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Solvency II – Capitalising on market distortions

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When the European Insurance and Occupational Pensions Authority enforces its new Solvency II regulations from January 1, 2013, the European insurance industry will graduate from a haphazard map of national regulations to a single, uniform system of rules. There is still uncertainty over the final regulations, but it is clear there are likely to be sizeable near-term implications for asset allocation.

At present, Europe’s regulatory models vary greatly. In each country, a different ‘magic’ asset class has come to be regarded, over time and, through practice and regulation, as the best long-term match for insurers’ liabilities. The magic asset class in the UK is credit; in France it is equities; and in Scandinavia it is infrastructure. Solvency II will force insurers in every country to converge on a single investment approach, but from a very different starting point.

While Solvency I focused on the ability of insurers to meet liabilities as they fell due over time, with assets assessed according to their long-term characteristics, Solvency II focuses more on the short-term market value volatility of assets versus liabilities.

At present, industries in each country are lobbying fiercely to steer the universal rules towards their preferred asset class. However, given that the basic concepts of Solvency II differ so fundamentally, changes will occur for most insurers and the impact will be far-reaching for the wider financial markets.

What is changing?

Solvency II aims to improve risk management in the European insurance industry and provide better consumer protection by making sure participants can remain solvent during adverse market events. It will replace Solvency I and a series of national level supplements designed to anticipate Solvency II, colloquially referred to as Solvency 1.5. Changes can be broken down into three main areas: assets, liabilities and capital adequacy.

Assets will be judged by market value, rather than by book value, which is currently a more common method. Liabilities will also be judged by market value, based on a theoretical replicating portfolio of market instruments.

Capital adequacy will be assessed by a value-at-risk framework, which will highlight the economic risks of any net asset/liability mismatch. It will also ensure the market value of assets is sufficient, even after a one-in-200-years market shock, to be able to cover the market value of liabilities in a run-off or portfolio transfer. This will be policed either through using an internal model that has been pre-approved by the regulator or through a standard formula that is provided by the Solvency II directive.

How will Solvency II create market distortions?

Due to these changes, optimal portfolios are likely to differ materially from those under Solvency I. Favoured assets will also be more consistent across the whole €7 trillion ($10 trillion) European insurance sector, and this mass migration may create either an abundance or a dearth of buyers in certain asset classes.

At present, different national regulations create more of a supply-demand balance. For example, under the current Solvency 1.5 regime, Dutch and Danish pension funds need interest rate options to hedge guarantees. This need is typically met by German insurers, subject to a book-value regime, who sell volatility to enhance short-term yields.

As a mark-to-market regime, Solvency II is also naturally
pro-cyclical, and so insurers may tend to exacerbate market cycles. At the same time, other financial market players such as hedge funds and banks’ proprietary trading desks have less financial leverage to be able to take advantage of resulting market distortions and arbitrage them away.

How might different markets be impacted?

Even though the final Solvency II rules are still to be determined, market distortions are inevitable. Based on the standard solvency capital requirement formula used for the fifth Quantitative Impact Study, impacts could be:

  • Interest rates. Interest rate curves will likely become more artificially flat or even inverted out to liquid maturities. Demand for swaps will increase over government bonds because swaps form the basis of the risk-free rate used to value liabilities.
  • Credit and liquidity. The spreads on long-dated credit will probably increase versus spreads on shorter-dated credit because insurers will be penalised for holding longer paper. Long-dated spreads are now often lower than short-dated spreads, which reflects an opposite distortion caused by Solvency I.
  • Liquidity. Differences between Basel III and Solvency II regulations may encourage the transfer of funding and liquidity risk from the banking sector to the insurance sector.
  • Interest rate volatility. The need for hedging will increase because insurers will have to hold capital against any unhedged guarantees in their liabilities. In addition, the supply of interest rate volatility will likely be disrupted as discussed above, causing implied volatility to rise.
  • Equity. Insurers may reduce equity holdings or look to hold equity in a capital-protected format due to increased capital charges.
  • Real estate and infrastructure. Infrastructure, real estate and other assets with secure long-dated cashflows may need securitising because their liability-matching benefits are not recognised.
  • Insurance. Risk will increasingly be transferred away from the insurance sector and towards the capital markets through instruments such as longevity swaps. Risks may also be swapped between insurers, via portfolio transfers or synthetically, to benefit from diversification.

What strategy should insurers take?

Under Solvency II, insurers will need more capital against asset/liability mismatches, based on their potential exposures in extreme one-in-200-years adverse scenarios. In this framework, hedges can represent a form of efficient contingent capital, allowing insurers to continue to retain risks. However, insurers will need to weigh up the costs of hedging in terms of reduced returns versus the benefits in terms of reduced capital.

When assessing risk and return, insurers will need to take into account market distortions. With all European insurers facing the same framework, the cost of hedges are likely to become distorted from their fair value. Distortions to hedging markets could include:

  • biases to forward-rate curves with long-dated yields artificially low;
  • an increase in interest rate volatility above realised levels; and
  • increases in the cost of protection against extreme events, i.e. skew.

How does the Royal Bank of Scotland (RBS) help clients?

The RBS efficient hedging framework uses the ‘risk-neutral’ market price of financial market instruments to back out market-implied distributions for equities, interest rates and other asset classes. It then compares these to a client’s real-world scenarios for the same risks, based on historic performance and their own views. The framework then compares the expected return on capital for different approaches to identify market opportunities and efficient hedging strategies. In particular, efficient hedging can actually enable insurers to benefit from the market distortions caused by their peers.

Efficient hedging case studies

  • Inflation. UK pension fund liabilities are typically indexed to retail price inflation but capped at 5% and floored at 0%, so-called limited price indexation. This has led to the price of the 0% floors exceeding that of the 5% caps, despite UK inflation being close to 5% and long-term market inflation expectations of more than 3.5%. RBS worked with a general insurance company concerned about its exposure to high inflation. The efficient hedging framework identified that, rather than buying inflation swaps or index-linked bonds, the company could buy 5% caps on inflation funded by selling 0% floors at zero cost.
  • Equity. Equity collars – out-of-the-money puts funded by selling an out-of-the-money call – are a common way to hedge equity positions. Consequently, market pricing is distorted so that the purchased puts are more expensive than the sold calls, and rolling collars tend to ultimately destroy equity performance. RBS’s efficient hedging framework identified this market nuance and led one client to implement the opposite strategy: selling physical equity, buying calls and selling puts. This enabled the client to retain upside exposure to equities and reduce downside risk, with expected returns higher than physical equity.

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