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Institutional Investment - February 20, 2012

Maximising the benefits of equity investments for insurance companies facing Solvency II constraints

The Solvency II directive, which should come into force at the beginning of 2013, introduces a prudential framework for the computation of the regulatory capital requirements of insurers. In particular, it defines a standard formula that must be applied by default and serves as a reference point for more advanced approaches, notably partial and full-blown internal models. For the insurance sector, the capital requirements associated with equity investments remain prohibitive using this standard formula, which will be especially prejudicial to firms that are unable to develop an internal risk model. In reaction, a forced shift away from equity has already started so as to prepare for the new regulatory constraints.

This is not good news for the industry. The basis for sound investment should be proper diversification and risk management, not shying away altogether from capturing the equity risk premium. In order to alleviate this issue, EDHEC-Risk Institute is introducing a framework for designing dedicated dynamic asset allocation solutions, as part of a research chair supported by Russell Investments. These Solvency II dynamic allocation benchmarks, or Solvency II benchmarks for short, are meant to be regarded as substitutes for static equity investments by insurance companies. They can use them to achieve substantial exposure to equity risk and the associated premium, while maintaining strict and explicit control over the implied Solvency II charge.

Meeting the challenges of Solvency II by relying on an external framework

The Solvency II framework draws lessons from the Basel II banking regulation, but it involves a number of distinct features. First, Solvency II allows diversification not only within risk types, but also across risk types. Second, Solvency II has arguably given more focus to risk management by allowing internal models that fully reflect the risks and management actions of insurance companies.

To attain its objectives, Solvency II encourages a move towards a tailored risk-management approach to match the specific features of each firm. The aim is not to lay down new rules for capital or provisions but to create incentives for more sophisticated partial or total internal models. It is in this context that we propose the development of equity benchmarks that could be a starting point for building a partial internal model defining risk management strategies. The solvency capital requirement (SCR) corresponds to a Value at Risk (VaR) of basic own funds with a confidence level at 99.5% over a one-year horizon calculated under the assumption of continuity of business. It covers unexpected losses arising from the insurer’s current and future business that will be written over the following twelve months. The SCR has been calibrated to take into account all quantifiable risks to which an insurance company can be exposed, including life, non-life, health underwriting risks, market, credit and operational risks.

The aim of the EDHEC-Risk study is to propose a methodological framework based on objective and thoroughly-tested academic references to design dynamic risk management strategies in the form of benchmarks that allow exposure to be gained to equity markets, while maintaining a reasonable solvency capital requirement. Because dynamic hedging is not recognised as a risk mitigation technique in the standard formula, it will be necessary to implement a partial internal model in order to better reflect the real risk exposure.

The EDHEC-Risk benchmarks would constitute a reference for developing a partial internal model that supports a dynamic approach for equity investments. Moreover, the Solvency II benchmarks framework is public, totally transparent, well-documented and grounded in a rules-based approach and on solid academic foundations. As a consequence, these benchmarks constitute an independent external reference; they are easily replicable and ensure the rules-based approach is more easily respected by insurance companies applying them. This transparency also allows Solvency II compliance and facilitates internal and external (auditors and regulators) control of these partial internal models.

The size of team necessary for fully-fledged management of financial risks is only expected at the largest firms. Other companies should instead adopt a rigorous but simplified approach to financial risk management, relying on proxies and externalising the implementation. These insurance companies should therefore give great importance to rules, because they make it easy to have appropriate, responsive and easy-to-implement management of market risk without the need for a specific financial risk management team. In this sense, the Solvency II dynamic allocation benchmarks will offer insurance companies an objective reference for developing partial internal models. The Solvency II benchmarks used within the context of Pillar II may contribute to the validation of internal models thanks to their transparency and their academic soundness. Validation includes ranges of methods, techniques and verifications, which involve all players, both internally (notably internal control, risk management, compliance, and the actuarial function) and externally (statutory auditors and regulators). For now, however, some aspects of auditing and validation processes for insurers under Solvency II are not completely fleshed out by the legislators. Ultimately, we believe some implementing measures will define the requirements more precisely.

The qualitative review process is a fundamental step in assessing the validity of an internal model and it involves every link in the chain. Solvency II has not set out very explicit requirements at this stage. The qualitative review will be more difficult to outsource; however, it will be greatly simplified if the investment process follows an external benchmark. The use of external models and data should be accompanied by articulated strategies for validating and regularly reviewing the performance of these models and data. These strategies should include expert judgement, a use test, a documentation “sufficiently detailed and comprehensive enough to allow knowledgeable third parties to understand the internal model”, and finally some data policies to ensure “the accuracy, completeness and appropriateness of the data used by the internal model.”

The quantitative processes for model validation under Solvency II are not yet set in stone, and it is not clear how comprehensive the testing should be for a firm to gain approval from the supervisor. However, some general principles and methods are already being discussed and should become clearer as insurance companies achieve conformity. They include input validation, model replication, benchmarking, backtesting, and stress testing, sensitivity testing, and profit and loss attribution. In any case, it is very likely that some discretion will be left to national supervisory bodies.

Introducing the EDHEC-Risk Solvency II Benchmarks

The EDHEC-Risk Solvency II benchmarks rely on two main paradigms, respectively known as life-cycle investing (LCI) and risk-controlled investing (RCI). These two components allow long-term performance objectives and short-term solvency constraints to be reconciled. The RCI component is designed to maximise the probability of reaching the long-term objectives while respecting the short-term risk constraints, i.e. the presence of Solvency II risk budgets. The LCI component ensures the insurance company’s investment horizon is taken into account, and immunises the long-term portfolio against changes in key risk factors. In this context, Solvency II constraints should be incorporated ex-ante as key ingredients in the design of the optimal investment solutions.

This leads to the design of dynamic risk-controlled allocation strategies that mean giving up part of the upside potential of the performance-seeking portfolio, and more specifically, of the equity portfolio, in exchange for protection on the downside. The practical implication of the introduction of short-term constraints is that optimal investment in the risky equity index is a function not only of risk aversion but also of risk budgets, as well as of the likelihood of the risk budget being spent before the horizon. Then, we propose a comprehensive long-horizon dynamic allocation model in the presence of stochastic inflation and interest rates, mean-reverting equity risk premium and stochastic volatility.

On the implementation side, we design 16 Solvency II benchmarks, combining time horizons of 3, 5, 10, 15 years and Solvency risk budgets of 5%, 10%, 15%, and 20%. The benchmarks are rebalanced on a monthly basis, based on parsimonious dynamic estimates for the equity risk premium and volatility. The risk budget for these benchmarks is reset at the end of each year so as to meet the target capital requirement level. The benchmarks involve a time- and time horizon- dependent allocation between equity, proxied by the Russell Global Equity Index (or the Russell Developed Equity Index in their euro-hedged version), and cash, proxied by the EURIBOR 1M. The practical implementation of these benchmarks is done in discrete time, because continuous trading would create prohibitively high transaction costs. The robustness of these benchmarks has been checked through numerical testing and thoroughly backtested on two historical datasets. They all respect the target Solvency II risk budgets at the 99.5% confidence level set up in the Directive, and perform consistently across a wide range of alternative calibration methods.

To sum up, our view is that long-term Solvency II equity benchmarks such as the ones introduced by EDHEC-Risk, if they are properly documented and implemented in a systematic manner by investment firms, can be recognised as investments in equity with low capital consumption for insurance companies. In that case, it is expected that proper documentation by the benchmark provider and adequate risk management systems by the investment firm are sufficient to ensure approval by supervisors of a partial model for market risk. Thus, an initiative focusing on the publication of Solvency II dynamic allocation benchmarks may enable all European insurance companies which do not have a full internal model to avail of an objective academic reference that can serve as a starting point for a partial internal model. We expect that this original approach will facilitate dialogue with both regulators and auditors for the validation of risk management practices that allow for divergence from the standard formula and reintroduce equity as an affordable asset class for investment.