Work in progress for insurance companies’ asset allocation decisions
The current parameters of Solvency II standard formula favour government bonds and short-term corporate bonds, and encourage the use of derivative products.
he last lap. European insurance companies have only two years to prepare for the prudential system laid down in Solvency II, which will apply from 1stJanuary 2013. They recently participated in the directive’s fifth and last quantitative impact study (QIS 5), whose results are expected to be published by the European Insurance and Occupational Pensions Authority (EIOPA) at the beginning of March 2011. The European Commission will take account of these results when determining in 2011 the final parameters of the standard formula to be used to calculate capital requirements.
Insurance companies will have until then to review not only their risk management and internal control policies, but also their asset allocation. According to a survey carried out by Morgan Stanley and Oliver Wyman, almost 60 % of the sector’s solvency capital requirements (SCR) will be generated, with the QIS 5 parameters, solely by market risk. Insurance companies have warned on several occasions that excessive requirements would limit their investment capacity and the largest insurers have started to re-orientate their decisions. "Our asset allocation is already compatible with Solvency II. It may be fine-tuned slightly, but there will not be any major revolution, notes Joël Prohin, Head of Investment Strategy at Allianz France (70 billion euros of assets under management, excluding unit-linked contracts). Over and above their needs in capital, our investments depend more on our risk policy."
Finding the right balance
The current parameters clearly favour government bonds and short-term corporate bonds versus equities and real estate(see chart page 8)."Because of the attractive SCR yield, given the current level of credit spreads, short-term bonds, with a maturity of around three years, are likely to become the favourite risky asset class for many insurance companies, according to the authors of the survey conducted by Morgan Stanley and Oliver Wyman, who also expect a divorce between the durations of assets and liabilities.Swaps and other interest rate derivatives, or government bonds in some markets, will be used to match liability durations."
Several groups have already announced their intention to reduce their equity investments, whether on account of Solvency II or the crisis(see the interview). For example, Groupama has invested 100 % of its cash-flows in bonds in 2010 and wants to reduce its equity exposure from 15 % at the end of 2009 to 5 % in 2012. Axa France, Swiss Life France and CNP Assurances have also reduced their equity allocation or are planning to do so. Even the companies that have long term liabilities via retirement products, for which the equity shock has been reduced to 22 %, could take this route. "We will probably follow the market in reviewing the allocation of our general account liabilities to find the right balance between the yield of each asset class and its capital cost, notes David Simon, Director of Accounting, Management Control and Risks at AG2R La Mondiale (38 billions of assets under management, excluding unit-linked contracts).If the text remains as it currently stands, we will probably have to reduce our exposure to risky assets such as equities and real estate, or at least dilute them in our portfolio."
Volatility in IFRS standards
Insurance companies’ asset allocation decisions will depend above all on the budget that they are ready to allocate to market risk(see chart page 10). "If mutual health insurers, which have very short-term liabilities, between 3 months and 1 year, want to reduce their market SCR, they will have to reduce their risky asset allocation and refocus on government bonds, saysNicolas Demont, CEO of the asset management company Egamo, which manages 2.2 billion euros of assets, including 2.1 billion for MGEN. If they have sufficient capital, they will be able to maintain an asset allocation which does not necessarily correspond to their liabilities."
Other criteria also have to be taken into account, which makes asset-liability management extremely complicated. "The objective is to reduce risks, but with the least possible impact on profitability, explains Elodie Laugel, Head of Financial Engineering at Axa Investment Managers (522 billion euros of assets under management, including 60 % on behalf of the Axa group). It is important to examine allocation as a whole and to optimise it according to the risk, return and diversification potential of each asset." A shrewd balance. "It is also possible to optimise the return-risk combination of each asset class, in particular by using derivative products, such as equity puts", adds Elodie Laugel. Derivatives can in fact reduce the market SCR and generate only a low counterparty SCR. "They operate well under Solvency II, but generate excessive profit and loss account volatility in IFRS standards", notes however Joël Prohin. In addition, these products do not exist for all assets and their prices are very volatile.
Other optimisation tactics are possible, such as purchasing convertible bonds. The inclusion of a limited number of convertible bonds in a portfolio of equities and bonds could help to improve the solvency margin coverage ratio, according to a survey carried out by Winter & Associés on behalf of UBI - Groupe Union Bancaire Privée. "Convertible bonds are the optimal means of maintaining equity exposure while limiting capital requirements, notes Dominique Leprévots, Chairman of the Executive Board of the asset management company. Holdings in Europe are however limited to around 100 billion euros."
Not all insurance companies have resolved the question of their asset allocation under Solvency II. That is the case in particular of small and medium-sized insurers. "They are waiting for the analysis of their QIS 5 results before taking their allocation decisions, notes Maxime du Chayla, Deputy General Manager of OFI Asset Management (48.7 billion of assets under management), 95 % of whose clients are institutional investors, including among other Macif and Matmut. They are likely to have to examine closely their equity and corporate bond allocations, possibly favouring shorter maturities for the latter, even if this results in a liability mismatch."
At the end of the day, insurance companies will have to make adjustments, but a majority of their assets will still be invested in bonds (72 % of their investments at the end of 2009, according to the insurers control authority). "We will not witness a major revolution or a massive asset reallocation, sums-up Jean-Pierre Grimaud, Chief Investment Officer of Swiss Life France and Chairman of the French Association of Institutional Investors. Almost two-thirds of the latter’s members are affected by Solvency II. After two financial crises in ten years and numerous quantitative impact studies, companies have already carried out an asset reallocation and management strategies are compatible with the directive. Only small companies may have to take more significant decisions."