There is still no clarity about the final shape of Solvency II regulations for insurers, but investment banks are already considering ways to help insurance clients earn the returns they need without excessive capital charges.

Solvency II hovers over the insurance industry’s horizon like a threatening thunderhead, promising a violent reshaping of the investment landscape when it finally breaks. The absence, so far, of any wholesale rush to transform their asset profiles may simply be the calm before the storm, particularly since detailed rules have yet to be finalised. But it may also be, as some believe, because the change will be rather less dramatic than prophesied. One insurance banker says it reminds him of the Millennium Bug – frenzied anticipation and a boom for consultants followed by, well, business more or less as usual.

This is not to suggest that Solvency II will not revolutionise the way insurance companies in the EU look at their balance sheets. It is their Basel II and III, forcing them to take a risk-based approach to the capital they require. Under the old regime – which still applies, further restraining any headlong changes for the time being – capital requirements were calculated only against liabilities. They took no account of asset risk or of any mismatch between assets and liabilities. At the same time, each EU jurisdiction had its own country-specific rules on asset holdings.

Solvency II will be riddled with exceptions and special treatment for different member states but, essentially, its asset-related provisions will impose an EU-wide system of capital charges for different asset types. One of the risks to be taken into account is market risk and, for the first time, insurers will have to value their assets and liabilities on a market-consistent basis. Carrying assets at current market prices rather than book value will force companies to look even harder at the kind of assets they buy, with regular stress-testing for worst-possible, one-in-200-years outcomes.

Changing product appetites

The capital treatment rules are not yet set in stone but a broad picture emerged early on, as different asset classes were assigned varying capital charges according to their perceived riskiness. For bonds, the charges increase as maturities lengthen and as credit ratings fall. Standard model charges range from 0.9% for a one-year AAA bond, for example, to 66% for a 25-year B-rated issue. Covered bonds, however, get preferential treatment (0.7% for AAA one-year), and bonds issued by Organisation for Economic Co-operation and Development or European Economic Area governments have been declared risk-free, requiring no capital at all – at least until now. Unsurprisingly, given the current volatility in some European sovereign paper, recent word is that insurers should no longer assume sovereign debt will be risk-free, even (or, perhaps, especially not) within the eurozone.

Given that the worst-possible outcome in 200 years for structured credit was the US subprime disaster, this gets especially punitive treatment, rising quickly to 40%, 80% or even 100% depending on the rating. This will obviously dampen insurers’ appetite for asset-backed securities. In a survey of insurance companies and asset managers by the Association for Financial Markets in Europe, published in April, 100% of respondents said that the proposed rules would either dramatically reduce (67%) or eliminate (33%) their willingness to allocate funds to securitisations. Nearly a quarter of them (22%) said that once they had abandoned the sector they would never return, even if the capital charges were reduced at a later date.

European insurers – expectations of  securitisation exit

In search of returns

The swap curve is to replace sovereign bonds as the basis for the risk-free rate insurers must use to discount their liabilities. That in itself will boost demand for swaps at the expense of government bonds. Solvency II’s ‘last liquid point’ on the euro swap curve, the point beyond which market depth is deemed insufficient to fix data points, has been set at 20 years. “If, before, you hedged a 30-year liability with a 30-year swap, now you will hedge it with a 20-year swap, because swap rates after 20 years will have no impact on your liabilities,” says Ross Evans, director, insurance asset liability management advisory at Royal Bank of Scotland. He adds that the euro swap curve is already starting to steepen as a result. 

There are those who are convinced that Solvency II will force insurers inexorably in the direction of AAA sovereigns and covered bonds at the expense of other asset classes. Yet Solvency II rewards diversification, and a need for half-decent returns to meet liabilities will act as a counterbalancing attraction. Which leads us to equities.

Equities also attract high capital charges, at 39% for listed and 49% for unlisted, subject to a symmetric adjustment of 10% either way. This clearly limits their attractions, and suggests that the hedging of equity positions to reduce capital impact will increase. “Hedging equities is a hot topic right now,” says Eric Viet, head of financial advisory, cross-asset solutions at Société Générale. “You either sell it or you find a smart way to hedge it. Alternatively, you  could buy a structured product linked to the performance of the equity.”

Hedging with conventional put options is expensive and, after stress-testing, can result in minimal benefit. “If you want to buy equities but only want 25% capital consumption, you can use a modified put, create something with rolling strikes, or buy a series every week so that the average strike price moves with the market. It is a question of how to get there. You can do the same on credit, commodities, interest rates or any asset class.”

Though insurers are currently more transfixed by the eurozone crisis than by the prospect of new Solvency II products, banks are already putting a lot of work into developing appropriate structures for the new age. Notable among them are equity products with embedded derivatives, designed to mitigate the full equity charge. Yet, as one banker notes: “You can go into a meeting with an Aladdin’s cave of products, which is all very well, but they are only interested in how to hedge their peripheral eurozone government exposures.” There is no point in buying a pension if you’re going to die at age 30, he adds, by way of explanation.

Equities still wanted

Though some believe the new regime is particularly bad news for equities, others are more sanguine. Tom Keatinge, head of insurance for Europe, the Middle East and Africa at JPMorgan, thinks there are a number of reasons why Solvency II will not hurt equities quite as badly as the gloomsayers have predicted. One is that life companies are not heavily invested in the asset class even today, at least in the insurance side of their business.

“If you look at the amount of equity in the matched portfolios of life companies, they are not buying a lot of equities currently,” he says. “So if they buy less – and that is far from certain – it probably will not make that much of an impact.”

Mr Keatinge points out that insurers do not buy assets only for their matched portfolios. Since they have mutual and other investment funds that are not run on a matched basis, a lot of their buying power is unrelated to Solvency II. Finally, he believes that equities will continue to have a place even in the matched portfolio.

“Yes, they will attract high charges, though they are lower than was originally suggested,” he observes. “But if you are only earning low single-digit returns on AAA paper, what you can earn in dividend yield alone looks attractive from a return perspective.”

As Mr Keatinge implies, it is all very well to obsess over capital charges but, in the end, it is the risk-adjusted returns that count. There is another argument against a significant shift in equity allocation, which is that different EU states have already come to terms with equities in their own different ways. In countries such as Germany and Italy, where equity allocations are typically less than 4%, the equity rules will have little impact. There is more potential for disruption in places such as the UK, the Netherlands and Switzerland, where insurers are much more invested in equities. But in these countries, and in the UK in particular, the regulatory regimes are already sensitive to equity risk and so their insurers will not notice a huge difference.

Alternative assets

Other heavily risk-weighted assets include hedge funds and, bizarrely, infrastructure. One of the underlying principles of Solvency II is to penalise mismatches between assets and liabilities. Infrastructure projects, with their steady cash flows and long duration, are the perfect match for insurers’ long-term liabilities – hence Allianz’s failed attempt to buy the UK’s High Speed One rail link to the Channel Tunnel, for example.

If, before, you hedged a 30-year liability with a 30-year swap, now you will hedge it with a 20-year swap, because swap rates after 20 years will have no impact on your liabilities

Ross Evans

“Infrastructure and property are sensible assets for life companies to hold, but they have not been rewarded with realistic regulatory treatment so far,” says Johan Eriksson, head of the UBS capital solutions team. “We can structure infrastructure into bonds, and that will be a bigger topic if and when the Solvency II treatment becomes more appropriate. The whole public sector budget would benefit from shifting these significant investments into the private sector. It would be a win-win situation.”

This reasoning has prompted much lobbying in Brussels on the subject, clearly with some effect. In June, Michel Barnier, European internal market commissioner, promised that Solvency II would make it easier for insurers to invest in infrastructure projects.

Property has similar attractions for those wishing to match their long-term liabilities and less onerous capital charges though, as Mr Eriksson demonstrates, some think they are still too high. European insurers are already increasing their exposure, and companies such as AXA and Legal & General have begun lending directly to the sector. There is an irony in this, since insurers used to be big property lenders until banks wrestled the business away in the 1980s. Now that Basel III is increasing the amount of capital they will have to hold against such loans, banks are reducing their exposure, and insurers are among those taking up the slack.

AXA, for example, has said it will lend €2bn to European property companies this year, largely in Germany and France. It will concentrate on senior debt, secured against high-quality property, noting that senior loans offer “by far the most attractive risk-adjusted returns”.

Hedge funds without hassles

The regulatory benefits of diversification increase the appeal of alternative assets in general, as long as institutions go about it in the right way. “The challenge is that, if you invest in alternatives via a hedge fund, Solvency II treatment is punitive – worse than for equities,” says Tom Leake, European head of equities structuring group at Deutsche Bank. “So you want to invest in vehicles that allow [the regulator] to see the underlying exposure.”

One way to achieve this is through managed account platforms, reproducing hedge fund strategies but without attracting their capital charges. These provide the same skills as a hedge fund manager but in a more transparent way, because the investor owns the assets directly.

Another approach to alternatives which echoes hedge fund strategies and which may find a following is the portfolio of risk premia, or risk factors. Instead of focusing on classic betas such as bonds and equities, it creates a diversified portfolio from different return sources or risk premia. These include ‘style’ and ‘strategy’ risk premia such as small cap, merger arbitrage or currency momentum. 

Hedging equities is a hot topic right now… You either sell it or you find a smart way to hedge it. Alternatively, you could buy a structured product linked to the performance of the equity

Eric Viet

Using a long/short strategy, often via indices, the portfolio would capture the small cap premium, for example, by going long small caps and short large caps. The promoters of the approach say a historical portfolio of 11 risk premia delivers returns similar to a traditional 60/40 equities/bonds allocation but with 65% less volatility.

“A portfolio of risk factors is diversifying as an investment and, if done properly, can be very beneficial from a capital perspective,” says Mr Leake. He advocates using a combination of derivatives and changes in asset allocation to improve capital efficiency, but in a way that avoids the use of normal options. “Buying options for the whole portfolio is a losing trade,” he says. “Insurance companies sell insurance. Why would they buy insurance and pay a premium?”

Keep calm and carry on

Solvency II has been a long time coming – in gestation for a decade and already twice delayed. It is now due to come into force at the beginning of 2014, though no one would be surprised if that date slipped as well. As UBS’s Mr Eriksson emphasises, how it comes will be at least as significant as when it comes. It looks possible that there may be plenty of provisions in the way of grandfathering and transition periods for this national industry and that.

When it comes, and when it has finally got into its stride, the insurance industry will undoubtedly be making more use of derivatives than it used to. But how much more? Some have their doubts.

“Solvency II is another reason to use derivatives,” Deutsche Bank’s Mr Leake concedes. “But in countries such as the UK and the Netherlands, where there is a lot of equity risk, their use is very widespread already. And in countries such as Germany and Italy, where they do not use them, there will only be increased use at the margin.”

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