Preparing for Solvency II

Solvency II is making European insurers take a fresh look at their assets and liabilities, leading some to exit costly exposures and seek investments that look attractive under the rules. As implementation draws closer, bankers expect the trend to accelerate. Mark Pengelly reports

Tom Keatinge

Solvency II has been a long time in the making. It may take even longer yet – a January 19 proposal from the European Commission postpones its introduction until the beginning of 2013. Even after this date, various parts of the new risk-based capital regime for European insurers will be phased in, possibly over a period of several years. Despite the delay, Solvency II is occupying the minds of some European insurers now – and bankers are also taking a keen interest in the rules.

“Everywhere you look, there’s a Solvency II tsar or a Solvency II working committee studying market risk and the qualitative costs of Solvency II. We are at a point where insurers want to know what trades mean for them under Solvency II, particularly if they are long-dated. They want to know how they can unwind them with limited cost if it’s not appropriate under the requirements of future regulation,” explains Tom Keatinge, London-based managing director of insurance capital management for Europe, the Middle East and Africa at JP Morgan.

Dubbed Omnibus II, the January proposal allows for a transition period of up to 10 years for some of the more onerous requirements of the new regime. Additional changes may still materialise – a fifth official study into the quantitative impact of Solvency II was published on March 14, which may result in further tweaks to the rules.

Given the uncertainty about the final shape of the regulation, few insurance companies are willing to make significant changes to systems and processes – nor to investment practices. Nonetheless, the rule-making process has helped drive greater awareness of risk management and economic capital models in general, say dealers.

“Risk management has become more of an important topic. There is also more focus on economic value creation, where everything is defined by the return on economic capital. So there is a prioritisation of new products and strategies that try to maximise value on these fronts,” says David Prieul, head of the insurance and pensions solutions group at Credit Suisse in London.

While the majority of insurance firms have yet to radically change their asset-liability mix in anticipation of Solvency II, a few of the larger insurance companies are looking to get a head-start, claim bankers. “The big players are looking to adopt and report their Solvency II ratios as quickly as possible because there is a race out there to be the first and the best, and to show the market they have sufficiently high capital under Solvency II,” says Ludovic Antony, director of global solutions for financial institutions at Société Générale Corporate and Investment Banking (SG CIB) in Paris.

Many of the current discussions between dealers and insurers focus on two fronts. The first involves asset and liability mismatches. Solvency II is designed to promote asset-liability matching, and a mismatch under Solvency II will result in an increased capital charge, dealers note.

“You will start to find that because you’re marking to market all the assets and liabilities on your solvency balance sheet, suddenly all the asset-liability mismatches on your balance sheet come through into the regulatory framework, so you’ve got a more volatile solvency balance sheet. Furthermore, those mismatches trigger a capital charge,” explains Jeff Sayer, managing director of institutional solutions at Morgan Stanley in London.

The other is the composition of investment portfolios. The capital charges brought in by Solvency II will alter the relative attractiveness of certain asset classes for insurers. Asset-backed securities (ABSs) and direct equity holdings will be penalised under the rules, while shorter-dated credit will be favoured over longer-dated debt, for example. Moreover, in a move that has been questioned in light of the recent sovereign debt crisis, European government bonds will be favoured with a capital charge of zero. “You’ve changed the capital framework for insurers, so you’ve also changed the risk-reward framework of every asset class and its attractiveness on an absolute and relative basis,” says Sayer.

Some insurers have already started to think about adjusting their portfolios. Pieter D’Hoore, portfolio manager at ING Investment Management in The Hague, says his firm could look to exit asset classes that aren’t capital-efficient under the new rules and invest in instruments that are treated more favourably. “We are actively looking for new asset classes with Solvency II in mind, or asset classes that are already Solvency II-friendly,” he says. In particular, ING currently has ABS exposure in its portfolio, which will be hard hit under Solvency II. In response, the firm is searching for more capital-friendly alternatives that will also generate sufficient yield.

Dealers are thinking hard about how to pitch new products in this context. SG CIB, for instance, conducted an analysis of various equity investment strategies, in an attempt to determine which performed best from a return and capital perspective. “We did a big study on the best way to invest in equities under Solvency II and we compared the different equity option strategies that insurers would be implementing. We ran a lot of simulations to determine the average internal rate of return of the various investments, net of the average cost of Solvency II capital,” explains Antony.

The analysis compared several ways of investing in equities, including constant proportion portfolio insurance and direct investments with collars – where the purchase of a put is partly or wholly financed by the sale of a call. The bank simulated returns on the strategies over an eight-year period, trying to find the best return given the cost of capital under the new rules.

“We found that investing in medium- to long-term capital-guaranteed products with indexation to equity performance was the most efficient method. The long-term guarantee provided significant capital relief, while enabling the companies to benefit significantly from positive equity performances,” says Antony.

The study served as a starting point for the bank’s efforts to tailor Solvency II-efficient structured products. One of these is Titanium – an instrument that offers an equity investment with a capital guarantee that pays out like a bond, with annual coupons exposed to yearly equity performance through a volatility adjustment. The structure is intended to provide better long-term performance than traditional long equity exposure with hedges (collars), but is subject to a reduced capital requirement under Solvency II. As it is structured as a bond, it can also benefit from friendly accounting treatment under International Financial Reporting Standards (IFRS), SG CIB claims.

Other banks are also looking to apply equity derivatives and structured products technology to help insurers adapt to Solvency II – in particular, applying some form of principal protection. That could include the purchase of a put (financed by the sale of a call) to protect against downside risk on a passive equity portfolio tracking an index, but could be extended to other asset classes. “If you can provide any kind of principal protection – not necessarily 100% protection – there could be a benefit compared with an unprotected asset. We’re spending a lot of time internally looking at the cost and benefit of protection and whether it makes sense for insurance companies,” says Andrew Berman, co-head of European insurance and pensions sales at Deutsche Bank in London.

European insurers already have hefty government bond portfolios, and these are only likely to grow due to the incentives built into Solvency II. Eager to earn a higher return on capital, some insurers are already putting these portfolios to work by entering into repurchase agreements with banks. Dealers expect this trend to continue, as insurers with large government bond holdings continue to seek higher yields. “There is a lot of demand on repos. Most insurance companies hold maximum amounts of government bonds, and a repo transaction can effectively and very clearly give them a yield pick-up,” says Michalis Ioannides, head of insurance solutions at BNP Paribas in Paris.

The exact structure of the deal may vary, but it generally involves insurers placing government bonds with dealers, which can then pledge the assets with central banks to obtain liquidity. The insurer’s exposure to the bank is then collateralised with other assets that offer a more enticing yield, such as ABSs.

“Insurance companies and banks can enter into transactions whereby insurance companies exchange their government bonds against certain bank assets. The exchanges are collateralised in such a way that insurance companies run very little risk compared with their initial investment, which translates into a very low Solvency II requirement against a significant yield pick-up over government bond yields,” says Antony at SG CIB. The transaction would normally be over-collateralised, meaning the value of the ABSs or other securities posted to the insurer would exceed that of the government bonds. If the collateral loses value, it can be quickly topped up by the dealer on a daily basis, Antony adds.

Market participants characterise these transactions – dubbed ‘switch trades’ – as a win-win for banks and insurers. On one hand, banks gain crucial liquidity, which is likely to become yet more valuable with the introduction of two new liquidity ratios embedded in Basel III. On the other, insurers should receive higher yields on their asset portfolios, despite having to hold large amounts of government debt.

Usually, the Solvency II capital charge for a fixed-income asset is contingent on its underlying credit quality, category and maturity. However, if the assets are used by banks to collateralise these kinds of repo transactions, they fall into the counterparty risk category of the rules, say dealers. As a result, the capital requirement becomes contingent on the credit rating of the bank counterparty.

“There are two ways an insurer can take market and asset risk and earn returns under Solvency II. One is to own assets outright, and there the capital charge is a function of the assets you own. The other is to take counterparty risk and to earn your return through a swap,” explains Keatinge at JP Morgan. Dealers say they are aware of individual trades of anything from €500 million to €4 billion.

Elsewhere, with asset-liability mismatches set to be penalised by higher capital charges, some insurance firms are looking to limit their duration risk. Typically, liabilities are longer dated than the assets held by insurance companies – and dealers have been eager to assist by providing hedges that work in harmony with Solvency II.

In one recent example, BNP Paribas put together a structured hedge for a large European insurer that helped it eliminate its duration mismatch through the purchase of a zero-coupon strip on a forward basis. Classified as an all-in-one hedge under IFRS, the trade obviated the need for selling the existing portfolio of assets to buy long-dated bonds or pay cash upfront. It also took advantage of the steepness of interest rate and asset swap curves, allowing the client to lock in a high yield, BNP Paribas says. To reduce the cost of financing the strip, the bank entered into a repo with the insurer, receiving government bonds it was able to pledge with a central bank. BNP Paribas claims to have executed more than €2 billion in similar duration mismatch trades – and Ioannides says it plans to do more.

Monetising VIF
Another area the bank plans to focus on is monetising the value-in-force (VIF), or present value of future profits, embedded in blocks of life insurance business. The business is not new and a few VIF securitisations have taken place over recent years. Nonetheless, Ioannides says the trades are still relevant for insurers, which will want to reduce the volatility of their balance sheets under Solvency II rules. “VIF securitisations still have merit, as they can be used to convert an illiquid form or soft form of capital into a liquid form. In addition to the liquidity benefits, VIF securitisation aims to insulate the insurer’s future profits from volatility induced by financial and insurance risks,” he says.

This is a point echoed by SG CIB’s Antony. “While the inclusion of VIF into Tier I capital would significantly increase the solvency ratio of certain life companies, it would also increase significantly the volatility of the solvency position of the company, because it is highly dependent on market parameters and policyholder behaviour,” he says.

The reason only a limited number of VIF securitisations has taken place over recent years is the difficulty of modelling these exposures, which involve hybrid market risks, longevity exposure and the risk that policyholders could simply cancel their plan. Nonetheless, Antony says the bank intends to use the same models involved in VIF securitisations to create hedges for the newly minted Tier I capital embedded in life portfolios. This source of Tier I capital could then be protected via the use of a hybrid put option wrapped in a format that is amenable to Solvency II, he says. Although the bank has not yet conducted any trades with insurers along these lines, it has structured similar hedges for pension funds, he claims.

In addition to highly complex structured trades, many simpler ideas will become more appealing under Solvency II. In what is perhaps an unintended consequence of the new rules, bankers say negative basis trades – in which a bond is purchased along with an accompanying credit default swap – could begin to look more attractive. “Negative basis packages could make sense under Solvency II. Under the risk mitigation module, if you have what is theoretically a perfect hedge, you can take credit for it. If you earn a certain amount on the bond and you pay less than that for your protection, you should be able to lock in that difference as revenue,” says JP Morgan’s Keatinge.

Given the massive losses racked up on negative basis trades in the past, whether this is advisable is open to question, he notes. Similarly, with a zero risk charge for European government debt, some market participants believe insurers could simply pile into the bonds of countries that offer the best-looking yields. An insurance industry heavily invested in shaky Greek or Portuguese government debt would be a perverse outcome of a risk-based capital regime, they note.