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Solvency II: Look-through treatment will help calibrate capital costs

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By James Williams – Solvency II is an EU-wide piece of regulation which aims to introduce stronger rules on capital adequacy and risk management for insurance companies, and ultimately increase the protection of the final beneficiary. The Directive represents a major change in the way that insurance companies will operate because at its heart lies a requirement to focus far more exclusively on the assets being held on the balance sheet, and the inherent risks they represent. 

Previously, insurance companies used to focus on liability risk assessment but the ’08 financial crisis has prompted regulators to ensure that greater risk management and governance within firms are in place to avoid systemic risk. The new regime will apply to all insurance firms with gross premium income exceeding EUR5million or gross technical provisions in excess of EUR25million. Like the banking regulation, Basel III, the essence of Solvency II is to ensure that firms have adequate capital requirements to withstand a market shock.

“Under Solvency I a life insurance firm would have 70 per cent of its global risk and capital requirements just on liability risk. Under Solvency II, that is now only 25 per cent, with up to 70 per cent of total risk applicable to the market (i.e. on the asset side). This is quite a dramatic change. Now, life insurers really need to focus on asset risk,” comments Maxime Gibault, head of the insurance company client segment at BNP Paribas Securities Services.

The Directive was due to come into effect on 1 January 2013 but implementation has since been delayed until 2015 for reasons that will be explained later. Omnibus II, aimed at defining all the rules of the Directive, is, however, expected to be ready by 1 July 2013.

The upshot of this is that whilst most of Europe’s biggest firms have been getting their internal risk management and governance controls in place, the imminent threat of Solvency II has somewhat receded.

Nevertheless, the capital adequacy component of the Directive is compelling and causing insurers to re-assess the assets they invest in from a cost and risk budgeting perspective. Under Solvency II, a capital charge of 39 per cent will apply for global equities (and 49 per cent for other equities), and a charge of 25 per cent will apply to holding direct real estate investments. Debt-related instruments could, potentially, be cheaper, at 15 per cent.

Although not as powerful a catalyst for change were the Directive to be introduced this year, capital costs are to some extent influencing insurers and prompting them to look more closely at debt funds as an alternative asset class.

“Whilst Solvency II generated a lot of sound and fury a while ago, my impression is that it has gone off the boil to a certain extent. Implementation now appears to be quite a long way down the track but as a behavioural driver, under Pillar I the capital cost for debt is less than it is for equity investments. In terms of turning insurance companies on to debt investments, that is a motivating factor,” comments David Williams, partner at Simmons and Simmons.

Three pillars to Solvency II

Pillar 1 is a quantitative pillar, requiring the insurer to use every type of methodology to monitor all potential risks being taken and to then calculate the capital requirements for each of those risk exposures.

Pillar 2 is the governance pillar. On top of the capital requirement calculation, a governance element also needs to be put in place. This is to ensure that everything is done to mitigate every type of risk being taken. The internal process of risks and solvency is known as ORSA: Own Risk and Solvency Assessment.

Pillar 3 is the reporting pillar, which can be split in two: one piece relates to private reporting and is required by local regulators. The other piece is public reporting, which details the strategy of the insurance company, the risks being taken, and the amount of capital being immobilised.

BNP Paribas Securities Services recently conducted a client study. It found that while insurers were advanced in terms of preparing for the Directive’s quantitative requirements under Pillar 1, some 60 per cent of insurers were yet to address the requirements on public and regulatory reporting.

Calculating the capital costs

When it comes to the calculation methodology there are basically three options available: insurers can either use the standard calibration methodology based on a set of risk factors established by the EU regulator, the European Insurance and Occupational Pensions Authority (EIOPA), use their own internal risk model, provided it has been approved by their national regulator, or use a combination of both.

There are two levels of capital requirements that need to be determined from the calculation methodology. As Gibault explains: “These include a Solvency Capital Requirement (SCR) and a Minimum Capital Requirement (MCR), which is a percentage of the SCR. If an insurer were to fall below the MCR, the local regulator could stop them from operating to protect the final beneficiary.

“This is the most important piece of regulation to have ever affected insurers. Even though the final set of rules is yet to be fully defined, it definitely changes the focus of their responsibilities.”

But insurers who are thinking of diversifying into debt funds face a catch 22 situation. As a new asset class, debt funds, per se, have not been taken into consideration under Solvency II. There remains significant confusion as to how such instruments would be treated using the SCR assessment. Gibault elaborates on the point:

“It’s actually a bit of a contradictory situation. There is a huge need for financing real estate projects; last year France required EUR100billion for real estate and EUR160billion for infrastructure, so there was huge demand. The duration of those debt loan investments is significant which sits well with the liability objectives of the insurer, so they are a perfect match in terms of duration and yield.

“However, even though insurers are interested in those types of investments, they don’t exactly know how they will be treated within their Solvency Capital Requirement assessment. It’s still early days for these investors with respect to diversifying into debt loan funds.”

It’s for precisely this reason that EIOPA have delayed the introduction of Solvency II as they seek to iron these creases in the standard calculation.

What the regulator needs to ensure is that insurance companies do not get put off from investing in securitisations through CLO funds, or in the bonds of long-term infrastructure projects, because of fears of overly punitive capital costs. Tim Wilkins, a senior consultant at Towers Watson, told “A 10-year securitisation rated AAA attracts a higher capital charge than a junk bond.”

Another commentator was quoted in the press as saying that current Solvency II calibrations “vastly overstate the risk of many securitisations and make it almost impossible to invest in this asset class”.

The “look-through” methodology

One way to overcome the potential complexity of holding debt fund investments could be for insurance companies to allocate capital into segregated managed accounts. This would give them full transparency, and favourable liquidity terms.

But there is another option, which the regulator will likely apply within a funds context, and that is something referred to as a “look-through” treatment of collective investments.

“A debt fund will invest in debt instruments – real estate loans, securitisation interests, etc, but may itself be a corporate vehicle that issues shares to its investors. The general intention of Solvency II is to “look-through” the fund vehicle to the underlying assets in order to calculate the necessary risk capital. Previously, there had been concern as to how the look-through provisions would operate, but the most recent technical specifications have given some helpful clarification as to the need to search for “economic substance”,” says Williams.

Polyanna Deane, partner at Simmons & Simmons, adds additional context by confirming that a sliding scale of capital charges will apply to corporate bonds, asset backed securities and different tranches of structured credit products such as CLOs, depending on credit rating and duration of the debt investment:

“For example, it is currently proposed that a top-rated corporate bond of any duration will attract a capital charge of 0 per cent and a top-rated structured investment with a maximum duration of six years will attract a capital charge of seven per cent. However, a top-rated re-securitised structured product with a maximum duration of three years will require a capital charge of 33 per cent, making it potentially less attractive to an investor than the 25 per cent charge for holding real estate directly, but more attractive than an investment in unlisted equities, private equity or hedge funds as they attract a capital charge of 49 per cent.”

“However,” stresses Deane, “we still don’t have the final rules on this.”

Transparency will be key

This look-through treatment will allow insurers to see exactly what’s in a debt fund (or any fund for that matter). Gibault adds that by using either the standard model or their own internal model it would at least enable an investor to arrive at an estimated SCR: “Having that look-through capability is the only way they can rate and assess the cost of the investment. We assessed a standard portfolio debt fund with a six-year duration, and based on our look-through assessment the cost of capital was only 17 per cent.”

The transparency aspect represents a challenge to both insurers and fund managers alike.

Williams says that one of the challenges for fund managers is to ensure that they can “deliver the transparency that the investor needs, not least so that they can meet their internal and external disclosure requirements”. This might, he says, limit the choice of managers: “Those that already have significant institutional infrastructure will be better placed compared to a smaller player entering the debt fund space for the first time.”

Equally, the ability for insurers to diversify into debt funds and direct lending will depend on their having an internal infrastructure in place to forensically assess each position. This might necessarily favour the biggest insurers.

“What is already happening is that the biggest insurers – AXA, Alliance – are engaging in direct loan activity with corporates. I don’t know where the market is going to be in 2016 but for sure we’ll continue to see direct lending to corporates and infrastructure projects.

“Ultimately it will depend on the individual insurance company, but also on the final rules of the directive,” comments Gibault.

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