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Institutional Investment - March 23, 2010

The influence of Solvency II on an insurer’s strategic policy

By Wendy Montulet, Ortec Finance, Steven Hooghwerff, Ortec Finance, and Elske van de Burgt, Ortec Finance and Research Associate, EDHEC-Risk Institute

The upcoming Solvency II guidelines will have a profound influence on capital budgeting and risk management for insurers. For example, under Solvency I the investment policy has no impact on the solvency ratio. This picture will change completely under Solvency II. The investment policy in terms of the asset allocation and asset duration will therefore have a large impact on the capital requirements. It may also be the case that by reducing the short-term risk (as measured by the required capital) the long-term expected return also decreases. Insurers should therefore perform additional multi-period calculations for different stochastic scenarios to truly optimize their risk / return trade-off in terms of setting the appropriate investment policy. This article uses practical examples to explain how a strategic approach to Solvency II strengthens an insurer’s balance sheet in both the long and the short term.

Solvency II will solve a number of serious shortcomings of the current (Solvency I) regulations. Under Solvency I, only liability driven risk is taken into account (and also in a rather simplified way). Investment risk is completely ignored: the required capital for an 80% equity and 20% bonds asset allocation is the same as for a 20% equity and 80% bonds asset allocation, while the corresponding balance sheet risks are obviously completely different. All calculations in this article are based on the guidelines of QIS 4, the fourth Quantitative Impact Study. For the upcoming QIS 5 guidelines, the solvency capital requirements will probably become even higher because of the substantially higher stress parameters proposed in recent consultation papers.

Minimizing the required solvency margin

Figure 1 below shows, as an example, the dependency that can exist between the required capital under Solvency II (the Solvency Capital Requirement, or SCR), the allocation to equity and real estate in the investment portfolio and the duration of the assets. It turns out that we can minimize the SCR by matching the duration of the liabilities and reducing the allocation to risky assets like equity and real estate. In the example in figure 1 the required capital is minimized when the duration of the assets is approximately equal to 10 and risky assets are not part of the strategic asset allocation. In this case the interest rate risk, due to a duration mismatch with the liabilities, is minimized. The required capital associated with risky assets obviously decreases when the allocation to these categories becomes smaller. This short term approach may however lead to an underperformance in the long run, since a low risk investment portfolio typically also generates a mediocre return. This trade-off between minimizing the required capital and optimizing the long-term return is crucial for retaining a competitive edge in the insurance business.

Figure 1: The required capital under Solvency II (Solvency Capital Requirement, SCR) as a function of the asset duration and the allocation to risky assets. The required capital is expressed as a percentage of the market value of the liabilities.

Long term implications

Solvency II stipulates that the available capital has to exceed the required capital. However, available capital in excess of the required capital at the current moment does not guarantee that future risks are limited. We start by considering the current situation (30% equity and real estate and an asset duration of approximately 3). Figure 2 shows the evolution over time of the capital surplus (available capital minus required capital) in a large number of stochastic economic scenarios. Although we start from a positive capital surplus a sizeable probability of a future capital shortage occurs for the current investment policy.

Figure 2: The evolution of the capital surplus (available capital minus required capital) expressed as a percentage of the market value of the liabilities.

Figure 2 shows that sufficient available capital at the current moment does not guarantee that this will remain the case in the future. This underlines the importance of gaining insight into the consequences of Solvency II both on the long and short term.

Strategic decision-making

Under Solvency II, a low solvency ratio can be improved by reducing the risks in the current policy. The balance sheet can for example be de-risked by exchanging risky assets for fixed income when the solvency ratio is too low. It is however important to realize that risk reductions must often take place during unfavourable economic circumstances. Examples of such unfavourable economic circumstance are:

  • Selling equity after sharp drops in value.
  • Hedging interest rate risk when interest rates are low.
  • Reinsuring insurance risk when reinsurers are also struggling with their financial position.
  • Raising capital from investors during economic turmoil.
The above examples indicate the risks associated with a dynamic policy. It is therefore preferable to agree on a robust long term policy, which can be maintained during economically turbulent times.

Figure 2 showed that the probability of a capital shortage in future years is large for the current asset allocation. In order to reduce this probability it is useful to analyze the effect of several alternative investment strategies for both the long and the short term. Figure 3 provides a summary of the long-term effect of these investment strategies. The circles on the first (top) line provide strategic asset allocations in which the allocation to risky assets is reduced from 30% to 0% in steps of 5%, with no further adjustments. We find that reducing the allocation to risky assets has only a limited effect on the solvency risks. The second line shows the effect of changing the asset duration. It is clearly shown that changing the asset duration is more efficient than reducing the allocation to risky assets. Note that we can achieve a higher return at a lower risk by optimizing the asset duration and keeping the strategic asset allocation constant. The most efficient investment strategies can be found on the third (bottom) line. On this line the allocation to risky assets is varied given the optimal duration of 10.

Figure 3: The influence of strategic asset allocation and duration policy on long term risk and return. The current policy allocates 30% to risky assets and has an asset duration of 2.5.

In this example the insurer will typically select one of the investment strategies on the third line. This choice is generally contingent on the amount of risk that can be taken (the ‘risk appetite’).

This practical example shows that the investment policy, in terms of the strategic asset allocation and the asset duration, has a large influence on the risk-return trade-off under Solvency II. Under Solvency II the investments influence not only the available capital (as is the case under Solvency I) but also the required capital. The solvency ratio hence is sensitive for investment risk in two different ways. This double influence on solvency development requires insurers to integrate the long term into short term policy choices.

Alternative investments

Under Solvency II alternative investments such as hedge funds and commodities are treated differently from stocks. This is underlined by table 1, which provides the most important characteristics of (developed) equity and hedge funds (fund of funds). The table provides arithmetic returns. These assumptions correspond to the economic scenario set that Ortec Finance provides periodically to its licensing customers. This scenario set uses historical data up to and including the year 2009. The risk charges pertain to the fourth quantitative impact study of Solvency II (QIS 4).

Developed equityHedge funds
Expected return8.25%7.0%
Volatility20%8.5%
Solvency II risk change32%45%

Table 1: Expected return, volatility and Solvency II risk charge of developed equity and hedge funds.

Under Solvency I adding alternative investments to the strategic asset allocation typically improves the investment portfolio in terms of risk and return. The most important reasons for this are the relatively low volatility and the (usually) low correlation of alternative investments with other investment categories. As a consequence of this hedge funds can be a useful addition to the investment portfolio under Solvency I.

Under Solvency II alternative investments as well as other equity investments will be subject to a risk charge. For hedge funds (45%) a substantially large buffer needs to be held than for developed equity, even though hedge funds are generally less volatile. This 45% risk charge is likely to make hedge funds an unattractive investment category for many insurers.

Standard model versus internal model

Solvency II promotes the use of an internal model as an alternative to the supervisor’s standard model. An important advantage of using an internal model is that insurers are stimulated to fully understand and manage risks in their balance sheets.

In an internal model the development of the entire balance sheet of an insurer needs to be determined for a one-year horizon. On this horizon the available capital needs to exceed the SCR with 99.5% certainty. If an insurer has an asset liability management (ALM) model based on Monte Carlo simulation, the step towards an internal model can be readily made. ALM models furthermore can provide quantitative support in the calibration of the risk parameters of Solvency II.

Stochastic scenario analysis allows an insurer to make all balance sheet risks clear in a transparent way. An ALM model can determine the Solvency II risk buffers according to both the supervisor’s standard model and the internal model according to the insurer’s calibration of the risk parameters.

Concluding remarks

Most insurers are currently very busy redesigning their internal processes according to the (pillar 2) guidelines of Solvency II. From a risk management point of view it is equally important to make the long term consequences of Solvency II insightful. Every insurer should currently adequately take both the long and short term consequences of Solvency II into account when determining its strategic (investment) policy.