 - German covered bond yield vs. sovereign yield Source: Bloomberg 3-5 year German covered bond yield 4 year German government bond yield Insurance companies generally hold significant amounts of covered bonds in their books. A survey with 13 European insurers conducted by Insurance Europe and Oliver Wyman (2013) has shown that covered bonds constitute nearly 10% of their total assets. Similarly, a report by the ECBC (2013) has 16 Germany represents nearly 20% of all covered bond amounts outstanding, see ECBC,

68 shown that insures account for 10% of the aggregated demand in euro denominated covered bonds over the period January 2011 to April For covered bonds with a maturity higher than 10 years, the share of insurers increases to 36%. In sum, covered bonds could be seen as an alternative to government bonds as they provide a low risk, long-term investment with a potential to match long-term liabilities. The all-in capital charge under Solvency II can become lower compared to Basel III charges for covered bonds with very high durations. Covered bonds are also highly liquid investments, as their issue size is often larger compared to senior unsecured bonds (see ECBC, 2013). Nevertheless, Solvency II does not appear to excessively promote investments in covered bonds. Solvency II only provides a slight advantage in spread risk charge for covered bonds compared to corporate bonds. We also show that the yield pickup of covered bonds compared to sovereigns can be very tight. Hence, from a pure return on capital view, covered bonds appear to be less attractive compared to mortgage loans or corporate bonds. Long-term lending: infrastructure loans The previous chapters have shown how the Basel III capital ratios, capital quality standards, and liquidity ratios have reduced the attractiveness of infrastructure debt. The current uncertainty about the NSFR calibration provides an additional challenge for the infrastructure loan market. Infrastructure debt is generally viewed as a low risk asset class. Moody s recently published a report assessing the performance of infrastructure debt over the period The main findings include: - Cumulative default rates (CDRs) for investment-grade infrastructure debt and non-financial corporate debt are very similar for horizons up to 4 years. Beyond 4 years, CDRs are significantly lower for infrastructure exposures, demonstrating the greater stability of this asset class. - The average recovery rates for infrastructure debt are higher than for non-financial corporates. - Infrastructure debt and non-financial corporate debt show similar credit loss rates for horizons up to 4 years. Beyond 4 years, loss rates are significantly lower for infrastructure debt compared to like-rated non-financial corporates, demonstrating the greater stability of infrastructure. Even though infrastructure debt demonstrates low risk characteristics, infrastructure loans seem to provide a higher yield compared to A rated corporate debt, as shown in figure

69 Figure 26 - Credit spreads of infrastructure debt and coporate bonds Spreads are measured in basis points over the 12 month Euribor or Libor. Euro area corporate bonds vs. worldwide infrastructure debt. Table 42 provides a comparison of Basel III and Solvency II capital charges for infrastructure debt: Table 42 - Comparison of Solvency II and Basel III capital charges for long-term lending Asset class rating duration Source: Bloomberg and Projectware Solvency II stand-alone capital charge Solvency II all-in capital charge Basel III standard capital charge AA 10 year A 10 year Infrastructure debt Corporate debt AAA 10 years 7.15% 2.23% 2.1% 1.69% Corporate debt AAA 15 years 9.65% 1.36% 2.1% 1.69% Corporate debt AAA 20 years 12.15% 0.50% 2.1% 1.69% Corporate debt AAA 25 years 14.65% -0.58% 2.1% 1.69% Corporate debt AA 10 years 8.40% 2.84% 2.1% 2.41% Corporate debt AA 15 years 10.90% 1.97% 2.1% 2.41% Corporate debt AA 20 years 13.40% 1.11% 2.1% 2.41% Corporate debt AA 25 years 15.90% 0.27% 2.1% 2.41% Corporate debt A 10 years 10.50% 3.86% 5.25% 4.46% Corporate debt A 15 years 13.00% 3.00% 5.25% 4.46% Corporate debt A 20 years 15.50% 2.14% 5.25% 4.46% Corporate debt A 25 years 18.00% 1.30% 5.25% 4.46% Corporate debt BBB 10 years 20.00% 8.52% 10.5% 8.63% Corporate debt BBB 15 years 25.00% 8.89% 10.5% 8.63% Corporate debt BBB 20 years 30.00% 9.28% 10.5% 8.63% Corporate debt BBB 25 years 32.50% 8.44% 10.5% 8.63% Basel III internal capital charge Table 42 shows how all-in capital charges for infrastructure debt under Solvency II are generally lower compared to the Basel III standard calibrations. Indeed, the long durations possible in the infrastructure market provide potential for asset-liability matching, hence a lower interest rate risk capital charge. As an example, 20 year A rated infrastructure debt is given an all-in capital charge of 2.14%, which is significantly lower compared to Basel III calibrations. It should be noted that Solvency II does not provide specific spread risk charges for infrastructure loans, hence the calculations in table 42 use the standard corporate debt spread risk calibrations. Insurers using 67

70 internal models may use lower spread risk charges, thereby further reducing the all-in Solvency II capital charge for insurers. Another relevant factor is the valuation of illiquid investments such as infrastructure debt. Market prices for such loans are often unavailable, and the appraisal values used to value such loans are often less volatile. Hence, investments in infrastructure loans effectively reduce the volatility of the insurer s own-funds. Practice confirms the attractiveness of infrastructure debt for insurance companies. As an example, six UK insurers have recently announced plans to invest 25 billion in UK infrastructure projects over the next 5 years 17. The insurers involved are Legal & General, Prudential, Aviva, Standard Life, Friends Life and Scottish Widows. Our interviews with 10 European banks also confirm the findings above. It has been noted during one of the interviews that banks are not competitive compared to insurers for long dated, high rated infrastructure projects with fixed cash flows. Banks are more competitive for floating rate financing, assets with construction risk, or assets with refinancing in the future. Several banks also admit to have set up partnerships with insurers to co-finance infrastructure debt, where banks often finance the construction period, and insurers finance the lower risk, long-term maintenance phase. An example of a partnership between a bank and insurer is the co-financing agreement between Natxis and Ageas; in this partnership, the bank and insurer are both financing the construction and the operation phase together. In sum, the low risk, attractive yields, high durations possible, and relatively low capital charges under Solvency II make infrastructure loans an attractive asset class for insurers. The emergence of project bonds, infrastructure debt funds and partnerships between banks and insurers are all signs of a shift of infrastructure lending from banks to insurers. Long-term lending: export finance and public sector entity debt Both export finance and debt raised by non-central government public sector entities (PSEs) are available at longer maturities. Such loans often include guarantees, either provided by the central government or by export credit agencies. Their capital requirements under Basel III and Solvency II are very similar to the high rated exposures presented under table 42. It appears that, from a capital charge viewpoint, such loans are often cheaper for insurers compared to banks. Furthermore, insurers do not bear the increased liquidity costs of the LCR and NSFR introduced by Basel III. 17 Reuters, 4 December 2013, UK insurers plan to invest 25 billion pounds in infrastructure, 68

71 A common example of PSE debt are loans provided to social housing corporations. Such loans often benefit from an (implicit) government guarantee and are available at very long maturities. Insurers have shown a strong appetite for such loans over the past years. As an example, the UK insurer Legal & General has provided a total of 455 million in loans to social housing corporations over the past 18 months 18. Our interviews with 10 European banks also showed an increased competition from insurers in the segments of export finance and PSE debt. Certain banks indeed noted that insurers can offer a more competitive pricing than banks in these segments. One bank also admitted to fund their long-term export loans through institutional investors. In this particular financing scheme, the export loan remains on the banks balance sheet, while an institutional investor funds this loan. The institutional investor gets a state guarantee in return. The bank benefits from this deal as it is able to fund its loans at lower interest rate compared to normal bank bonds. The institutional investors basically bears a sovereign risk on its investment, but still gets a yield pickup compared to investing in normal, liquid, government bonds. Hence, such a financing scheme is a good example of how insurers can benefit from the illiquidity premium inherent in certain loans. 18 Legal & General, 2 June 2014, L&G expands commitment to the social housing sector with 50M loan to housing solutions, 69

72 CONCLUSION This report identified the impact of Basel III and Solvency II on asset allocation decisions of banks and insurers. We analysed Basel III regulations, how these influence banks funding costs, and what the specific Basel III implications are for several asset classes. We furthermore presented an overview of Solvency II framework for insurers, and assessed to which extend Solvency II may affect an efficient asset allocation of insurance undertakings. We found that a wide range of portfolios of our efficient frontier were admissible under a budget for market risk capital, while portfolios which allocated heavily towards securitization exposures were inadmissible. We also found that the market portfolio of an average European life insurer is likely to comply with a stringent budget for market risk capital. This report also compared the Solvency II framework with Basel III. The core of this report was to compare Basel III and Solvency II capital charges for different asset classes. We found that the incentives provided by Basel III and Solvency II are largely consistent with the business model of banks and insurers. As such, Solvency II directs insurers towards long-term fixed income investments, which match the long-term liabilities of insurance companies. Basel III, on the other hand, favours investments with a shorter maturity. More specifically, this report showed that insurers face significantly lower capital charges compared to banks for residential mortgage loans and other long-term lending segments such as infrastructure debt, long-term export finance, and long-term loans to local authorities. We found that sovereign debt is treated favourably under both Basel III and Solvency II. The treatment of other, shorter term asset classes was found to be similar under both regulatory frameworks. As such, we reported that capital charges for short- and medium-term corporate exposures are largely comparable under both Basel III and Solvency II. Securitised assets proved to be an exception to this rule: capital charges for securitisations are highly unattractive for insurers compared to banks. On a final note, figure 27 visually represents the attractiveness of Basel III and Solvency II capital charges for different asset classes. 70

73 Figure 27 - Attractiveness of Basel III and Solvency II capital charges Less interesting for insurers More interesting for insurers Long term lending securitisations Less interesting for banks Sovereign debt Mortgage loans corporate debt covered bonds More interesting for banks 71

74 ANNEX I - BASEL II VS. BASEL III This annex presents an overview of the core modifications introduced by Basel III. We focus on the regulatory modifications relating to the banking book and do not cover regulations for trading activities. We start with discussing the new capital quality and quantity standards imposed by Basel III, followed by a discussion of the increased risk weights for certain asset classes. New liquidity ratios, including the LCR and NSFR are also major modifications in the new framework. This annex is based on the most recent publications of the Basel Committee on Banking Supervision (BCBS). CAPITAL RATIOS Common equity, Tier 1 and Tier 2 capital ratios New Basel III rules require banks to hold additional capital, compared to Basel II, for the same risks. Traditionally, banks were obliged to hold 8% of capital, with a minimum common equity ratio of only 2%. Under the new framework, Common Equity Tier 1 (CET1) 19 has to attain at least 4.5% of riskweighted assets. The minimum of Tier 1 capital is set at 6%. Similar to Basel II, the sum of Tier 1 and Tier 2 capital must be at least 8%. Capital conservation buffer The capital conservation buffer is a new instrument that should provide banks with an additional safety net. It consists of common equity of 2.5% in risk-weighted assets, bringing the total common equity ratio to 7%. When a bank falls into this buffer range, supervisors can intervene gradually by restricting discretionary distributions. Countercyclical buffer The countercyclical buffer is a common equity tranche ranging between 0 and 2.5%. It is imposed by national supervisory authorities during periods of excessive credit growth and build-up of systematic risk. Figure 28 summarises the changes in capital ratio requirements imposed by Basel III. 19 CET1 is the capital tranche of the highest quality. It consists of the sum of common shares, share premium related to CET1 instruments, retained earnings, accumulated other comprehensive income and other disclosed reserves, and common shares issued by consolidated subsidiaries of the bank and held by third parties that meet the criteria for inclusion in CET1. 72

75 Figure 28 - Basel II vs. Basel III capital ratios 4,0% 2,0% 2,0% B A S E L I I 0-2.5% 2,5% 2,0% 1,5% 4,5% B A S E L I I I Common equity Additional Tier 1 Tier 2 Capital Conservation Buffer Countercyclical Buffer Capital quality Basel III also introduces more rigorous requirements regarding the quality of capital instruments which compose the different tiers. Innovative step-up hybrid capital previously included under Tier 1 will now be phased out. The classification of Tier 2 capital into higher and lower Tier 2 capital will be removed in order to simplify the framework. Tier 3 capital, consisting of short term subordinated debt, is now eliminated. This capital tranche was previously only available to cover market risks. In addition, Basel III requires banks to deduct several balance sheet items from common equity tier 1 capital. The most important deductions are goodwill (previously deducted from Tier 1 under Basel II), other intangibles and deferred tax assets. Systemically important financial institutions (SIFIs) Basel III imposes higher capital ratios on systemically important financial institutions (SIFIs) in order to reflect their higher risks and externalities imposed on the financial system. Depending on the bank s systemic importance, a common equity surcharge ranging from 1% to 2.5% will be applied. An additional surcharge of 1% may be imposed as a disincentive for certain banks to materially raise their global systemic risk in the future. Capital loss absorption at the point of non-viability All capital instruments (Tier 1 and Tier 2) can be imposed a full write-off or conversion to common shares when a supervisory authority judges a financial institution to be non-viable. 73

76 Non-risk-based leverage ratio Basel III introduces a non-risk based maximum of total leverage, which will serve as a floor to the risk based capital ratios. Its purpose is to impede system wide build-up of leverage as observed prior to the financial crisis. The Basel III leverage ratio is defined as: Tier 1 capital exposure measure 3% The exposure measure is the sum of on-balance sheet items (including repurchase agreements, securities financing transactions and derivatives) and off-balance sheet items (calculated with a credit conversion factor 20 between 10% and 100%). The current Basel III calibrations propose a 3% leverage ratio. Phase-in arrangements Imposing these capital requirements immediately would have forced banks to raise capital or deleverage portfolios vigorously. In order to avoid these difficulties, a long transition phase has been chosen. The phase-in period started in 2013 and ends in 2019 when all capital requirements should be in place. For instance, the minimum capital conservation buffer will gradually increase from 0% in 2013 to 2.5% in RISK WEIGHTS The Basel III reforms reported in this section discuss the increased risk weights for (re)securitisations and interbank exposures. (Re)securitisations The Basel III calibrations for (re)securitisation exposures are currently still under revision. The most recent consultative document (BCBS, 2013) indicates increased risk weights for a wide range of securitisations. Table 43 specifies the risk weights for long-term senior securitisations under the external ratingsbased approach. This table shows that risk weights under Basel III for investment grade securitisations have risen considerably compared to Basel II. Furthermore, whereas Basel II calibrations were insensitive to maturity, Basel III risk weights rise with longer maturities. More specifically, banks have to linearly interpolate between the risk weights for one and 5 years, as specified under table The credit conversion factor (CCF) is the estimated exposure at default divided by the off-balance sheet exposure. 74

77 Table 43 - Ratings-based approach risk weights for long-term senior securitisations Rating Basel III 1 year Basel III 5 years Basel II AAA 15% 25% 7% AA 25% 50% 8% A 50% 75% 12% BBB 90% 130% 60% BB 160% 230% 425% B 310% 420% deduction from capital CCC 460% 530% deduction from capital Below CCC 1,250% 1,250% deduction from capital Basel III also imposes stronger risk weights for resecuritisations. In the past, a resecuritisation (e.g. CDO or CDO²) would have been treated similarly to a securitisation (e.g. ABS or MBS), but Basel III introduces two separate regimes. More specifically, Basel III requires resecuritisations to be treated under the standardised approach. In addition, this standardised approach specifies stressed calibrations for resecuritisations compared to ordinary securitisations. These calibrations result in significantly higher capital charges for resecuritisations. Table 44 illustrates these risk weights for (re)securitisations under the standardised approach of Basel III. Table 44 - Risk weights for (re)securitisations under the standardised approach of Basel III 21 Interbank lending Rating Basel III resecuritisations Basel III securitisations AAA 69% 28% AA 693% 525% A 1111% 1049% BBB 1250% 1250% BB 1250% 1250% Basel III raises risk weights on exposures to financial institutions relative to the non-financial corporate sector, since these financial exposures are more highly correlated than non-financial ones. More specifically, Basel III introduces the so-called asset value correlation multiplier, which increases correlation assumptions for large financial institutions by 25%. Such correlation assumptions significantly increase risk weights for banks using the internal ratings-based approach for interbank exposures. 21 The inputs for attachment points and detachments points are based on Bank of America Merill Lynch (2012). 75

78 LIQUIDITY RATIOS The liquidity requirements must be one of the most important changes introduced by Basel III. Capital requirements alone have proven to be insufficient in order to prevent the past financial crisis. Basel II did not include any specific liquidity measure, while liquidity risk can have a substantial impact during periods of financial distress. Therefore, two new ratios are included with Basel III: the liquidity coverage ratio (LCR), which focuses on short-term stress, and the net stable funding ratio (NSFR), which requires to map illiquid assets to long-term, stable funding sources. Liquidity coverage ratio (LCR) The liquidity coverage ratio (LCR) requires banks to hold a sufficient amount of high-quality, liquid assets (HQLA) that can be used to offset net cash outflows under an 30-day stress scenario. The LCR is defined as: Stock of high quality liquid assets ( QLA) Net cash outflows over a 30 day period 100% The numerator of the LCR are unencumbered high-quality liquid assets (HQLA), which consist of assets that can be converted into cash at little or no loss of value during times of stress. Table 45 defines the main assets considered as HQLA, and the factor of the total amount of the respective assets which can be included as HQLA. Table 45 - High quality liquid assets (HQLA) High-quality liquid assets (HQLA) Level 1 assets: coins, bank notes, central bank reserves, securities from sovereigns, central banks, public sector entities and multilateral development banks, sovereign and central bank debt with a 0% risk weighting Level 2A assets: sovereign, central bank, multilateral development bank or public sector entity assets with a 20% risk weighting, corporate debt securities rated AA- or higher, covered bonds rated AA- or higher Level 2B assets: RMBS, corporate debt securities rated between A+ and BBB-, common equity shares Factor 100% 85% 50% - 75% Net cash outflows in the formula of the LCR are defined as the total estimated cash outflows minus the total estimated cash inflows under a 30-day stress scenario. These cash flows are calculated by multiplying the outstanding balances of various types of receivables and liabilities by the rates at which they are expected to run off or flow in. Some examples of receivables and liabilities and their respective rates are displayed under Table

79 Table 46 - Cash in- and outflows Cash outflows Factor Stable retail deposits 3% Stable term deposits provided by SMEs 5% Operational deposits generated by cash management activities 25% Undrawn committed credit lines provided to SMEs 5% Undrawn committed credit lines provided to regulated banks 40% Cash inflows Factor Maturing lending transactions backed by Level 1 assets Maturing lending transactions backed by Level 2A assets Maturing lending transactions backed by Level 2B assets Credit or liquidity facilities provided to the reporting bank Net derivative cash inflows 0% 15% 50% 0% 100% Total cash inflows are subject to an aggregate limit of 75% of total estimated cash outflows, thereby ensuring a minimum level of liquid assets under the stress scenario. Net stable funding ratio The net stable funding ratio (NSFR) is a longer-term structural ratio designed to address liquidity mismatches. The NSFR promotes more medium and long-term funding for banks and aims to limit over-reliance on wholesale funding during periods of readily available market liquidity. The NSFR is defined as: Available stable funding Required stable funding 100% The available stable funding (ASF) is determined by weighting the liabilities of the bank by the socalled ASF Factor. Table 47 specifies the most important components of each ASF category. Components of ASF category Table 47 - Available stable funding (ASF) Total regulatory capital Other capital instruments and liabilities with effective residual maturity of one year or more Stable deposits and term deposits with residual maturity of less than one year provided by retail and SME customers Funding with residual maturity of less than one year provided by non-financial corporate customers Operational deposits Funding with residual maturity of less than one year from sovereigns, public sector entities, and multilateral and national development banks Other funding with residual maturity between six months and one year Other liabilities 0% ASF factor 100% 95% 50% 77

80 The amount of required stable funding (RSF) is calculated by taking the sum of the assets weighted by the respective RSF factor. Some examples of asset categories and their RSF factors are displayed in table 48. Components of RSF category Table 48 - Required stable funding (RSF) Coins and banknotes, central bank reserves, unencumbered loans to banks with 0% residual maturities of less than six months Unencumbered Level 1 assets, excluding coins, banknotes and central bank reserves 5% Unencumbered Level 2A assets 15% Unencumbered Level 2B assets Other assets with residual maturity of less than one year Unencumbered residential mortgages Other unencumbered loans with a risk weight of less than or equal to 35%, excluding loans to financial institutions RSF factor Unencumbered securities that are not in default, physical traded commodities, other 85% unencumbered performing loans excluding loans to financial institutions All other assets not included in the above categories 100% 50% 65% Phase-in arrangements The LCR will start to be effective in 2015 with a minimum requirement of 60%. This ratio will gradually increase to 100% in The NSFR is currently under revision; its minimum standard will be introduced in

81 ANNEX II LIST OF INTERVIEWEES Name (fuction) Simon Barnasconi (Head of Financial Institutions Group) and Udo van der Linden (Debt Solutions) Dirk Gyselinck (Member of the Executive Committee, Public & Wholesale Banking and Financial Markets) Hedwige Nuyens (Head of Group Prudential Affairs) Yvan De Cock (Head of Corporate & Public Bank Belgium) Michel Verstraeten (Head of corporate lending Belgium and Luxemburg) and Bart Eekhaut (Head of business lending) Bart Guns (Senior General Manager Group Credit Risk Directorate), Carl De Bourdeaud huy ( ead Credit Risk Management) Benjamin Sirgue (Global head of aircraft, export & infrastructure finance) Peter Van Raemdonck (Director corporate finance debt capital markets) Jan-Jaap Meindersma (Head of Alternative Credit Solutions) Eric Viet (Head Financial Insitututions Advisory) Bank ABN AMRO Belfius BNP Paribas BNP Paribas Fortis ING KBC Natixis Petercam Rabobank Société Générale 79

82 ANNEX III PRODUCT COST INCREASE DUE TO BASEL III This annex details the product cost increases due to Basel III mentioned in tables 1, 4, 5, 6, 7 and 8. These calculations are based on our own methodology. Changes in capital costs are based on the following assumptions: - Required return on capital: 10% - Basel II target capital ratio: 8% - Basel III target capital ratio: 10.5% - Costs due to higher capital quality: 20.0% As a reference: the monitoring exercise as of 30 June 2011 conducted by the Basel Committee on Banking Supervisions indicates that capital deductions not previously applied under Basel II reduce the gross CET1 of Group 1 banks under the Basel III framework by 32.0%. We conservatively estimate that the total of measures which increase in capital quality - including capital deductions, a larger focus on CET1 capital, phasing out of some capital instruments and the elimination of Tier 3 capital increase the costs of holding capital by 20%. - Risk weights under the standardised approach are assumed for most asset classes. For securitisations, the ratings based approach is used. For resecuritisations, the standardised approach is used assuming the attachment points and detachments points provided by Bank of America Merill Lynch (2012). The change in capital costs is measured as: risk weight * Basel III target capital ratio * Required return on capital * costs due to higher capital quality - standard risk weight * Basel II target capital ratio * required return on capital The change in liquidity costs is measured as the sum of costs due to the LCR and NSFR. LCR and NSFR costs partly offset each other. LCR costs are measured as follows: - Shortfall of high quality liquid assets (HQLA) compared to the balance sheet total: 4%. The monitoring exercise as of 30 June 2011 conducted by the Basel Committee on Banking Supervision indicates a shortfall of liquid assets of 1.76 trillion, compared to a 58.5 trillion total assets of the aggregate sample. This implies a HQLA shortfall of 3% compared to the balance sheet total. Since banks are likely to target a LCR of higher than 100%, we assume a HQLA shortfall of 4%. 80

83 - Yield reduction due to a shift in HQLA: 2.72%. A shift in allocation from loans to HQLA will reduce the yield such assets. We assume that bank loans yielding 3.33% (ECB statistics of February 2014 on the interest rates of Euro area loans to non-financial corporations over 1 and up to 5 years) are shifted to government bonds yielding 0.61% (FTSE Euro zone government bond index 3 to 5 years maturity). - LCR costs are calculated as: shortfall of HQLA*yield reduction due to a shift in HQLA NSFR costs are measured as follows: - NSFR target ratio: 105% - NSFR ratio prior to Basel III: 94% The monitoring exercise as of 30 June 2011 conducted by the Basel Committee on Banking Supervision indicates that the weighted average NSFR for each of the bank sub-groups is 94%. - Yield increase due to a shift from non-stable to stable funding: 0.203%. We assume that banks incur costs when shifting from non-stable to stable funding. We assume a yield of non-stable funding of 0.443% (Bloomberg BFV EUR finance A 3 months yield, 0% ASF factor) and a yield of stable funding of 0.646% (Bloomberg BFV EUR finance A 2 years yield, 100% ASF factor). - We assume that banks which invest more in HQLA will equally reduce their required stable funding (RSF). - LCR costs are calculated as: RSF factor of the particular asset * yield increase due to a shift from non-stable to stable funding *[NSFR target ratio NSFR ratio prior to Basel III / (1 shortfall of HQLA * RSF factor of the particular asset)] 81

84 ANNEX IV SOLVENCY II CAPITAL CHARGE CALCULATIONS Most of our assumptions regarding our calculations of the Solvency II all-in capital charge are derived from a model provided by EIOPA in their Technical Report on Standard Formula Design and Calibration for Certain Long-Term Investments, p The most important calculation steps and assumptions of our model included the following: - We calculate the capital charge for an average European life insurer making a 10 million investment on a balance sheet total of 1000 million. - The initial balance sheet of this insurer has the following structure: Assets Corporate Bonds 340 Government bonds 260 Covered bonds 60 Equity 120 Property 40 Mortgage Loans 50 Cash 50 Reinsurance asset 80 Total assets 1000 Market value We assume that the fixed income portfolio of this insurer has a duration of 7 years, the market value of the liability portfolio is 850 and its duration is 9 years, and that the insurer has aggregate own-funds of 15% of total assets. - The calibrations for spread risk, counterparty default risk and interest rate risk are based on EIOPA s Technical Specification for the Preparatory Phase (Part I). - Interest rate risk: we gather risk-free interest rates from the Euro swap curves (EUSAYY Curncy) from Bloomberg. Given these currently low risk-free interest rates, Solvency II calibrations ask to apply a 100 bps stress on the value of assets and liabilities. We assume that the insurer substitutes 10 million from its fixed income book (average duration of 7 years) with another 10 million investment. If this investment has duration different from 7 years, than the average duration of the fixed income book changes, and the capital charge for interest rate risk will change, too. As such, if the 10 million investment has a duration lower (higher) than 7 years, the capital charge for interest rate risk will increase (decrease). - Diversification: we account for diversification using the correlation tables provided in the Solvency II technical specification. 82

85 - The loss absorbing capacity of deferred tax assets and technical provisions is estimated at 40% of the Basic Solvency Capital Requirement (BSCR). Special reference too residential mortgage loans under the counterparty default module The Solvency II capital charge for residential mortgage loans is given under the counterparty default risk module. The following capital charge is applied to residential mortgage loans: 15%*E+ 90%*E past-due Where E is the sum of the values of the exposures and E past-due is the sum of the values of the exposures which are due for more than 3 months. The value of the exposures may be reduced by the risk-adjusted value of the collateral. The standalone risk charge for property investment is 25%. We assume the value of receivables due for more than 3 months to be 0. We assume diversification benefits for property investment to be at 20%. For a loan-to-value of 80% (i.e. the value of the collateral is 125% of the value of the loan), the stand-alone risk charge for mortgage loans under Solvency II then becomes: 15%*(100%-(125%-125%*25%*80%)) +90%*0 = 0.00% 83

86 ANNEX V COMPARISON BETWEEN EFFICIENT FRONTIER AND THE AVERAGE LIFE INSURERS PORTFOLIO This annex compares portfolio 38 of the efficient frontier calculated in chapter 4 with the market portfolio of an average European life insurer, as documented by Höring (2013). We conclude that both portfolio have largely similar allocations, rating and duration characteristics. Asset Allocation of portfolio 38 Allocation of the average life insurer Government bonds 40.0% 40.0% Covered bonds 25.4% 12.5% Corporate bonds and 11.6% 29.5% securitized assets Property 17.0% 11.0% Equity 6.0% 7.0% The table above shows that both portfolios are largely similar. Portfolio 38, however, seems to allocate less to corporate bonds to the benefit of covered bonds. Rating breakdown portfolio 38 Rating breakdown for the average life insurer AAA 36.4% 49.6% AA 68.3% 15.8% A 5.5% 22.0% BBB 16.4% 8.6% BB or lower 0.0% 2.0% Unrated 0.0% 2.1% Average rating AA- AA The table above shows that both portfolios have the same average rating of AA. However, portfolio 38 seems to be concentrated around AA investments, whereas the average European life insurer holds fixed income more evenly among AAA, AA and A. Maturity breakdown portfolio 38% Maturity breakdown for the average life insurer 1-5 years 14.1% 35.6% 5-10 years 52.9% 33.7% 10+ years 33.0% 30.7% Duration fixed income (years) Duration total assets (years)

87 The table above shows very similar maturity and duration characteristics for both portfolios. Portfolio 38 does seem to allocate slightly more to 5-10 year maturities and less to 1-5 year maturities, which also explains the slightly higher duration of portfolio

88 SOURCES AFME, 2012, Economic recovery will be hampered by negative impact of Solvency II on securitisation investment AFME, 2013, Securitisation Data Report Q3:2013. Bank of America Merrill Lynch, 2012, Simplified Supervisory Formula Approach: good in theory, flawed in practice, Barclays, 2013, Leverage ratio an attack on Repo. Basel Committee on Banking Supervision, 2006, International Convergence of Capital Measurement and Capital Standards, Basel Committee on Banking Supervision, 2011, Basel III: A global regulatory framework for more resilient banks and banking systems, Basel Committee on Banking Supervision, 2012, Results of the Basel III monitoring exercise as of 30 June 2011, Basel Committee on Banking Supervision, 2012, Results of the Basel III monitoring exercise as of 31 December 2011, Basel Committee on Banking Supervision, 2013, Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, Basel Committee on Banking Supervision, 2013, Results of the Basel III monitoring exercise as of 30 June 2012, Basel Committee on Banking Supervision, 2013, Results of the Basel III monitoring exercise as of 31 December 2012, Basel Committee on Banking Supervision, 2013, Consultative Document, Revisions to the securitisation framework, Basel Committee on Banking Supervision, 2014, Consultative Document, Basel III: The Net Stable Funding Ratio, Basel Committee on Banking Supervision, 2014, Results of the Basel III monitoring exercise as of 30 June 2013, CEIOPS, 2007, QIS3 Calibration of the underwriting risk, market risk and MCR, CEIOPS, 2010, Solvency II Calibration Paper, Doff R., 2006, Risk management for insurance firms, A framework for fair value and economic capital, chapter 5. ECBC, 2012, Covered Bond Data to 2012, 86

89 ECBC, 2013, European covered bond fact book, EIOPA, 2011, EIOPA Report on the fifth quantitative impact study (QIS5) for Solvency II, EIOPA, 2013, Technical Report on Standard Formula Design and Calibration for Certain Long-Term Investments, Term_Investments 2_.pdf EIOPA, 2014, Technical Specification for the Preparatory Phase (Part I), _Technical_Specification_for_the_Preparatory_Phase Part_I_.pdf European Parliament, 2002, Directive 2002/13/EC of the European Parliament and of the Council, of 5 March 2002, European Parliament, 2002, Directive 2002/83/EC of the European Parliament and of the Council of 5 November 2002, European Parliament, 2009, 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 ), European Parliament, 2013, Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013, ( CRR ) Fitch Ratings, 2012, Solvency II and Securitisation: Significant Negative Impact on European Market, Fitch Ratings, 2013, Basel III: Shifting the Credit Landscape, Höring, D., 2013, Will Solvency II market risk requirements bite? The impact of Solvency II on Insurers asset allocation, The Geneva Papers. Institute of International Finance and Oliver Wyman, 2011, The implications of financial regulatory reform for the insurance industry, Moody s, 2012, Infrastructure default and recovery rates H1. 87

90 88