|By Paul Fulcher, Managing Director, Head of European Insurance & Pensions ALM Advisory|
This fundamental step means the legal framework of Solvency II is closer to completion and the 2014 deadline is likely to remain. But even more importantly, it gives insurers clarity on how they can best match their assets to their liabilities under the new rules, clearing the way for them to reallocate their combined EUR7 trillion (USD9 trillion) of assets. This move is likely to trigger significant market distortions and provide opportunities for quick-thinking investors.
What are the fundamental disagreements?
Under Solvency II, the European insurance industry will graduate from a haphazard map of national regulations to a single, uniform system of rules. 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, the new regulations focus more on the short-term market value volatility of assets versus liabilities.
The convergence to a single set of rules has proved more complicated than anticipated to agree because countries come from very different starting points. National regulatory models vary greatly so the presumed magic asset class which is regarded as the best long-term match for insurers liabilities is quite different (see table below). The current favoured asset class in the UK is credit; in France it is equities; and in Germany it is shorter-dated bonds.
Industries in each country have lobbied fiercely to steer the universal rules towards their preferred asset class, a process that has created uncertainty for market participants as deadlines approach. A number of mechanisms proposed to deal with issues - including the countercyclical premium to dampen the impact of extreme market movements, the matching premium to deal with long-dated credit and extrapolation for long-dated interest rates - could not be agreed upon and the search for a solution moved to the European Parliament.
Earlier this month, Karel Van Hulle, head of unit for insurance and pensions at the European Commission, told online magazine InsuranceERM that the industry needs to put aside differences and finalise things as quickly as possible...the longer you have the project on the table, the more problems you will have. The industry has listened, finally.
The impact will be far reaching and there could be unintended consequences. Already there has been press speculation that Prudential Plc, the UKs biggest insurer by market value, is considering moving its headquarters to Asia if the new European regulations hamper their non-EU business.
Why are these changes significant?
Solvency II will change the way insurers measure their assets, their liabilities and their capital adequacy. The aim is to improve risk management and provide better consumer protection by making sure participants can remain solvent during adverse market events.
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 distort the market?
The changes mean that the magic asset class will alter dramatically for many European insurers and will be more consistent across the whole EUR7 trillion (USD9 trillion) sector. This will likely trigger mass migration of assets and 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, 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 will it affect different markets?
Market distortions are inevitable. Based on the compromise reached in the European Parliament the impacts could be:
- Interest rates. The Euro curve is expected to steepen past the 20-year tenor that has been deemed to be the last liquid point. Demand for swaps will increase over government bonds because swaps form the basis of the risk-free rate used to value liabilities.
- Credit. The recent compromise reached on the matching premium was intended to reduce the need for large-scale reallocations out of long-dated credit. However, the restrictions around the use of this premium are still expected to lead to portfolio changes, for example making BBB credit less attractive.
- 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.
What strategy should insurers take?
Under Solvency II, insurers will need more capital against asset/liability mismatches, making hedges a form of efficient contingent capital and 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 any resultant 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
- Increases in the cost of protection against extreme events, i.e. skew
How does RBS help clients the efficient hedging framework
The RBS efficient hedging framework (see figure below) 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 clients 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.
Inflation. UK pension fund liabilities are typically indexed to retail price inflation but capped at 5 per cent and floored at 0 per cent, so-called limited price indexation. This has led to the price of the 0 per cent floors exceeding that of the 5 per cent caps, despite UK inflation being close to 5 per cent and long-term market inflation expectations of more than 3.5 per cent. 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 per cent caps on inflation funded by selling 0 per cent 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 tends to ultimately destroy equity performance. RBSs efficient hedging framework identified this market nuance and has been used to help clients develop more efficient hedging strategies.
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