Meeting economic and regulatory objectives under Solvency II

Transcription

1 RESEARCH PAPER Meeting economic and regulatory objectives under Solvency II RUDYARD EKINDI, HEAD OF INVESTMENT SOLUTIONS - EQUITIES, UNIGESTION, SPRING 2016 Since the start of 2016, Solvency II has no longer been a question, but a reality. Rather than being seen just as an administrative burden, we believe that Solvency II creates a regulatory incentive for insurers to maximise the efficiency of their capital allocations. The way Solvency II is being implemented differs in each European country, so it is difficult to provide generalised solutions. In this note we discuss some of the issues that insurers need to consider when making their capital allocations, using some real-life examples to show how they can use equities and cross-asset solutions to meet their individual economic and regulatory objectives. In our view, while the temptation is great to shift to a solution that maximises the regulatory benefits derived from Solvency II implementation (for instance, increasing their allocation to low-yielding government bonds by selling growth assets, or passively hedging their equity exposure), the basis of any investment decision should still be an identified economic objective.

2 Contents 1. Some not-so-obvious choices Solvency-II-friendly solutions can help insurers meet both their economic and regulatory objectives Turnover and grandfathering Cost of capital for with-profits policies How to optimise an allocation to equities under Solvency II An example of multi-asset investing under Solvency II Summary Important Information Read more of our publications online: Unigestion SA I 2/15

3 1. Some not-so-obvious choices Solvency II regulation defines how much capital, as defined by the Solvency Capital Ratio (SCR), that insurance companies need to allocate to each asset class they invest in. Figure 1 shows the capital charges that are applied to various classes of equity and bond. Government debt from the European Economic Area (EEA) requires no capital reserve, while equities from the Organisation for Economic Corporation and Development area require around four times more capital than an investment in a ten-year corporate bond from the EEA. Figure 1 - Capital charges for selected asset classes under Solvency II Source: EIOPA, July 2014 Although Figure 1 is not a depiction of an asset allocation rule book, it could very much be interpreted as one. This is because it implies that in order to achieve an efficient balance sheet, an insurance company subject to Solvency II should expect an allocation to equities to provide a total return around four times greater than the same allocation to an A-rated corporate bond. As of 31 March, the ten-year bund yields of Germany, which has an AAA rating from S&P, were trading at 15bp. On the same day, Italian BBB+ rated ten-year bonds were yielding 121bp. Yet under Solvency II, these two investments are both considered to bear no risk. Furthermore, the low yields provided by assets such as German bunds are unlikely to help insurers meet their long-term liabilities. This means that as long as fixed income yields remain close to zero, insurers will need to take on significant exposure to growth assets. So at the strategic level, long-term liabilities need to be met through exposure to the equity risk premium. Read more of our publications online: Unigestion SA I 3/15

4 Some insurers have attempted to optimise their SCR by replacing some of their equity allocation with convertible bonds, as convertibles incur a lower capital charge while still providing some exposure to the equity risk premium. But convertibles involve a number of drawbacks: Convertible bonds have a higher sensitivity to changes in interest rates than equities. This might not be a risk factor that investors should take greater exposure to in the current market environment Convertibles are less liquid than equities: as of March 2016, the average value traded daily in each holding in the SPDR Barclays Convertible ETF was around USD 1.7 million, while the equivalent figure for the S&P 600 Small Cap index was USD 9 million (and USD 115 million for the S&P 500). The convertibles universe is limited in breadth. For example, the Barclays U.S. Convertible Bond >$500MM Index, which consists of US convertible securities with outstanding issue sizes greater than USD 500 million, contained just 101 positions at the end of Q We believe that as convertible bonds are hybrids of equities and bonds, allocating to the asset class in fact represents a shift away from equities to a multi-asset solution. In our view, more efficient multi-asset strategies exist, as we outline in Chapter 4. In practice, insurance companies need to find the right compromise between meeting their economic objectives (often a performance target), the amount of capital they allocate to this insurance portfolio, and the expected remuneration they receive for immobilising this capital. Read more of our publications online: Unigestion SA I 4/15

5 2. Solvency-II-friendly solutions can help insurers meet both their economic and regulatory objectives In this section we look at some of the common objectives of insurance companies as they seek to manage their balance sheet, and Solvency II solutions that could help them meet their aims. When considering possible solutions, insurers should consider if the proposed strategy helps them meet the following three criteria: improve their Sharpe ratio reduce their required capital ensure a stable reserve and minimise the risk of capital calls, which in turn can reduce their cost of borrowing Turnover and grandfathering The grandfathering rule stipulates that the capital charge for direct investments in OECD-listed equities ( type I equities ) made prior to 1st January 2016 and held for a minimum period of seven years is reduced from 39% to 22%, increasing linearly up to 39% by the end of the seven-year period. If any turnover occurs prior to the seven-year deadline, the capital charge is automatically set at 39%. Figure 2 Solvency Capital Requirement of equity portfolios under the grandfathering schedule 50% 40% SCR 30% 20% 10% Grandfathering Period SCR = Active hedged Portfolio SCR Long Only Active SCR equity (Standard Formula) 0% Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Source: Unigestion, EOPIA Under this rule, insurers are incentivised to buy and hold investments for seven years but in doing so they forego the benefits that active management can provide. In order to measure the trade-off between economic and regulatory optimisation, we compare the SCR outcomes of a passive investment in the Stoxx 600 Europe equity index with that of an investment in Unigestion s actively risk-managed European equities strategy based on its performance from 2004 to From May 2004 until December 2015, Unigestion s active European equities strategy s average seven-year rolling excess outperformance of its benchmark was 246bp per annum net of fees. The average monthly turnover of our strategy is 7%, which means it takes an average of 15 months to rotate the entire portfolio and therefore reach the maximum 39% SCR charge for this strategy. We show how the SCRs of investments in our European equities strategy and in the benchmark evolve in Figure 3, in which we assume the investments are made on 31 December 2015 the last day before the new rules came in. Read more of our publications online: Unigestion SA I 5/15

6 Figure 3 SCRs of passive and active European equities strategies under grandfathering regulation Buy and hold (0% turnover) Strategy (7% AVGE monthly TO) 45% 40% 35% 30% 25% 20% 15% Source: Unigestion. Simulated data. Please refer to the Important information on performance at the end of this document. Past performance is not indicative of future performance. Figure 4 shows the extra SCR of our active strategy compared with that of the buy-and-hold investment over the seven years in question. It rises to a maximum of 13 percentage points higher than the passive investment 15 months after the initial investment, but then falls towards zero over the remainder of the seven-year period. Figure 4 - Excess SCR of active relative to passive European equities strategies under grandfathering rules 16% 14% Marginal SCR 12% 10% 8% 6% 4% 2% 0% -2% Source: Unigestion. Simulated data. Please refer to the Important information on performance at the end of this document. Past performance is not indicative of future performance. Read more of our publications online: Unigestion SA I 6/15

7 Figure 5 shows the remuneration of capital for choosing the active strategy, as measured by dividing its average excess return by the rolling excess SCR. In the first 15 months, the SCR of the active strategy rises faster than the linear rate of passive grandfathering. This is why the curve in Figure 5 declines initially because the excess return of the active strategy is divided by a rising excess SCR. But afterwards, the opposite happens: the incremental SCR diminishes as the grandfathering rate gets closer and closer to 39%. The lowest point of figure 5 is at 20%, this means that, based on an excess performance and a turnover equal to what our strategy delivered between , the excess SCR of active over passive is remunerated by at least 20% return of capital over the seven year grandfathering period. Figure 5 - Remuneration of active SCR Source: Unigestion, simulated data. Please refer to the Important information on performance at the end of this document. Past performance is not indicative of future performance. When choosing to invest in an active strategy rather than passive grandfathering, an insurance company will assess whether the potential for excess performance of the active strategy outweighs the short term increase in SCR Cost of capital for with-profits policies With-profits strategies offer a guaranteed level of performance to an insurance company s policyholders, and this leads to a higher capital requirement for the insurance company s shareholders. In addition, any performance achieved in excess of the with-profits policyholders set guarantee is distributed between those policyholders and the shareholders according to a pre-defined rule generally, 85% of the surplus might go to policyholders and 15% to the shareholders. This makes with-profits products capital-expensive for insurers and with an asymmetric profits sharing rule since most of the excess return is in favour of the policy holder. Solvency II-friendly solutions for with-profits portfolios can help make policies a lot more economical for insurance companies by ensuring that no more capital than is necessary is used to achieve their performance and risk targets. This can be summarised in the three objectives below: Read more of our publications online: Unigestion SA I 7/15

8 ensuring there is a high probability that the guaranteed performance is achieved ensuring minimal use of capital ensuring that the remuneration of the capital that is used is high because the share of profit for the company is low. We have modelled a with-profits policy assuming that assets are invested on the one hand in the MSCI World index and on the other in a risk-managed global equity portfolio that uses dynamic hedging strategies to provide downside protection. The former strategy carries an SCR of 39%, while the latter has an estimated SCR of around 25% due to the reduced downside risk it involves thanks to its hedging policy. Table 1: Simulated return, risk and SCR profiles of a risk-managed global equities portfolio relative to the MSCI AC World MSCI World ACWI Risk-managed equities with dynamic hedge Average annual return 6.92% 7.06% Average volatility 13.20% 5.90% Sharpe ratio Maximum drawdown 30.32% 8.20% SCR 39% 25.4% Average return on SCR 14.31% 21.29% Source: Unigestion, simulated performance in US dollars, gross of fees, from 20 December 2002 to 18 December Please refer to the Important information on performance at the end of this document. Past performance is not indicative of future performance. According to our simulations, the risk-managed strategy provides better risk-adjusted returns over this period and better remuneration of capital. What s more, as Figure 6 below shows, the delivery of the guaranteed return is never in question (unlike for the index strategy) in this simulation while the grey line of the MSCI World falls beneath the guarantee level during the market turbulence of 2008, the hedged strategy remains well above it, maintaining a large reserve throughout the period. Read more of our publications online: Unigestion SA I 8/15

9 Figure 6 - Cumulative NAV of with-profits solution compared with passive equity investment 30'000 25'000 20'000 MSCI World ACWI, Distributed Surplus :75% Profit Sharing: 15% Navigator, Distributed Surplus :0% Profit Sharing: 0% MSCI World ACWI+ Policy Holder Reserve Navigator+ Policy Holder Reserve MSCI World ACWI Guarantee Line Navigator Guarantee Line 15'000 10'000 5' Source: Unigestion, simulated performance in US dollars, gross of fees, from 20 December 2002 to 18 December Please refer to the Important information on performance at the end of this document. Past performance is not indicative of future performance. The risk-managed strategy also offers better downside protection, as Figure 7 shows. We can see that the unhedged passive investment suffers much worse drawdowns than the hedged solution. Figure 7 - Cumulative drawdowns of risk-managed global equity portfolio using dynamic hedging and the MSCI AC World 0.00% % % % MSCI World ACWI: Drawdown Navigator: Drawdown % % % % Source: Unigestion, simulated performance in US dollars, gross of fees, from 20 December 2002 to 18 December Please refer to the Important information on performance at the end of this document. Past performance is not indicative of future performance. Read more of our publications online: Unigestion SA I 9/15

10 3. How to optimise an allocation to equities under Solvency II Solvency II regulation states that the SCR of an equity allocation could be reduced using risk mitigation techniques in other words, hedging. In determining the appropriate hedging strategy for their equity portfolio, an investor needs to decide what level of total SCR they wish to target. This decision depends on the trade-off between expected return and the level of SCR they want to achieve. Figure 88 shows the return to SCR ratios that can be achieved using an actively risk-managed strategy (as represented by Unigestion s risk-managed European equities strategy the red dots) or a passive investment (as represented by the Stoxx Europe 600 the grey dots) with an overlay of various hedging strategies and hedging ratios. Figure 8 - Choosing the SCR target of an equity portfolio 9.0% 8.0% Annualized performance 7.0% 6.0% 5.0% 4.0% Fund + Collar (Long 50% Put 1Y-100 at the money / Short 100% Call 1M-105 Out of Fund + Collar (Long 50% Put 1Y-90 Out of the money) Fund + Short 33% index future the money / Short 100% Call 1M-105 Out Fund + Short 25% index future of the money) Fund + Long 50% Put 1Y-100 at the money Fund + Long 50% Put 1Y-95 out of the money Fund + Put Spread (50% Long 1Y-95 out of the money - Short 1Y-80 out of the money) Index + Collar (Long 50% Put 1Y-100 at the money / Short 100% Call 1M-105 Out Index + Collar (Long 50% Put 1Y-90 Out of of the money) the money / Short 100% Call 1M-105 Out Index + Short 33% index future of the money) Index + Short 25% index future Uni-Global Equities Europe 3.0% Index + Long 50% Put 1Y-100 at the money Index + Long 50% Put 1Y-95 out of the money Index + Put Spread (50% Long 1Y-95 out of the money - Short 1Y-80 out of the money) Stoxx Europe 600 TR Net 2.0% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Estimated SCR Based on simulated performance from 21 April 2006 to 31 March Options underlying is the Euro Stoxx 50. Futures are based on the generic contract of the Euro Stoxx 50, ticker VG1 Index. Source: Unigestion, Bloomberg, Morgan Stanley. Please refer to the Important information on performance at the end of this document. Past performance is not indicative of future performance. Each hedging strategy impacts the pay-off profile differently, as Figure 9 shows. This means that the investor can choose the strategy that best suits their individual needs. Generally, systematic hedging strategies help improve a portfolio s Sharpe ratio, as is the case in the table below. Yet because of the specifics of the period that we looked at ex dividends, the Eurostoxx 50 falls in value between April 2006 and March 2016 the hedges also result in higher absolute performance:. However, dynamic hedging strategies are able to achieve higher Sharpe ratios and absolute returns even when the underlying index rises in value. Read more of our publications online: Unigestion SA I 10/15

11 Figure 9 Impact on the risk budget From 21 April 2006 to 31 March 2016 Perf p.a. Volatility Max draw down SCR Return/ volatility Return/ draw down Return/ SCR Stoxx Europe 600TR Net 2.83% 20.5% -58.7% 43% Uni-Global equities Europe 5.83% 14.7% -44.7% 43% Hedging overlay Short 33% index future Index 4.05% 13.2% -43.2% 30.0% Fund 6.41% 8.7% -26.2% 30.0% Long 50% Put 1Y-100 at the money Index 3.18% 14.3% -47.0% 21.0% Fund 5.72% 9.5% -30.1% 21.0% Put spread (50% Long 1Y-95 out of the money-short 1Y-80 out of the money) Index 3.15% 18.1% -54.6% 32.0% Fund 5.98% 12.6% -39.5% 32.0% Collar (Long 50% Put 1Y-90 Out of the money/short 100% call 1M-105 Out of the money) Index 3.81% 13.5% -40.3% 26.0% Fund 61.8% 10.0% -27.5% 26.0% Simulated performance from 21 April 2006 to 31 March Options underlying is the Euro Stoxx 50. Future is based on the generic contract of the Euro Stoxx 50, ticker VG1 Index. Source: Unigestion, Bloomberg, Morgan Stanley Please refer to the Important information on performance at the end of this document. Past performance is not indicative of future performance. Read more of our publications online: Unigestion SA I 11/15

12 4. An example of multi-asset investing under Solvency II Let s consider Unigestion s macro-risk-based multi-asset strategy, Uni-Global Cross Assets Navigator, which invests in cash, derivatives, bonds, equities, credit, and currencies. The strategy is highly diversified, which helps reduce its SCR. Solvency II regulation uses the correlation matrix below for multi-asset portfolios. We can see that all the correlations in this matrix are either zero or positive which is, in the real world, unrealistic. Table 2 - Correlations between asset classes under the standard formula Bonds Equities Real estate FX Credit Bonds Equities Real estate FX Credit Source: EIOPA All calculations in this section are as of 31 January On that date, the respective shock values used for SCR purposes, as specified by the European Insurance and Occupational Pensions Authority, were: Table 3 - SCR for individual asset classes of the strategy SCR Bonds 0.75% SCR Equities 8.67% SCR Forex 4.49% SCR Credit 4.76% Source: Unigestion, European Insurance and Occupational Pensions Authority The total SCR the Navigator portfolio is obtained by applying the figures in the correlation matrix above to these individual SCR figures, so we get 18.68% of the total portfolio. If all assets were perfectly correlated in which case the correlation matrix would be filled with ones the total SCR of Unigestion s multi-asset strategy would be 25.98% (obtained by adding the individual SCRs). So under the standard formula method, the improvement in the SCR resulting from diversification can be estimated to be 7.31% (25.98% minus 18.68%). It is also interesting to see which assets contribute most to the reduction in SCR that results from diversification, as the figure below shows. Read more of our publications online: Unigestion SA I 12/15

13 Chart 1- Contribution to SCR of individual asset classes 100% 90% 15% 80% 70% 60% 50% 40% 30% 20% 10% 0% 36% 19% 30% contrib to SCR reduction FX Credit Equities Bonds Source, Unigestion, data as of 31 st January 2016 We can also estimate the SCR of Navigator using the internal formula, which involves estimating the one-year 99.5% value at risk (VaR) of the total portfolio. Doing so results in the following SCR breakdown. Table 4 - VaR contribution of each asset class, breakdown of internal SCR VaR contributions Bond -0.30% DM Equity 9.19% EM Equity 2.19% Credit 0.91% FX 1.42% Commodities 0.00% Cash 0.18% Total 13.58% Source, Unigestion The total SCR obtained in this case is substantially lower than with the standard formula. It also gives a different breakdown of SCR contributions, which we show below. Read more of our publications online: Unigestion SA I 13/15

14 Figure 10 - Comparison of SCR breakdown for standard and internal formula 120.0% 100.0% 80.0% 60.0% 40.0% 20.0% Credit FX Equities Bonds 0.0% -20.0% Contribution to Gross Nominal Exposure Contribution to Standard Formula SCR Contribution to Internal Formula SCR Source: Unigestion We can see that under the internal formula, bonds make a negative contribution to the SCR, which cannot happen with the standard formula because all correlations are positive in that framework. The impact of equities on the SCR is much larger under the internal formula, and one can assume that under the standard formula the contribution to SCR of credit is overstated. Overall, Unigestion s macro-risk based multi-asset strategy offers significant SCR reduction compared to a default 49% for this type of strategies. This SCR reduction is substantial using the standard formula and even more under the internal formula. Both methods present the same hierarchy of SCR contributors. The main limitation of the standard formula is that it fails to account for a marginally negative impact of bond instruments. Read more of our publications online: Unigestion SA I 14/15

15 5. Summary Solvency II regulation creates incentives for insurers to optimise their capital allocation. Yet there is the risk that the capital charges set by this regulation are not necessarily in line with the real risk that institutional investors face over the medium to long term. Clearly, there is a need to achieve the right trade-off between meeting their economic and regulatory objectives. In this paper we have shown how allocating to risk-managed strategies, using a variety of hedging techniques and diversifying their assets using multi-asset strategies are among the techniques that can help investors achieve the right balance between reducing their solvency capital ratio while preserving or even improving the Sharpe ratios of their investments. If you would like to find out more about our Solvency II solutions, please get in touch with us at one of the following addresses. Institutional investors: Consultants: Journalists/press agencies: clients@unigestion.com consultants@unigestion.com pressrelations@unigestion.com Important Information This document is addressed to professional investors, as described in the MiFID directive and has therefore not been adapted to retail clients. This document has been prepared for information only and must not be distributed, published, reproduced or disclosed by recipients to any other person. It does not constitute an offer to sell or a solicitation to subscribe in the strategies or in the investment vehicles it refers to, which may be construed as high risk and not readily realisable investments which may experience substantial and sudden losses including total loss of investment. The views expressed in this document do not purport to be a complete description of the securities, markets and developments referred to in it. To the extent that this report contains statements about the future, such statements are forward-looking and subject to a number of risks and uncertainties, including, but not limited to, the impact of competitive products, market acceptance risks and other risks. All information provided here is subject to change without notice. It should only be considered current as of the date of publication without regard to the date on which you may access the information. All investors must obtain and carefully read the prospectus which contains additional information needed to evaluate the potential investment and provides important disclosures regarding risks, fees and expenses. Past performance is not a guide to future performance. You should remember that the value of investments and the income from them may fall as well as rise and are not guaranteed. Rates of exchange may cause the value of investments to go up or down. An investment with Unigestion, like all investments, contains risks, including total loss for the investor. Data and graphical information herein are for information only and may have been derived from third party sources. Unigestion takes reasonable steps to verify, but does not guarantee, the accuracy and completeness of this information. As a result, no representation or warranty, expressed or implied, is or will be made by Unigestion in this respect and no responsibility or liability is or will be accepted. Unless otherwise stated the source is Unigestion. Read more of our publications online: Unigestion SA I 15/15