Guy Cameron, a director at Edinburgh-based fixed income manager, Cameron Hume, argues that Solvency II requires a fundamental rethink of how insurance assets are managed by third party managers.
Solvency II is just a few months into its implementation, and both insurance companies and asset managers are still feeling their way through its many codes and regulations.
The full impact of this seismic shift has yet to be felt by the EU insurance industry and decisions taken now by insurers and asset managers will determine its future direction of travel for decades to come.
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What is clear already is that fundamental changes are required both to business models and products, as well as to the ways in which insurers and asset managers work together to increase capital efficiency and improve returns.
Above all, Solvency II requires a fundamental rethink of how insurance assets are managed by third party managers.
Asset management is dominated by products which have a primary aim of outperforming a specified benchmark. Rather than thinking in terms of a benchmark and a return above this, we believe that asset managers need to consider assets and liabilities together.
Liabilities are the new benchmark
In the post-Solvency II world, liabilities are the new benchmark and returns in excess of liabilities should be considered to be the goal, relative to a capital charge.
We think this approach will help insurers to set up their balance sheets in a way that is both transparent and clearly articulated to stakeholders
We believe that insurers can increase capital efficiency by working with asset managers who have a deep understanding of Solvency II.
Together, they can improve ‘liability matching’ and target a ‘return-seeking active overlay’ –hedging more effectively to limit the risk from adverse movements in foreign exchange-rates .
Using a risk-controlled, segregated mandate rather than pooled vehicles will help insurers and asset managers to be better aligned in their goals, providing accurate, timely data for instant, easily digestible assessments.
This approach will be particularly appealing for insurers with guarantees to meet as it allows a return to be targeted while also matching liabilities and keeping capital charges low.
Clearly, this relies on the ability of the active manager to meet or exceed targeted returns but the alternatives – raising capital or consolidation – will be less appealing.
Long before Solvency II was implemented, much attention was paid to the treatment of liabilities, with insurers building teams and technology to meet the new requirements.
Less attention was paid to the treatment and management of assets, but it’s clear that asset managers also need to change if they wish to continue servicing EU insurance clients.
Under the new regulations, insurers are required to apply a one-in-200 year stress to both assets and liabilities in determining the amount of capital they hold.
Massive amounts of data are needed to allow the insurer to incorporate these assets into their overall calculations. However this approach has a number of shortcomings:
- Data is not always detailed or timely enough.
- The choice of assets impacts the insurer’s capital charge.
- Assets tend to be managed to narrow objectives against standard benchmarks.
- Longer-term liabilities are sensitive to changes in the market credit and swap spread elements of the discount curve, which has implications for risk and performance of assets.
- Insurers need to find a balance between Solvency II, accounting requirements and their own risk assessment.
Many insurers, particularly in continental Europe, have traditionally offered guaranteed products and to meet those guarantees, they have used a large allocation-to-equities ratio.
This model no longer works under Solvency II because equities attract a high capital charge. Switching to bonds reduces capital required but doesn’t produce the returns needed to meet legacy guarantees.
While transitional measures are in place to smooth the impact of these changes, they will reduce year-on-year, requiring insurers to produce an excess return while keeping capital charges low.
Efficient use of capital
We believe insurers can make the most efficient use of capital in a number of ways. As well as treating liabilities as the new benchmark, they should also match liabilities, using ‘key rate durations’.
Choosing assets with a high expected return relative to capital requirements will also have a positive impact, as will targeting an excess return using an actively managed overlay.
Asset liability matching has traditionally attempted to match actual cash flows but it’s not always possible to do this precisely and, in most cases, it’s unnecessary.
Key rate durations, which measure the duration of an investment at specific points along its maturity curve, provide an accurate model of cash flows, that will converge as the number of key rates used increases.
This approach also allows consideration of ‘twist’ and ‘butterfly’ exposures which are not directly stressed under Solvency II, but should be part of the risk assessment and included in the mandate parameters for controlling risk.
Solvency II requires insurers to ‘look through’ to the assets in an investment vehicle to assess their capital requirement but many have found it hard to get enough information to identify and model more complex securities and there’s often a lag in receiving the data.
While Solvency II may allow lagged data to be used and only requires quarterly reporting, insurers should have much more frequent and accurate updates across their whole balance sheet.
To enable this, we suggest managing assets using segregated mandates rather than pooled vehicles because this will allow full transparency of assets and the systems for reporting to be used on a timely and accurate basis.
The mandate should build in controls that align the interests of the insurer and the investment manager.
The capital attracted by the assets is clearly one key parameter to incorporate into the mandate and a VAR number using a standard risk assessment, or measures related to accounting treatment, may also be included.
This also facilitates the active overlay approach that we advocate by allowing efficient use of collateral and of the insurers own derivative documentation.
The insurer and asset manager may also wish to address how new business and cash is managed to meet liabilities as they fall due. This may also be formalised through the mandate, and is another example of how the interests of the insurer and asset manager may be aligned more closely.
The treatment of surplus funds could also be agreed – for example these could have the active overlay applied and be managed relative to a LIBOR benchmark, reducing flows related to profit or loss, and consequently costs.
Rather than the mandate being a fairly static document, it can be reviewed regularly and allow the insurer to work with the asset manager to control key risk parameters based on their business requirements.
Solvency II provides diversification benefits in the calculation of the capital charge and the insurer may want to adjust their risk appetite on the asset side in order to optimise their overall capital charge.