Solvency II and Money Market Funds FOR INSTITUTIONAL INVESTORS ONLY NOT FOR USE BY OR DISTRIBUTION TO RETAIL INVESTORS
Background The new European insurance regulatory framework, Solvency II, will require insurance companies to look more closely at the interaction between assets and liabilities in order to provide a holistic risk appraisal of their balance sheets. Importantly, for insurance company CIOs and their investment teams, the regulations emphasise modelling of the discrete risk profiles of investment holdings, as opposed to applying capital charges based on asset class definitions. For insurance companies investing in money market funds, this has meaningful implications. Cash investments are likely to form a part of all insurers investment portfolios. The recent credit crisis and ongoing turbulence in the European banking sector has illustrated the importance of counterparty and liquidity risk. Yet under most current regulatory regimes cash investments, whether in the form of money market instruments, funds or cash, attract a zero capital charge. Solvency II prescribes a more detailed approach to capital, starting with cash deposits, which attract a Solvency Capital Requirement ( SCR ) in line with the counterparty risk of the deposit bank holding the balance. In this paper we examine the treatment of money market funds under Solvency II, based on our interpretation of the technical specifications contained within the fifth published Quantitative Impact Study ( QIS 5 ) 1. There will be ongoing deliberations around the treatment of cash instruments, but it is clear at this stage that insurers and fund managers alike will need to start developing an approach to money market investments that is in line with the new solvency requirements. Executive Summary Despite some uncertainty, we believe the intention is to model money market funds on a full look-through basis under Solvency II s Market Risk module. In cases where a look-through is not possible, we believe money market funds will be classified de facto as Other Equity, attracting an SCR of up to 49%. It will be essential for insurance companies to meet new reporting standards, requiring fund managers to provide a good level of transparency to underlying holdings in a timely manner. In summary, we believe that a well diversified money market fund is likely to produce a lower capital charge under Solvency II than direct cash investments. 1 QIS5 Technical Specification: This is a working document of the European Commission services for testing purposes and should be considered to be a guide to the final Solvency II Pillar I proposals. Solvency II and Money Market Funds 3
Look-Through Methodologies All investments held by insurance companies, including money market funds, fall under the Market Risk module and Default Risk module of the Solvency II framework. In order to measure the market risk inherent in a money market fund (or indeed in any collective investment vehicle) Solvency II requires the use of a look- through methodology 2. There are three options available: 1. Security level look-through A security level look-through applies the appropriate Market Risk sub-module to every security in the money market fund based on its individual risk profile. Under Solvency II, insurers are expected to carry out a full security level look-through unless there is a good reason not to, for example, if their investment manager cannot provide the portfolio holdings. 2. Portfolio level look-through Where a full security level look-through is not possible, the SCR calculation may be based on a fund s prospectus guidelines. However, insurers should be aware that many fund managers draft very broad investment guidelines in their prospectuses in order to maintain maximum flexibility, and so a market risk calculation based on such prospectus guidelines may be less reflective of actual risk and may therefore result in a higher SCR. 3. No look-through If no security or portfolio level look-through is possible, the fund will be classified as Other Equity, resulting in an SCR of up to 49%. Clearly, this would not be commensurate with the actual investment risk incurred, and would materially overstate the true market risk of a money market fund. A security level look-through will give the most accurate representation of market risk and will, in all likelihood, lead to a lower capital charge being applied to a money market fund investment. 2 Source: QIS 5 technical specifications SCR 5.4 page 109. 4 Solvency II and Money Market Funds
Risk Modules Applicable to Money Market Funds Figure 1 illustrates the Market Risk sub-modules that apply to money market funds 3. By undertaking a full security level look-through, insurance companies can place all of a money market fund s holdings in the appropriate risk sub-module, and calculate the SCR as if the company holds a direct investment in the underlying securities. Figure 1: The Market Risk Sub-Modules Applicable to Money Market Funds Currency Interest Spread Concentration Counterparty Certificate of Deposit 4 4 4 4 Commercial Paper 4 4 4 4 Corporate Bond 4 4 4 4 Government Bond EEA 4 4 Government Bond Non EEA 4 4 4 4 Repo (Short Maturities) 4 4 Repo (Longer Maturities) 4 4 4 4 Time Deposit (Longer Maturities) 4 4 4 4 Time Deposit (Short Maturities) 4 4 Currency Risk applies if the currency of the money market fund differs from the balance sheet reporting currency of the insurer. Interest Risk applies if the net asset value of a money market fund or its underlying holdings is sensitive to changes in the term structure of interest rates. It is measured by applying predefined up and down stresses to the term structure of the instrument and assessing the difference between the stressed and current valuations. Given the short-dated nature of money market instruments, the impact of interest rate risk to the overall SCR, although relevant, will be relatively low. 3 Implications for money market funds are based on the QIS5 Standard Formula. For internal models, the risk capital calibration should at least capture the risks in the market risk module of the standard formula. The methodology and the calibration could be different (e.g., Tail VaR risk measure) and new risk sub modules can be added. Solvency II and Money Market Funds 5
Spread Risk measures the price sensitivity of instruments to the volatility of credit spreads according to credit quality and duration. Given the typically high quality and short duration of the underlying holdings of a money market fund, one would expect Spread Risk to have a relatively low impact on the SCR. However, regulations require Spread Risk to be measured with a duration floor of one year. Most money market instruments have a materially shorter duration than this, so it could be argued that the standard model will inherently overstate Spread Risk. Note that all EEA sovereign debt is excluded from the Spread Risk charge 4. Concentration Risk applies if exposure to any counterparty exceeds a pre-defined threshold, which will vary by credit quality of the counterparty. If the exposure falls below the specified threshold, it is considered well diversified and no charge is applied. Importantly, counterparty exposure is measured across the balance sheet, not at portfolio level. For the purposes of our analysis, we are only able to consider counterparty concentrations at the portfolio level and therefore work under the assumption that there is no Concentration Risk charge. Note also, that all EEA sovereign debt is excluded from the Concentration Risk charge 5. Counterparty Risk reflects the probability of a counterparty default and the total resulting economic loss (i.e., loss caused by a default, based on historic loss severity data per credit rating). For cash deposits, the specifications assume a 100% loss in the event of default 6. In the event of deteriorating counterparty credit quality, the probability of default automatically increases, leading to a higher SCR. In the context of money market funds, the charge applies only to cash deposits, which we define in the following section. Increasing the number of counterparties will result in a diversification credit and a lower SCR 7. Counterparty Risk is a separate module to Market Risk and is therefore aggregated with Market Risk via a proscribed correlation matrix to produce the final SCR. For money market funds, counterparty risk is mitigated by the number of underlying securities and the high credit quality of the holdings. 4 SCR.5.88. No capital requirement should apply for the purposes of this sub-module to borrowings by or demonstrably guaranteed by national government of an EEA state, issued in the currency of the government, or issued by a multilateral development bank as listed in Annex VI, Part 1, Number 4 of the Capital Requirements Directive (2006/48/EC) or issued by an international organisation listed in Annex VI, Part 1, Number 5 of the Capital Requirements Directive (2006/48/EC) or issued by the European Central Bank. 5 SCR.5.124. No capital requirement should apply for the purposes of this sub-module to borrowings by or demonstrably guaranteed by national government of an EEA state, issued in the currency of the government. 6 Page 90, Q 212 CEIOPS Q&A Doc 2010 / 1104 makes reference to the recovery rate of cash. 7 Our analysis found that there are diminishing benefits of diversification when the number of counterparties goes beyond 15. Where there are more than 15 counterparties the calibration shifts to become a Type II exposure and by definition the expectation of loss for cash could make this more punitive. 6 Solvency II and Money Market Funds
Differentiating Between Cash Deposits and Time Deposits The Q&A published by EIOPA as part of QIS 5 explicitly addresses the treatment of time deposits 8. Time deposits should be covered in the Spread Risk, Interest Risk and Concentration Risk modules. Conversely, the Q&A goes on to state that cash at bank, which includes deposit accounts where the depositor can withdraw cash at any time and arrangements of a comparable risk profile, 9 is subject to the Counterparty Risk module. There is no explicit differentiation between time deposits and cash at bank (or cash deposits ) and in the absence of a clearer definition, we have interpreted cash deposits to mean any form of deposit with a maturity of 5 business days or less. The treatment of time deposits has attracted comment from key stakeholders in the money market fund industry. The contention is that Solvency II could potentially apply a lower SCR to a time deposit (subject only Spread and Concentration Risk) than to a diversified money market fund (subject to multiple Market Risk modules). This is clearly counter-intuitive, so the distinction drawn between instruments with a maturity of one week or less (i.e., cash deposits subject to Counterparty Risk) and longer instruments (subject to Market Risk modules) is important from a risk perspective in our view. Consequently, we have defined repo agreements and time deposits of one week or less as subject to Counterparty Risk, while instruments with a maturity of more than one week are treated like bonds, under the applicable Market Risk modules. A Worked Example: JPMorgan EUR Liquidity Fund We have looked at how the SCR would be calculated for a money market fund under the Standard Formula. Using the methodology described above we derived an SCR for the JPMorgan Liquidity Funds - Euro Liquidity Fund. While the analysis does not take account of the asset s interaction with the liability side of an insurance balance sheet, the indicative capital charge for investments in this fund would be around 1.1%. 8 P.59, Q83, CEIOPS Q&A Doc 2010 / 1104. 9 P.59, Q83, CEIOPS Q&A Doc 2010 / 1104. Solvency II and Money Market Funds 7
Cash Deposits versus Money Market Funds Comparing the standard look-through model SCR of the JPMorgan Liquidity Funds - Euro Liquidity Fund to cash deposited with institutions of varying credit ratings (Figure 2), the results of our analysis strongly support the case for money market funds, showing that the SCR of a welldiversified fund will be roughly equal to that of a AAA-rated deposit bank, but noticeably higher in the case of a lower rated deposit institution. Figure 2: Counterparty Risk for a Money Market Fund versus Cash Deposits by Credit Rating 1 0.8 One counterparty 15 counterparties Total SCR 0.6 0.4 0.2 0 EUR MMF AAA AA A BBB BB B or lower Source: J.P. Morgan Asset Management Valuations as at 31 December 2010 based on Standard formula - QIS 5 Technical Specifications. Assumes Asset only stresses on interest rate, Spread risk, currency risk and currency risk and counterparty risk. Money Market Fund Cash Deposits 1.6% Benefits of Interest Risk Diversification Counterparty Risk 1.4% 0.09% Solvency Capital Requirement 0.37% 1.2% Total SCR 0.56% 1.0% Spread Risk 0.8% Source: J.P. Morgan Asset Management Valuations as at 31 December 2010 based on Standard formula - QIS 5 Technical Specifications. Analysis based on type I counterparty exposure. 0.6% 1.10% Euro Liquidity Fund Rating AAA AA A BBB BB B or lower 1.1% 1 c/party 1.3% 3.0% 6.7% 14.7% 54.4% 100.0% 15 c/parties 0.9% 2.0% 4.5% 9.7% 36.0% 65.6% Even when deposits were spread among 15 counterparties, the money market fund compared favourably with respect 0.4% to the SCR. 0.82% 0.2% 0.0% 1.6% 8 Solvency II and Money Market Funds Cert. of Depos 0.33% Corp. Bonds 0.08% Repos 0.02% Treasury Bills 0.003% Gov. Bonds 0.0002% Benefits of Diversification 0.37%
Time Deposits versus Money Market Funds For time deposits with a maturity greater than one week, the analysis continues to support investing in a well-diversified fund over a time deposit from an SCR perspective. In the current market environment, most banks have a rating of AA or A, so we modelled the SCR impact of holding time deposits of varying terms with a AA-rated bank versus a position in a well-diversified fund. The results in Figure 3 show that, even against a one-week time deposit with a AA-rated bank, the overall SCR for a money market fund investment may still be lower. Figure 3: Counterparty Risk for a Money Market Fund versus Time Deposits Money Market Fund Time Deposits Euro Liquidity Fund 1 week 3 months 6 months Risk Module Counterparty, Spread, Interest Spread, Interest Spread, Interest Spread, Interest SCR 1.097% 1.100% 1.119% 1.175% Source: J.P. Morgan Asset Management Valuations as at 31 December 2010 based on Standard formula - QIS 5 Technical Specifications. The findings of this analysis should help alleviate some of the concerns expressed by market stakeholders. From a risk perspective, it is more prudent to buy the diversification inherent in a money market fund, as opposed to simply placing cash on deposit. Our modelling indicates that the QIS 5 specifications support this view. While it is not possible to say that a time deposit will always attract a higher SCR than a money market fund, the analysis shows that a welldiversified product should result in a lower capital charge. Solvency II and Money Market Funds 9
0.8 1 0.6 0.8 SCR 0.4 Attribution Total SCR Total SCR 1 0.6 0.2 0.4 0 0.2 One counterparty 15 counterparties One counterparty 15 counterparties EUR MMF AAA AA A BBB BB B or lower Turning now to the components of the SCR, the percentage of the total SCR attributable to the 0 specified Market Risk and Counterparty Risk modules are illustrated in Figure 4 below. EUR MMF AAA AA A BBB BB B or lower 1.6% Figure 4: SCR Attribution Counterparty by Risk Risk Module 1.4% Interest Risk 0.09% 1.6% 1.2% Interest Risk 1.4% 1.0% Counterparty 0.56% Risk Spread Risk 0.09% 0.8% 1.2% 0.56% 0.6% 1.0% Spread Risk 0.8% 0.4% 0.82% 0.6% 0.2% 0.4% 0.0% 0.82% 0.2% Benefits of Diversification Benefits 0.37% of Diversification 0.37% Total SCR Total SCR 1.10% 1.10% 0.0% Source: J.P. Morgan Asset Management Valuations as at 31 December 2010 based on Standard formula - QIS 5 Technical Specifications. Figure 5: SCR Attribution by Instrument 1.6% 1.4% Corp. Treasury Gov. Benefits of Comm. Cert. of Bonds Repos Bills Bonds Diversification Paper 1.6% 0.37% SCR 1.2% Depos 0.08% 0.02% 0.003% 0.0002% 0.48% 1.10% 0.33% 1.4% 1.0% Time Comm. Paper SCR 1.2% 0.8% Deposits 0.48% 1.10% 0.53% 1.0% 0.6% SCR Spread SCR Interest Time SCR counterparty Benefits of Diversification 0.8% 0.4% Deposits Total SCR 0.53% 0.6% 0.2% SCR Spread SCR Interest SCR counterparty Benefits of Diversification 0.4% 0.0% Total SCR Source: J.P. Morgan Asset Management Valuations as at 31 December 2010 based on Standard formula - QIS 5 Technical Specifications. 0.2% 0.0% Cert. of Depos 0.33% Corp. Bonds 0.08% Repos 0.02% Treasury Bills 0.003% Gov. Bonds 0.0002% Benefits of Diversification 0.37% Instrument Time Commercial Cert. of Corporate Repos Treasury Gov Type Deposit Paper Deposits Bonds Bills Bonds SCR 0.53% 0.48% 0.33% 0.08% 0.02% 0.003% 0.0002% Portfolio Weight 25.7% 36.7% 23.5% 6.6% 5.0% 2.3% 0.2% Source: J.P. Morgan Asset Management Valuations as at 31 December 2010. 10 Solvency II and Money Market Funds
Observations on the Attribution Analyses As expected, Spread Risk made the largest contribution to overall SCR. This is mainly due to the one-year duration floor imposed on Spread Risk by the QIS 5 specifications. Commercial Paper and Certificates of Deposit account for the majority of the Spread Risk SCR, although in practice their durations would be well below one year. A fund with a higher allocation to EEA government debt (which does not attract Spread Risk) would likely result in a lower SCR. Concentration Risk is dependent on the total balance sheet exposure to a counterparty and therefore including this risk module in an analysis focused only on the asset side would not be meaningful. The majority of insurers will, in any case, have counterparty monitoring mechanisms in place, and given the diversified nature of the fund, we would not anticipate this module leading to a significantly higher SCR. By instrument type, the largest contribution to SCR was the Counterparty Risk incurred by cash equivalent holdings with a maturity of less than one week. As stated previously, the QIS 5 specifications require these cash deposit holdings to be modelled with a loss given default of 100%, resulting in the relatively high contribution to SCR. Interest Risk was a small percentage of the SCR attribution due to the limited interest rate risk incurred by the underlying short-duration instruments. For the purposes of this paper, we have assumed that the insurance company is purchasing only money market funds denominated in the insurer s local currency, thereby eliminating the Currency Risk sub-module. Solvency II and Money Market Funds 11
Solvency II Reporting Requirements Solvency II s granular dissection of risk will impose an increased reporting obligation for insurers. Undertaking a full security level look-through, which we believe will lead to the most favourable SCR, requires the analysis of detailed and timely portfolio data on a regular basis. Moreover, under Solvency II, Pillar III, EIOPA is mandating insurers to provide regular public and private reporting, in addition to the continuing self-assessment of a company s solvency position required under Pillar II. Going forward, insurers will have a number of major reporting tasks, in addition to any reporting required by local regulators. The data requirements and timing for reporting are yet to be finalised, but it seems clear that the requirements will be substantial. Solvency II imposes a fiduciary responsibility on insurers to monitor their risk position on a continuous basis, so investment portfolio transparency will be crucial going forward. Selecting a fund provider that has a good understanding of the requirements and can deliver them within an appropriate timeframe will be essential. It is important to emphasise that the ultimate reporting templates and timelines are subject to ongoing consultation and we understand that the final requirements will not be determined until implementation measures are finalised (likely 2012). However, given the high level of data requirements specified to date, it is unlikely that insurers (and asset managers) can simply adopt a wait and see approach. Producing the necessary data will be an iterative process between insurers and fund providers, but needs to be an area of focus in the short-term. 12 Solvency II and Money Market Funds
Conclusion Solvency II introduces a significantly more granular approach to risk management of the insurance balance sheet. Under the Market Risk module specified in QIS 5, a look-though to individual investment positions will be a key requirement, as the alternatives to this approach will lead to a materially higher SCR on the standard model. In our view, money market funds and cash instruments will be treated similarly to other investments. From our analysis of the JPMorgan Liquidity Funds - Euro Liquidity Fund, we would highlight the following observations: A position level look-through leads to an indicative SCR of 1.1%. Based on our analysis, for a cash deposit held at a AA-rated bank, the SCR would be 3.0%. A money market fund also provides wider diversification of holdings. A portfolio level guideline look-though would lead to a higher SCR and we believe that an SCR of up to 49% would apply if no look-through is undertaken. Spread Risk and Counterparty Risk contributed the highest percentage to the overall SCR of the fund, while Interest Rate Risk was de minimis. Overall the fund benefitted from a 0.37% lowering of the SCR stemming from diversification credit. Spread Risk must be modelled with a one-year duration floor, which potentially overstates the risk on money market instruments for firms choosing to use the standard model. Concentration risk applies across assets and liabilities and therefore needs to be viewed on a net balance sheet basis. Solvency II will impose substantial reporting requirements that need to be considered for all investments, including money market funds. Insurers will need to work with their asset managers to obtain detailed information on their money market fund holdings, as well as all other holdings. Provided asset managers are willing and able to grant a suitable level of transparency on a money market fund s underlying assets, we believe the overall SCR will be modest. Moreover, the benefits of diversification offered by a high quality fund are likely to result in a lower capital charge than direct investment in money market securities. Solvency II and Money Market Funds 13
How can JPMorgan Global Liquidity help you? Solvency II will impose a raft of new reporting requirements on insurance companies. The implementation process for Solvency II is a pressing issue for insurance executives. Key issues need to be resolved, such as the treatment of cash instruments. As this progresses and further detail comes to hand, we will be looking at providing the best possible information to enable your firm to address your reporting requirements. In the meantime, should you have any questions or comments please contact your usual client advisor. 14 Solvency II and Money Market Funds
For further information, please contact our Insurance sales team: www.jpmorganassetmanagement.co.uk/insurance Philip Michaelsen, 020 7777 0377, philip.michaelsen@jpmorgan.com Bob Cast, 020 7742 3941, bob.h.cast@jpmorgan.com Important Information This material is for the use of UK insurance companies only not for use by or distributed to retail investors The value of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. Investing in alternative assets involves higher risks than traditional investments and investors should consult a professional adviser prior to investing. The information provided is for use by institutional investors within UK insurance companies only and is not for public distribution. It may include opinions based upon understanding of complex regulatory proposals that may well change or not be implemented at all. The services being promoted are not intended to be and should not be construed as providing investment advice or advice on regulatory requirements or the law. Readers should take appropriate independent professional advice on such matters which is relevant to their particular situation before acting on anything contained in this document. This document is for informational purposes only and is intended solely for the person to whom it is delivered by J.P. Morgan Asset Management. This document is confidential and may not be reproduced or distributed in any jurisdiction without the express prior written consent of J.P. Morgan Asset Management. The opinions expressed are those held by J.P. Morgan Asset Management at the time of publication and are subject to change. This material should not be considered by the recipient as a recommendation relation to the acquisition or disposal of investments. This material does not contain sufficient information to support an investment decision and investors should ensure they obtain all available relevant information before making any investment. Issued in the UK by JPMorgan Asset Management Marketing Limited which is authorised and regulated in the UK by the Financial Services Authority. Registered in England No. 288553. Registered address: 125 London Wall, London EC2Y 5AJ. LV JPM4357 11/239 05/11 Insight + Process = Results