The advent of Solvency II and Basel III means insurers are reconsidering where to invest, just as banks are looking for new sources of funding. Structurers are seeking ways to play these mutual interests.

Financial institutions face a daunting new regulatory landscape in the EU, requiring a complete overhaul of investment and funding strategies simultaneously across much of the sector. For insurers, Solvency II is due to usher in from 2013 – although with a long transition period – uniform standards for calculating solvency capital requirements (SCR). These standards will be based on the risks to which the insurer is exposed through both its written insurance liabilities and its invested assets. Capital will become a dynamic measurement driven by risks that are marked-to-market.

For banks, the regulatory capital components of Basel III have been increasingly absorbed, as many banks used 2010 to raise new equity or modify their hybrid capital structures. But the focus has shifted to the liquidity components of Basel III, requiring banks to rethink funding in a market for financing long-term assets that is still rather volatile.

Pascal Duval, president of European operations at fiduciary investment manager and advisor Russell Investments, estimates that Solvency II will apply to about 5000 insurers across Europe, managing as much as €6500bn in assets – twice the size of the European pensions sector. Outside of the UK, Netherlands and Scandinavia, life insurance products tend to dominate the retirement savings business, rather than personal pension schemes.

Comprehensive view

With Solvency II scheduled to come into effect at the start of 2013, insurers cannot wait too long to implement long-term investment strategies to better match their assets and liabilities based on SCR calculations. While the precise details of implementation at the national level are still being drafted into law by individual regulators, two themes are becoming clear.

Financial institutions have learnt in recent years that tail-risk is not so rare after all. It can lead to several risks occurring at the same time that trigger significant losses for the balance sheet

Eric Viet

The first is the need for insurers to develop a comprehensive picture of the interactions between their risks across assets and liabilities, including interest rates, inflation and actuarial risks on the liability side and assets such as equities, real estate and credit.

“Financial institutions have learnt in recent years that tail-risk is not so rare after all. It can lead to several risks occurring at the same time that trigger significant losses for the balance sheet. It is extremely expensive to hedge each risk individually, and that is where a cross-asset solution is helpful to mitigate a scenario where several risks occur at the same time, but for a cheaper premium,” says Eric Viet, head of financial institutions advisory at Société Générale Corporate & Investment Banking (SGCIB) in London.

Converging risk measurements across the EU could lead to some market distortions that will force insurers to think about the cost-effectiveness of their asset and liability management (ALM). Those market-technical elements are already obvious in long-dated interest rate swaps, says Paul Fulcher, head of European pensions and insurance advisory at Royal Bank of Scotland.

“In the US, where insurers have been under less regulatory pressure to match duration risk, the spread between 10 and 30 year swaps is as high as 100 basis points [bps]. In the UK, the curve has been inverted by up to 100bps due to institutional investor demand at the long end – there is no economic reason that justifies this difference,” he says.

This trend will become even more marked once insurers in other EU jurisdictions, such as Germany and France, are required to recalculate the net present value of their liabilities through the interest rate swaps market under Solvency II. As a result, Mr Fulcher says, insurers may need to think about proxy or partial hedges using cheaper parts of the curve to avoid eating too heavily into their profitability.

Reduce equity risk

The second clear theme is that straight cash equity exposure will be relatively penalised overall. Insurers will be required to hold at least 39% of the value of any equity investments in reserves, going up to 59% for more volatile and illiquid emerging market equities.

Many insurers have already substantially reduced equity holdings – Mr Duval estimates that equity exposure among larger insurers has fallen to just 4% of their portfolio, from about 12% historically. But simply switching to assets that carry a lower risk-weighting under Solvency II is not a complete answer. Sovereign debt is one of the low-risk assets, but prices are volatile due to fears over peripheral eurozone sovereigns. And with interest rates close to zero across the EU, US and Japan, returns on high-grade fixed-income investments are not good enough to match the growth rates of future liabilities.

By contrast, counterparty risk is not treated as a mark-to-market risk under Solvency II, but instead as the modelled risk of a counterparty default. So it makes sense to take exposure to growth assets via a derivative counterparty, through options or a total return swap. Options can be used to create a floor under equity downside risks that should allow insurers to hold less capital against their investment. But as Mr Fulcher observes, “markets charge a lot for disaster scenario hedging", and that premium can only rise if demand for equity floor and put options increases as Solvency II approaches.

This has opened the door for banks to design integrated structured products, usually fund-based, that provide capital protection or internal volatility control. The first generation of such a product was the constant proportion portfolio insurance (CPPI) model – a rules-based fund product that placed a floor (commonly about 70%) under the value of the investment by dynamically allocating away from equities as the market fell. The danger here was the so-called 'gap risk' – that a sharp fall in the market would cause the net asset value to hit its floor very suddenly, and the product would then lock all the remaining capital into low-yielding assets with little chance to recoup the lost 30% when the market recovered.

So the next generation of products is being built around a rolling put-option guarantee written on a dynamic index product that is designed to be inherently volatility-controlled. One example is GuardInvest, designed by the BNP Paribas equity derivatives team and launched through the bank’s asset management arm, Theam (formerly Harewood), as a fund in November 2010.

“We started with the classic Eurostoxx 50 Index [of 50 leading European equities], then created a new index on top via dynamic allocation that cuts exposure if volatility is higher than a set target. Then we gave this a rolling guarantee that the product cannot drop more than 10% over a 12-month period, so insurers know that their maximum drawdown for Solvency II purposes is 10%,” says Bertrand Delarue, head of institutional product engineering at BNP Paribas.

The put option used in the guarantee is a so-called 'memory put' that automatically resets each quarter based on the current net asset value. Pierre Vaysse, equity derivatives structurer at BNP Paribas, says the bank has already received inquiries for customised variations on GuardInvest, to allow exposure to other asset classes that are heavily penalised under Solvency II, such as commodities or hedge funds.

We are much more cautious about the effectiveness of proxy hedges for difficult-to-hedge risks because they might turn out to be mismatched in a stress scenario, leaving exposure to basis risk

Paul Fulcher

Regulatory dialogue

However, Mr Duval of Russell Investments sounds a note of caution. With national regulators still formulating the implementation of Solvency II, insurers will need to maintain a close dialogue with supervisors before selecting their products to ensure the capital relief that new products provide meets their expectations.

Russell Investments recently commissioned the risk institute of French school of finance EDHEC to prepare a Solvency II investment benchmark series to allow insurers to build a partial internal model, which is likely to be more capital-efficient than using the regulators’ prescribed standard model. Based on each insurer’s current ALM profile and prepared in close communication with regulators and auditors, the benchmarks will have a set level of duration, value-at-risk and return characteristics required by the insurers. The asset mix will then be chosen from this, and will dynamically reallocate as market conditions change. The EDHEC benchmarks will be publicly available, and Russell Investments hopes to make further contributions to the key developments in insurance ALM.

“We are experienced in fiduciary management from our work with minimum funding ratios in the pensions industry and we expect insurance fund management to converge with this style. It is not appropriate any more to just experiment with different asset exposures; insurers must be able to calculate their cost of capital for any given allocation,” says Mr Duval.

The pressure from regulators is also encouraging insurers themselves to take a more inquisitive view of the investment solutions offered by the structurers. Mr Fulcher says clients increasingly want to test how far their banks would be prepared to take the risk of the products they are designing onto their own balance sheet.

“It certainly focuses the mind. We generally find we would be willing to provide downside protection on a volatility-controlled product where we know what the maximum risk is likely to be. But we are much more cautious about the effectiveness of proxy hedges for difficult-to-hedge risks because they might turn out to be mismatched in a stress scenario, leaving exposure to basis risk,” he says.

Arnaud Sarfati, head of cross asset solutions at SGCIB, says banks are also paying attention to the “replication risk” of any assets on which they offer a put option. This means building volatility-controlled indices from liquid underlying assets or indices that the bank can short to hedge its own long-term options exposure.

And while turning market risk into counterparty risk appears to make sense under Solvency II, insurers will still need to think carefully about who is providing their guarantees or total return swaps. In the past, it might have looked efficient to carry out all over-the-counter trades with a single counterparty to net out positions.

Tom Keatinge, head of European insurance capital management at JPMorgan, says insurers who use derivatives regularly already have suitable credit support agreements (CSAs) and collateral arrangements in place. But Solvency II will still tighten up counterparty risk measurement.

“If an insurance company has been doing all its swaps and options with a highly concentrated group of bank counterparties, the insurer could find capital requirements increasing as – notwithstanding collateralisation – Solvency II is measuring concentration risk as well. That’s a level of detail that most insurers are not quite looking at yet, but we are beginning to see clients take action,” says Mr Keatinge.

Market risk for European insurers

Banks seeking liquidity

Counterparty risk is a reminder that banks face constraints of their own in designing products for insurers. Mr Sarfati says the need for many banks to improve their liquidity in the run-up to Basel III affects the pricing and structure that they are able to offer on investment products and wrappers.

“In the past, on derived assets such as volatility or dividends, there was a market price that could allow a consensus value. But liquidity is your own pricing regarding your specific needs. So on any solution, you have some market inputs, but there is one input that comes only from your own specific position, which means it is more difficult to have a market consensus price on any given proposal,” he says.

Mr Viet says the combination of Solvency II and Basel III will oblige both insurers and banks to take a long look at their business models. Life insurance products offer savers low returns only after several decades, while banks in southern European markets where wholesale funding is scarce are offering overnight deposit accounts paying more than 4% interest rates.

The main reason insurers can compete as a savings vehicle is favourable tax treatment for savers. But banks that operate in challenging wholesale funding markets such as Spain are already lobbying for fiscal authorities to level the playing field.

Growing competition for savings would damage margins for both industries, so co-operation seems more sensible. Banks have been financing long-term assets such as mortgages, public infrastructure or industrial projects with short-term funds that will be increasingly penalised under Basel III. And insurers whose liabilities fall due only gradually have traditionally been heavy buyers of low-yielding, highly liquid government bonds.

The mutually beneficial solution is for insurers to take on illiquid bank assets such as asset-backed securities, mortgage or loan portfolios or project finance assets through an overcollateralised exchange – a repo or total return swap. The insurer transfers to the bank a portfolio of liquid high-grade bonds that the bank can use as collateral for central bank financing.

Mr Keatinge at JPMorgan says real estate-related assets in these transactions should receive favourable treatment under Solvency II because there are multiple layers of overcollateralisation – the loan-to-value ratio of the mortgage itself, any overcollateralisation in a mortgage-backed security and then the haircut applied to the asset swap. Funding-constrained banks with in-house insurers, such as Lloyds in the UK, have been at the forefront of these initiatives, and SGCIB apparently has several such deals in its pipeline as a structurer.

“The bank receives the liquidity, while the insurer receives a yield pick-up for the liquidity premium, and double protection through the overcollateralisation and recourse to the counterparty bank. The risks that remain are those of an asset depreciation beyond the haircut applied, combined with the remote risk of a counterparty default, so from a Solvency II perspective the insurer will look through the trade to the haircut and the counterparty,” says Mr Viet.

As with any emerging financial product, there are concerns. As each trade is unique, establishing a fair price is difficult. Insurers will need to be confident that they have the tools to analyse the assets offered by a bank with the same rigour as the bank itself, and that the maturity of the swap matches their ALM requirements.

However, at least one banker believes the information gap could be the other way around. Large insurers generally have more resources for analysing diversified credit portfolios than the second-tier European banks that are suffering the greatest funding constraints.

Arnaud Sarfati

In the past, on derived assets such as volatility or dividends, there was a market price that could allow a consensus value. But liquidity is your own pricing regarding your specific needs

Arnaud Sarfati

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