Balancing risk, return and capital requirements the effect of solvency II on asset allocation and investment strategy

Balancing Risk, Return and Capital Requirements The Effect of Solvency II on Asset Allocation and Investment Strategy Written by   Balancing risk, return and capital requirements Foreword: Beyond Performance Despite several deferrals of the implementation deadline, Solvency II has already proved a major catalyst for change with insurers spending considerable time and resource on preparing for D-day At BlackRock®, we share this focus as we help insurers meet the outcomes they need in this rapidly shifting environment Specifically, we are investing heavily in our infrastructure and people to help you navigate this crucial transition successfully Yet this tremendous effort by the industry masks significant uncertainty: be it in terms of the final shape of the directive or how Solvency II will affect asset allocation, investment strategies and capital markets – all against a backdrop of a continued sovereign debt crisis Faced with this murky picture, insurers, not surprisingly, find it hard to have full confidence in their preparedness To help bring some clarity around the remaining key challenges, BlackRock has commissioned the Economist Intelligence Unit to conduct a comprehensive study among European insurers The findings offer a real insight into the challenges associated with each of the three pillars and the implications for insurers’ product offering and the wider capital markets Interestingly, the research highlights a degree of discrepancy between market perception and what your peers really think, particularly in relation to the use of alternatives and their levels of preparedness for Solvency II governance and disclosure requirements Personally speaking, the most important finding was the need to move beyond performance and seek full alignment of investment expertise and enterprise risk management In 2012 and beyond, we will work very closely with our clients to help them achieve that essential goal I hope you find the report thought-provoking and, above all, beneficial, and look forward to hearing your views Sincerely, David Lomas, ACII Head of Global Financial Institutions Group, BlackRock email: solvency2@blackrock.com Balancing risk, return and capital requirements  [ ] Contents Executive Summary and Key Findings About this Report  Introduction  The Future for Asset Allocation  Return-Seeking Assets  12 A Demanding Data Management Regime  18 Shifting Product Ranges  22 Consequences for Capital Markets  25 Equity and Debt Markets  28 Conclusion  32 BlackRock Commentators  34 About BlackRock  35 Appendix  36 [ ]  Balancing risk, return and capital requirements Balancing risk, return and capital requirements  [ ] Executive Summary Despite recent uncertainty about whether the implementation date of Solvency II will be pushed back a year, insurers are still working on the assumption that they have just one year to go, and therefore preparations for the new Directive are well under way The Europe-wide legislation will impose stringent new capital requirements across the insurance industry, creating a more risk-focused approach to better protect policy holders from future financial crises Data management will be overhauled, while many players will be forced to rethink their product range and investment strategies Coinciding with this final phase of preparations for Solvency II are some of the most testing market conditions in living memory The ongoing sovereign debt crisis has raised questions regarding the very foundations on which some pillars of Solvency II are built and as uncertainty over the final shape of the Directive persists, insurers face notable challenges when building their strategies for the future The Economist Intelligence Unit, on behalf of BlackRock, surveyed 223 insurers with operations in Europe With the survey sample representing at least half of the European market in terms of assets under management, the findings offer real insights into how insurers are managing Solvency II’s data management requirements; the impact of capital charges on their investment strategies, risk management and product ranges; and their views on the future for capital markets in a post-Solvency II world [ ]  Balancing risk, return and capital requirements Key Findings Asset Allocation Shifts have been Decided but Implementation is on Hold Allocations to Derivatives will Increase Under Solvency II Almost half (46%) of survey respondents say they already know how they are likely to change their asset allocation, with just 4% saying they have not made plans However, over half (53%) say they are waiting until closer to implementation of the Directive before making changes to their asset allocation Most changes are as expected – away from equities and towards corporate bonds Over half (60%) of survey respondents agree that the Directive will result in greater use of derivatives to better match assets and liabilities While some insurers say they are already confident in their derivative usage, as assetliability management (ALM) strategies become more complex and demanding in volatile markets, this will be an area on which many insurers will need to focus Over onethird (37%) of insurers agree that Solvency II will make them more likely to use derivatives in the future, although only 18% currently use derivatives and just 23% have definite plans to increase their overall holdings Allocations to Alternatives are set to Increase Some asset allocation changes are less expected Alternatives such as hedge funds and private equity will benefit from Solvency II, with 32% of survey respondents saying they will increase their allocations to these asset classes Just 9% and 6% respectively say they will decrease allocations These increases come despite the higher capital charges for these assets, with insurers betting that the higher charges will be worth the higher potential returns Almost three-quarters (70%) of survey respondents expect their asset allocation changes to result in higher returns Meeting Solvency II Data Requirements is a Major Concern, Whilst Pillar III Commands the Least Budget Over 90% of survey respondents are very or somewhat concerned about meeting the requirements for the timeliness (96%) and completeness (94%) of data under Solvency II, as well as the quality of data from third parties (92%) In particular, pressure is on third parties to provide the ‘look-through’ on pooled funds required by insurers, with 92% of respondents concerned that they will have to limit their investment strategy as some assets demand more rigorous data requirements Overall, survey respondents say they are most concerned about Pillar III, yet it is the pillar to which they are devoting the least budget Insurers will Re-Examine Guaranteed Products, Which may Become Prohibitively Expensive For some insurers, the Directive merely accelerates an ongoing trend away from guaranteed products, but for others it creates a whole new way of thinking about their business Two-thirds of life and composite insurer survey respondents say they will restructure in order to better manage their guaranteed funds in house, while almost half (49%) of life and composite respondents say they will seek advice on ALM As a result, insurers will be forced to more aggressively price their guaranteed products, which will likely drive consumers into other cheaper but less wellprotected offerings Annuities too will become potentially more expensive, as insurers factor in the increased costs of managing Solvency II market risk into pricing Solvency II Could Increase Market Volatility Just 5% of survey respondents disagree with the idea that there will be an increase in volatility in capital markets because of Solvency II Insurers are also anxious about the threat of pro-cyclicality If capital requirements reduce when markets are benign and increase during periods of volatility, losses due to falls in market prices could lead to a wave of forced selling, which could create further losses EIOPA plans to tackle this issue but insurers say the uncertainty makes planning, particularly at this late stage, a challenge Share Prices are Likely to be Hit by Solvency II Less than one in 10 (9%) of survey respondents disagree with the idea that, due to Solvency II, average share prices will be lower as demand for equities will be lower And even fewer (3%) disagree that the equity risk premium will need to increase significantly to encourage investing in equities However the overall supply of equities could be lower, as only 9% not believe that companies will favour issuing debt rather than equity for their funding needs Regulators may Have to Rethink Approach to ‘Risk-Free’ Assets As the security of government bonds is thrown into doubt, insurers believe the regulator may have to revisit the 0% capital charge for sovereign debt Insurers using their own internal models already factor in the ‘real’ risk presented by government debt, but organisations using the standard model may be exposed Planned changes to asset allocation, such as moves from government bonds into higher-rated corporate debt, support the view that insurers are assessing the risk and return trade off for themselves About this Report In October and November 2011, the Economist Intelligence Unit, on behalf of BlackRock, surveyed 223 insurers with operations in Europe to find out how they were handling the data management requirements of Solvency II, the impact of capital charges on investment strategies and product ranges, and their views on the future for capital markets in a post-Solvency II world Respondents comprised of 75 life, 65 non-life, and 57 composite insurers, while 26 were reinsurance companies Responses were collated from insurers with headquarters in all major EU countries Businesses were grouped by assets under management (AUM) covering 106 very large insurers with more than €25bn; 23 large insurers with €10bn-€25bn; 68 with €1bn-€10bn; and 26 with AUM of less than €1bn In addition, in-depth interviews were conducted with eight experts from insurance companies, regulators and trade bodies Our thanks are due to the following for their time and insight (listed alphabetically): Anders Brix, Risk management team, Danica Pension, Denmark Britta Burreau, Managing Director, Nordea Life, Sweden Frank Eijsink, Global Program Director for Solvency II, ING Life, Netherlands David Johnston, Senior Implementation Manager, Financial Services Authority, UK Olav Jones, Deputy Director-General, CEA, European insurance and reinsurance federation Isabella Mammerler, Head of European Regulatory Affairs, Swiss Re Carlos Montalvo, Executive Director, European Insurance and Occupational Pensions Authority (EIOPA) Ann Muldoon, Solvency II Director, Friends Life, UK The report was written by Gill Wadsworth and edited by Monica Woodley of the Economist Intelligence Unit Balancing risk, return and capital requirements  [ ] Introduction Insurers racing to meet the 2013 implementation date for sweeping changes to solvency regulations were given a year’s grace in the autumn of 2011, with regulators setting a new deadline of January 2014 Delays to the implementation of Solvency II are nothing new – and a further delay may be in the works - but the insurance industry is unlikely to view the latest push back as much of a reprieve in their efforts to comply with the Directive, particularly as by 2013 they will need to demonstrate how they will meet the final legislation The Solvency II Directive imposes stringent new capital requirements, creating a more riskfocused approach designed to better protect policyholders from future financial crises The legislation is far-reaching and complex, and has forced insurers to analyse everything from data management and risk analysis to asset allocation and product ranges As insurers continue with their preparations, the ongoing sovereign debt crisis has forced regulators back into negotiations to agree on a Directive that can withstand such unexpected changes in fortune Against this backdrop of uncertainty, insurers face notable challenges as they strive to formulate a successful strategy that will stand up to the rigours of a new regulatory regime and an unpredictable economic future [ ]  Balancing risk, return and capital requirements The Future for Asset Allocation Now that insurers have the fundamental systems building blocks in place following the first stages of preparation for Solvency II, they are turning their attention to investment strategies and asset allocation However, the survey reveals that insurers are not able to prepare to the extent that they would like as the Directive itself is still being finalised What is Your Current Asset Allocation? Corporate bonds 36% Government bonds 28% Cash 3% Almost half (46%) of respondents to the survey say they know how their asset allocations will change as a result of Solvency II, but more than half (53%) say they will wait until they are nearer to the final implementation date before effecting any change Non-life insurers are less confident than their life counterparts as to how their future asset allocations will look – 43% compared with 50% – and as such are more likely to wait until Solvency II is clearer before taking action David Johnston, Senior Implementation Manager at the UK’s Financial Services Authority, explains: “Until the Solvency II rules come into force in 2014 the current rules still apply, so insurers are welcome to make any changes they want in the interim, within the context of those rules But they might not be able to move to their ‘business-asusual post-Solvency II’ end state just yet.” Where insurers have examined the future for their investment strategies under the new regime, the overriding response is to keep asset allocations the same This is partly explained by the already conservative asset allocations the survey respondents report Property 4% Hedge funds 1% Derivatives 1% Other alternatives 5% Total equities 15% Other assets 7% Base: All respondents (n=223) Source: Economist Intelligence Unit Well before the advent of Solvency II, many insurers had started de-risking strategies – action which has since been accelerated by the difficult economic conditions Ann Muldoon, Solvency II Director at Friends Life in the UK, says: “In the UK we already make an assessment of risk-based capital [Individual Capital Assessment] and provide this as a private submission to the regulator This is already informing our strategic asset allocation decisions.” She adds that where Solvency II has the potential to change the individual capital assessment, the insurer will guide its strategic asset allocation studies accordingly Nearly two-thirds (64%) of the survey respondents’ total asset allocations are to fixed income, with government debt accounting for 28% and corporate bonds 36% Equities account for 15% of total portfolios, while alternative assets including private equity, hedge funds and derivatives amount to 7% In the fixed income category, just under half (49%) of respondents plan to keep allocations to corporate bonds the same, although one-third expect to increase investment in this asset class More than one-third (37%) of life companies say they will increase allocations to corporate bonds compared with 29% of non-life companies Just 18% of respondents overall say they will decrease corporate bond allocations [ 28 ]  Balancing risk, return and capital requirements Equity and Debt Markets Equity markets look the most likely to be negatively affected by Solvency II Only 9% of survey respondents disagree that share prices will fall, as demand for equities will be lower due to Solvency II An even smaller number (3%) disagree that the equity risk premium will have to increase in order to encourage investment in this area Smaller insurers with less than €1bn in assets are more likely to expect share prices to fall than their larger counterparts, with 62% expecting them to be hit compared with 43% Dutch and Nordic respondents show most concern about the Directive’s impact on equity markets, with 64% of insurers in the Netherlands believing share prices will fall, while 55% of Nordic respondents agree BlackRock View: Richard Turnill, Managing Director, Global Equity Team A crucial impact of Solvency II will be the creation of a more risk-focused approach, where the analysis of investment risk versus expected returns becomes the most important factor This focus will be especially pertinent considering the expected increase in equity market volatility Therefore, a low beta, high quality equity income strategy is likely to feature heavily within insurers’ equity allocation Research conducted by our Risk and Quantitative Analysis area shows that low volatility (high quality) equities outperform high volatility equities over the long-term This turns the well-established assumption of being paid to take more risk upside down The survey findings also indicate a consensus move away from equities and towards corporate bonds The resulting increase in demand will further depress already low fixed income yields, so re-allocating from broad equities towards high quality equities, with the much stronger risk/return profile, seems a better solution Balancing risk, return and capital requirements  [ 29 ] Due to Solvency II, Average Share Prices will be Lower as Demand for Equities will be Lower – you Agree or Disagree? Agree 46% Neutral 45% Disagree 9% Base: All respondents (n=223) Source: Economist Intelligence Unit Due to Solvency II, the Equity Risk Premium will Need to Increase Significantly to Encourage Investing in Equities – you Agree or Disagree? Agree 49% Neutral 48% Disagree 3% Base: All respondents (n=223) Source: Economist Intelligence Unit However Ms Muldoon of Friends Life says: “Although equities attract a relatively high capital charge under the Solvency II standard formula, this has been known for quite some time and we would expect the market to have already priced this in.” [ 30 ]  Balancing risk, return and capital requirements Equity and Debt Markets Continued The lower demand for equities may also be balanced out by a lower supply Forty percent of respondents believe that, due to Solvency II, companies will favour issuing debt rather than equity for their funding needs The subsequent increased supply of debt will be useful as nearly half (45%) of respondents say they expect high-rated corporate and government debt to become more attractive as a consequence of Solvency II Regulators may have to Rethink Approach to ‘Risk-Free’ Assets Under current proposals, the regulator attributes EEA sovereign debt a 0% capital charge, so for insurers able to use the asset class as a suitable matching proponent in a long-term investment strategy, this looks attractive However, the recent eurozone debt crisis has thrown the very inclusion of a ‘risk-free’ asset in the standard capital model into doubt Mr Eijsink of ING comments: “ING had already taken the opinion that it was a grave omission in the standard model and we can see that government bonds are not risk‑free What we dearly miss is a real risk-free asset since we have a risk-free definition on the liability side of the balance sheet but we don’t have a risk-free asset on the asset side.” Although it is unclear as to whether EIOPA will revise the 0% capital charge, this seems unlikely since the European Commission will wish to avoid any potential market disruption any rethink might cause Ultimately, insurers are responsible for understanding the real risks posed by any asset class in which they invest under the ORSA process Balancing risk, return and capital requirements  [ 31 ] BlackRock View: Scott Thiel, Deputy Chief Investment Officer, Fixed Income The continued stress in segments of the Eurozone government bond market certainly merits reconsideration of the current proposal that these assets should carry a 0% risk charge under the Solvency II standard model Indeed, as risk management practice continues to develop at European insurance companies and the use of internal models becomes more prevalent, it is possible that recent events will lead some companies to take more conservative capital charges in respect of this asset class, irrespective of the standard model In such cases, it is conceivable that the capital charges used could be lower than those for corporate bonds of equivalent credit rating The asset class may then remain more attractive than corporate bonds to the insurance sector, but this would be based upon an assessment of expected return versus capital requirement, which is part of a wider trend we expect as a consequence of the introduction of specific asset charges under Solvency II In any case, we continue to see Government bonds as a very important part of the asset portfolios of European insurers given our expectation that, in the long term, these instruments will still be considered a very low risk asset class, not to mention their role in matching the liability profile of an insurance portfolio Conclusion Conclusion While EIOPA and the relevant national regulators thrash out the final elements of the Directive and attempt to tackle the challenging issues of managing volatility, pro-cyclicality and risk-free assets, insurers should use the time to identify any mismatches between their perception of readiness and the reality Insurers’ anxieties about data management must be tackled if they are to achieve the optimum investment strategy and asset allocations to deliver superior returns, and they may need to revisit the amount of time and resource they invest in this area A disconnect persists between the perception of Solvency II limiting investment strategies and the reality, which actually opens the door to a wider field of asset classes via the ‘prudent person’ principle While insurers are concerned that they will be penalised for investing in ‘riskier’ asset classes including derivatives and alternatives, they are still set to increase their risk budgets in the pursuit of higher returns These final stages of implementation need to include effective measures to ensure insurers are allowed to invest in the strategies most suited to their business needs, and in turn, insurers and third parties must make certain they have robust reporting platforms to manage investment in these assets At the same time, insurers must wait and see how EIOPA and domestic regulators deal with concerns about systemic risk and market volatility and whether Solvency II will ultimately meet its aims – to protect consumers from future financial crises The survey data shows insurers still see the Directive as a useful tool in better managing risk But if it forces them to excessively limit product ranges, then it may be consumers who inadvertently fall foul of the very legislation designed to protect them As the cost of guaranteed products becomes prohibitively expensive, it could force consumers into other products where they shoulder the investment risk Just 13% of respondents disagree that Solvency II will be positive for insurers, but everything now hinges on ironing out the detail, particularly in Pillar I and ensuring the Directive allows insurers to function effectively in benign markets and be better prepared and protected in times of crisis Timely action is also needed – earlier delays in implementation were greeted with relief by many insurers as it gave them more time for preparation but at this stage further delays in clarity of rules will only frustrate the industry Balancing risk, return and capital requirements  [ 33 ] “A large number of financial institutions will adopt a common risk modelling framework, which will help ensure stability in financial markets” UK non-life insurer, [...]... optimum investment strategy and asset allocations to deliver superior returns, and they may need to revisit the amount of time and resource they invest in this area A disconnect persists between the perception of Solvency II limiting investment strategies and the reality, which actually opens the door to a wider field of asset classes via the ‘prudent person’ principle While insurers are concerned that they... risk of default we have seen the introduction of mandatory standards in the form of counterparty and collateral arrangements All of this is new, and in addition to the Solvency II requirements Furthermore, the notion of default risk now plays a part in pricing that hitherto it did not What this means is that Solvency II is not alone in ‘raising the bar’ for derivatives Taken together, the level of expertise... ‘somewhat concerned’ about meeting the requirements for quality of data; 96% say they have concerns about timeliness; and 94% say the completeness of data requirements are a cause of anxiety Balancing risk, return and capital requirements [ 19 ] Thinking About Each of the Specific Reporting Requirements Under Pillar III, how Concerned are you About Each of the Following Areas? Meeting the requirements. .. of the introduction of specific asset charges under Solvency II In any case, we continue to see Government bonds as a very important part of the asset portfolios of European insurers given our expectation that, in the long term, these instruments will still be considered a very low risk asset class, not to mention their role in matching the liability profile of an insurance portfolio Conclusion Conclusion... understand the risk of every investment they hold, even if it is a pooled vehicle One French survey respondent says: “I think under Solvency II the main challenge will be on quality reporting to the individual line item in pooled investment funds.” But only one-third of respondents are confident they understand how the relationship between pooled fund look-through and return will be altered under Solvency. .. risky assets and the volatility of that asset price Although hedge funds and private equity funds have low volatility in the asset price, you do have to set aside a significant amount of capital for those investments.” The increase in risk budget, alongside greater allocations to alternatives, leaves respondents confident of higher investment returns post -Solvency II Seventy percent say returns will either... under Solvency II to better match liabilities, provide capital guarantees and manage volatility This increased use of derivatives is set against a background of higher standards of transparency and additional capital being deployed under Solvency II Demanding as these requirements are on their own, the introduction of these standards comes at a point when derivative markets as a whole are in a state of. .. III, they have dedicated significant time and resources to meeting the Solvency II demands as a whole Over half of respondents have currently committed at least €5m to the project, while two respondents had allocated budgets of over €100m Mr Jones of the CEA believes that insurers’ preparedness for Solvency II has been reflected in the high level of responses to the European Insurance and Occupational... capital charge in light of the eurozone debt crisis (which is explored further on page 30) Many insurers operating in countries enduring the worse of the sovereign debt crisis are cautious about the future for their own region’s government bonds None of the Icelandic insurers and just 7% of Italian respondents plan to increase allocations to government bonds In contrast, in the Nordics where governments... All respondents (n=223) Source: Economist Intelligence Unit Figures do not add to 100% due to rounding However, the confidence in preparations for Pillar III was not borne out by responses to more detailed questions on Solvency II s data requirements In spite of more than half (55%) of respondents claiming to have the necessary data to meet the requirements of Solvency II, 97% say they are either ‘very’ ... static [ 14 ]  Balancing risk, return and capital requirements Return- Seeking Assets Continued Thinking About the Likely Effects of Solvency II, in Light of the Regulation’s Capital Requirements, ... background of higher standards of transparency and additional capital being deployed under Solvency II Demanding as these requirements are on their own, the introduction of these standards comes... increase allocations to corporate bonds compared with 29% of non-life companies Just 18% of respondents overall say they will decrease corporate bond allocations Balancing risk, return and capital requirements