By David Lomas, Global Head of BlackRock’s Financial Institutions Group
Alongside the effects of the sovereign bond crisis, Solvency II preparations continue to dominate the agendas of European insurers. Indeed, the radical nature of this new Europe-wide regulatory regime is forcing a major rethink of investment and business strategies, the long-term effects of which will be felt by other capital market participants including pension schemes.
Yet despite the tremendous efforts made by the industry to prepare for the changes ahead, much uncertainty remains as to how insurers can best achieve the outcomes they need. In an attempt to provide some clarity, in February BlackRock commissioned the Economist Intelligence Unit to conduct a detailed study on Solvency II across Europe.
The findings reveal the significant challenges facing insurers on the road to full compliance. Interestingly, the research highlights a degree of discrepancy between the market’s perception of what insurers think and what insurers really believe. This is particularly noticeable in relation to the use of alternatives, with 32% of insurers expecting to increase exposure to hedge funds and private equity, and their readiness for Solvency II’s more stringent governance and disclosure requirements, with over 90% of respondents citing concern about meeting these.
Overall, the most important finding was probably the need to move beyond performance and seek full alignment of investment expertise and enterprise risk management. As such, the research also offers valuable lessons to other institutional investors.
Adding alternatives and managing risk
In the wake of Solvency II most of the planned asset allocation changes are in line with market expectations, such as a move away from equities and towards corporate bonds, with one third of respondents expecting to increase exposure to this asset class. More surprising, however, is the proportion of insurers who plan to increase their allocations to alternatives (32%) – particularly given that alternative investments will attract higher charges under the standard formula used in Solvency II.
Beneath this apparent anomaly is a trade-off between cost and potential returns. It makes sense for insurers to diversify their portfolios and balance the impact of potentially higher capital charges for certain asset classes against potentially superior risk-adjusted returns – which many clearly believe they will be able to gain through alternatives.
This is even more urgent today as the challenging market environment makes stable and uncorrelated returns increasingly appealing.
The real challenge for insurers under Solvency II will be the associated risk management and transparency requirements. Insurers that are able to evidence ‘look-through’ and mitigate overall volatility can achieve significantly lower capital charges. This is why it is important that the industry invests the necessary resource and time to develop suitable solutions.
Importance of derivatives and data
The clear majority of insurers (60%) agree that Solvency II will result in greater use of derivatives to help match assets and liabilities, provide capital guarantees and manage volatility. As asset-liability management (ALM) strategies become more complex and demanding in volatile markets, we expect this to be an area of significant focus. Furthermore, the introduction of Solvency II comes at a point when the derivatives markets are in a state of flux and subject to extensive new regulation. Consequently, all users of derivatives, insurers included, will have to ‘raise the bar’ or look for a reliable investment partner with the necessary infrastructure and know-how to ensure best practice.
The vast majority of insurers participating in the research are concerned about the requirements for the timeliness and completeness of data under Solvency II. They also worry about the quality of data received from third parties, particularly in relation to the required ‘look-through’ on pooled funds, with many fearing that they will have to limit their exposure to certain assets given rigorous data requirements.
Annuities and buyouts revisited
Solvency II is acting as a trigger for insurers to reflect the full extent of the risk inherent in writing guarantees, with two-thirds of life and composite insurers indicating they will restructure in order to better manage their guaranteed funds in-house. While the associated cost will be higher, it may also lead to simpler guarantees that are designed specifically with risk management in mind.
The European authorities have now also agreed to allow a matching adjustment also known as ‘matching premium’ for certain long-term insurance products such as annuities where policyholder behaviour cannot adversely affect the profitability of the contract. The next step is for insurers to seek access to the right data and know-how to help them construct portfolios which maximise the value of the matching adjustment while retaining a prudent approach to credit risk.
The immediate threat to insurers’ annuity businesses has now been lifted. However, it is important to note that the matching adjustment has only been granted on a temporary basis, meaning that the cost of annuity-type contracts is set to increase despite the acceptance of a matching adjustment.
Wider implications
The research highlights how much remains to be done to ensure full compliance with Solvency II. Even in those countries that have already applied some Solvency II-type requirements, such as the UK and Denmark, insurers still face an uphill task, particularly in relation to data management. The regulation is acting as a catalyst for many changes that were overdue.
On the capital markets side, it is too early to fully assess the likely impact, but the research suggests that most insurers expect greater volatility and less demand for equities. At the same time, the need for yield remains a big issue for life assurers in particular. Overcoming this dilemma means seeking yield in different places while retaining a focus on careful portfolio construction to reduce the cost of capital.
Forpension schemes, the most immediate effect will be the increased cost of buyouts and therefore the need to achieve better investment outcomes. Longer term, however, it is likely that European pension funds will be required to adopt a more holistic approach to balance sheet management. The lessons learned as part of Solvency II preparations, be it in terms of governance or risk management and reporting, could therefore prove to be very valuable.
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