It has been referred to as the ‘Persaud paradox’ – the idea that by labelling assets as safe you herd investors into buying them and thereby cause those assets to become risky.
Here, in an exclusive interview with Risk.net, the author of that doctrine, Avinash Persaud, explains why he believes negative bond yields indicate just such a phenomenon is taking place now due, in part, to insurance regulation.
Persaud advocates a simple but fundamental change to the approach of Solvency II and similar risk-based capital regimes worldwide. Rather than testing the resilience of the balance sheet to shocks over a one-year horizon, insurers should measure resilience over a period based on the length of their liabilities.
At the core of his argument is the notion that a risky asset for one investor is not necessarily risky for another, with the differentiating factor being the shape of an institution’s liabilities. The risk capacity of a life insurer, for example, differs from that of a motor insurer, and regulators should be making allowances for that fact, Persaud says.
Persaud’s career spreads across finance, academia and public policy. He is currently non-resident senior fellow at the Peterson Institute for International Economics in Washington, DC, emeritus professor of Gresham College in the UK and non-executive chairman of Elara Capital. He is a former senior executive of JP Morgan, UBS, State Street and GAM London.
You have written recently about flaws in Europe’s Solvency II directive. What do you see as the dangers in the new regime?
Avinash Persaud: Right now I would argue that the large amount of bonds with near zero or negative yields up to the end of April relates in part to regulatory developments, in particular to the strong bias that has been created towards insurers investing in instruments that are deemed safe.
We need to introduce a new concept, which I call risk capacity
That bias has reached such an extreme point that it is turning assets from being safe assets into risky assets. They are priced for perfection and when we force insurers to own more of them, the likelihood is they fall in price. The regulatory fetish for capital is turning safe assets into risky assets.
Do you have specific reasons to think Solvency II, in particular, has contributed to negative yields?
AP: There are only two possible explanations for negative yields. Either people are required to own assets irrespective of the price or they believe the fundamental economic outlook justifies negative yield.
Something like $5 trillion of assets now have negative yields. They happen to be the assets that under Solvency II insurers put up least capital against. In today’s world, where there is so much uncertainty about growth, the situation in Greece, the impact of QE and other developments, it is hard to justify the economic pricing of negative yields on those bonds.
There is a strong reason to believe that Solvency II has played a role, although not just Solvency II, which is of course part of a wider regulatory apparatus.
Doesn’t quantitative easing (QE) explain negative yields?
AP: Quantitative easing can’t justify negative yields. It can justify near-zero yields. QE justifies low yields because you’ve got a guaranteed buyer for your bonds, so the risks are lower, so you are prepared to own the bond for a lower yield. But the European Central Bank (ECB) is not going to buy bonds above par. So although you have a guaranteed buyer, that guarantee is at a lower price than you have at the moment.
Compared with banks, for example, how big an influence do you think European life firms have been on these moves in pricing?
AP: The biggest banks have assets of $60 trillion. If they are required to shift a significant chunk of their assets into these bonds it has a big impact. If you imagine $60 trillion of assets and you are talking about capital adequacy requirements in the region of 15–20% of risk-weighted assets, with sovereign bonds having very low risk weights, there are big incentives to invest a large proportion of a large amount of assets in sovereign bonds.
Life insurers and pension funds worldwide have something like $50 trillion of assets as well. European life insurers have around $10 trillion of assets. But Solvency II has to be seen in the context of wider international capital standards. It is not just Solvency II that is doing this. It is Solvency II and all Solvency II-like regulations.
What are the implications for insurers?
AP: We are going to see a continuation of large institutional investors showing a bias towards sovereign government bonds that will keep yields at hard-to-justify levels in economic terms. That means later the owners of those bonds are going to suffer a loss. Insurers are going to come under pressure and, more importantly, the customers of those firms are going to suffer losses. These are vulnerable customers. These are customers who are perhaps not well equipped to deal with that.
So, do you think sovereign bonds are wrongly-treated under Solvency II?
AP: One of the reasons this is happening is regulators have got a false sense of safety and risk. They have this old-fashioned view that some instruments are born with original sin – they are risky – and some are born with original virtue – they are safe. But in today’s world, risk and safety is about behaviour.
An instrument that is forced to be overvalued and is held in concentrated hands might be called safe, but it is not safe anymore. We need to have classifications of safety and risk that are not about what instruments are called. Regulators need to reconsider classifying sovereign government bonds as safe assets.
Do you think Solvency II should be changed?
AP: The directive focuses on 12-month volatility, but that makes no sense for an insurer with, say, 20-year liabilities. It is not the appropriate risk. Risk is about an insurer’s liabilities and its ability to meet them. The shortfall risk for a 20-year life insurer is a very different risk from the shortfall risk for a casualty insurer that has to pay out on motor insurance tomorrow.
We need to introduce a new concept, which I call risk capacity. Rather than the risk sensitivity of assets, it is the risk capacity of a fund based on the maturity of its liabilities that matters. Life insurance companies have long-term liabilities and so have the capacity to take certain types of risk like liquidity risk. They don’t have the capacity for taking other types of risk such as credit risk. From a life insurance perspective, investments in equity will probably have less shortfall risk than many corporate bonds and some sovereign government bonds.
How would a focus on risk capacity work in practice?
AP: People think of this as more complicated than it is. Let’s imagine we’ve got a life insurer with 20-year liabilities. It would not put up much capital against assets with high credit quality but low liquidity. An example might be a government-guaranteed illiquid infrastructure instrument or maybe a private equity fund that has a government guarantee. That is a low-risk asset for a 20-year life insurer.
Under Solvency II, the company would have to put up a lot of capital against that asset because it is a private equity fund. Instead, insurers should be putting up capital where there is the greatest mismatch between the risk they are taking and their capacity for risk as determined by the maturity of their liabilities.
What should insurers be investing in?
AP: Looking at data going back to 1928, there is no 20-year period in which the S&P 500 has had negative returns. Part of the return of the equity market is for taking liquidity risk. If you have the capacity for liquidity risk because your liabilities are long, and you can avoid the worst times to sell, you can earn the liquidity premium in equities for free.
But you can’t do that if you are a casualty insurer that has to pay out tomorrow. From the perspective of a 20-year life insurer the equity market is a low-risk instrument. Solvency II is not making allowance for that. It is forcing people into the wrong risks. The cost of that will rest with insurance companies and consumers.
The Solvency II approach for assets is completely inappropriate. It is assuming that everyone has 12-month liabilities, which is actually too long for a casualty insurer and too short for a life insurer.
Where did the one-year horizon come from?
AP: There hasn’t been a lot of fundamental thinking in insurance regulation. When people came to insurance regulation their starting point was not a blank sheet of paper, it was Basel II. They thought: ‘We’ve spent a lot of time on banking regulation so let’s adjust banking regulation to fit insurance.’
Arguably 12 months is too long a horizon for banks because the legal maturity of banks’ liabilities is often one day. But the effective maturity is more than one day. You are more likely to get divorced than to change your bank account, which is why a 12-month horizon makes sense in banking.
It makes no sense for life insurers. Extending Basel II to insurance regulation wasn’t just mimicking the mistakes of banking, it was amplifying those mistakes. You needed a piece of legislation that began from the point that liabilities in the insurance world are different than in the banking world.
By pushing insurers into certain assets, does Solvency II present a systemic risk in itself?
AP: Under Solvency II, regulators classify certain assets as safe. They then incentivise investment into those assets as a result of the lower capital requirements. You would have to believe the equity market would outperform by a huge margin to justify owning equities under Solvency II, given the capital requirements of investing in equities as compared to sovereign bonds.
So we have incentivised people to herd into one asset. The concentration of herding into the same assets shifts the price of those assets up. We end up with an overvalued asset with a concentrated set of owners. But that is the very definition of risk in finance: overvalued and concentrated. What is risk? Risk is concentration. How do you avoid risk? You avoid risk by diversifying. Here we have done the opposite. If a long-term investor wanted to invest in safe assets they would look for undervalued diversified stuff, and Solvency II is forcing them to invest in overvalued concentrated stuff.
When sovereign bonds have negative yields, by calling something safe we have created a behaviour that turns it into something risky.
Would it be feasible to change Solvency II?
AP: It isn’t as hard as it sounds. It all hinges on that one chapter of Solvency II about volatility. If we said the standard was the volatility of the assets over a period equal to the maturity of the average liability, you would dramatically change Solvency II’s problem.
You could have a one-in-200-year event that your assets over, say, 20 years would fall short of the liability. If the probability of that event were above 0.5%, you would need to put in more capital. If you were a casualty insurer it might be that the average maturity of your liabilities was 24 days, in which case you should be using volatility over 20 days.
What would be the mechanism for such a change?
AP: Solvency II allows for supervisory discretion. What is required is one bold regulator to say: ‘I’m taking Solvency II but I’m going to adjust the calibration from being fixed on 12 months to being fixed to the maturity of the liabilities and, where firms use a period greater than 12 months, they simply have to prove to me their liabilities have a longer maturity.’
Could a national supervisor do that?
AP: They could. But insurance regulators are not brave or courageous. To be wrong conventionally is a professionally safer thing than to be right unconventionally.
It is hard for regulators. They are in the middle of a process. They are too invested in the route they are on. You speak to regulators and, individually, they say this is something they are worried about. But there is no bravery, no courage to stand up and say they are going to do something different in their country.
The degree of courage required could be modest. You could allow firms in their internal modelling to match the volatility to the maturity of their liabilities. You could recommend they do that, but allow firms to stick to 12 months if they wished. I don’t think that requires a lot of courage, just some deeper thinking about what exactly they are doing.
What about the role of the European Insurance and Occupational Pensions Authority (Eiopa) to ensure consistent implementation across countries?
AP: One of the fundamentalisms in regulation is that we have to reduce arbitrage. There is a concern that if countries do something differently it will create opportunities for arbitrage. But if some countries act so their companies have more appropriate risks – that is not an arbitrage that undermines the system. It is an arbitrage that supports the system.
Who might take such a view?
AP: I think a non-European supervisor would be the first to break the ranks. In Europe, supervisors are focused on consistency and reducing prospective arbitrage, in a zealous way. But maybe one of the US state regulators might take a different view, or one of the large emerging market countries that might be considering adopting Solvency II-type rules – maybe a G20 country that is not part of Europe. I think that is where the greatest opportunity for change lies.
Why hasn’t there been more debate about this point over the past decade?
AP: These issues can appear technical, and economists who understand the systematic issues have largely steered away from the area. You are left with a set of people who have technical expertise, who may understand insurance contracts. But they do not have a tradition of standing back and looking at the wider, systemic implications.
The people who should be thinking about the systemic risk implications are the central banks. You can see inside some of the central banks that there is a worry that regulation might have unintended consequences. But it is amazing we are not seeing more people write about systemic risks, even to conclude the risks are overstated.
Why has the lobbying from insurers been so poor?
AP: One of the reasons why the industry has been acquiescent in its reaction to Solvency II is that capital requirements under Solvency II are no greater and are sometimes lower than before. The problem for someone like me who is worried about systemic issues is that the allocation of capital is going to change behaviour in a way that creates systemic risk. But no one at an insurance company sees it as their job to think about systemic risk. They think someone else is thinking about it.
If you are a risk manager, your boss will tell you it is definitely not your job to upset the regulator. If you are the boss, you are more concerned about how to give your shareholders a better return. It is a real challenge. The economists have abdicated the responsibility because they think the area is too technical, too legal and uninteresting. So who is there to speak up about systemic risk? It should be the central banks.
The insurance industry is creating a lot of data through the implementation of Solvency II. Eiopa’s job is to look at the insurance market implications. But whose job is it to say, well, you might think you have made insurers safer but the entire system has become less safe? That is the central banks’ job. But they are not doing it as yet.