In the head offices of insurers across Europe, investment specialists are anxiously eyeing their desk calendars, as each torn-off page brings them closer to January 1, 2016. That is the day when the European Union’s Solvency II directive, a full 12 years in the making, comes into force.
Solvency II seeks to improve policyholder protection across Europe by imposing on insurers the same kind of risk-based capital requirements that the Basel III accord sets for banks. By basing capital charges on insurers’ investment portfolios, the new rules seek to encourage sound investment. EU regulators’ assessment of what is sound is already leading to far-reaching changes in insurers’ investing styles, particularly in certain asset classes such as asset-backed securities.
“Everyone is focused on the January 1 implementation. This is beginning to drive investment behavior,” says David Brealey, London-based head of European ABS at Conning & Co., a Hartford, Connecticut–based firm that manages $92 billion in assets, much of it for insurance companies.
The most important change to investment is the increased incentive to diversify. “Solvency II allows you to reduce the capital charge made against any asset class that’s seen as diversifying your risks,” says Patrick Liedtke, head of the financial institutions group for Europe, the Middle East and Africa at $4.7 trillion U.S. asset manager BlackRock in London. For example, if private equity accounted for the entirety of a portfolio, it would attract a capital charge of 49 percent. However, for an insurer with a conventional and conservative portfolio of sovereign and corporate bonds, the first dollar of new private equity investment attracts a charge of only about 27 percent, after taking the diversification benefit into account.
How, in practice, are insurers likely to respond to this incentive to diversify? Liedtke says they are moving farther into illiquid assets such as real estate, bank loans and infrastructure, continuing a trend set off by aggressive central bank monetary easing that pushed bond yields down to record low levels. A February 2015 poll of BlackRock’s 49 largest insurance clients found that 59 percent planned to increase allocations to private equity, 57 percent to real estate and 44 percent to bank loans. Insurers’ steady stream of premium income gives them the flexibility to invest in these assets and earn the illiquidity premium that they offer.
Bruce Porteous, investment director of insurance solutions at Standard Life Investments, the £258 billion ($403 billion) asset management arm of Edinburgh-based insurer Standard Life, has seen a move into multiasset funds (by Standard Life itself, as well as by other insurers) because multiasset investing is also rewarded by the directive’s preference for diversification. “Under Solvency II, investors in multiasset funds have to look through the funds to the underlying assets,” explains Porteous. “These funds contain diversifying strategies, with falls in one asset offset by rises in another.” SLI has found that its multiasset Global Absolute Return Strategies Fund requires capital charges under Solvency II that are only one third to one half the charges for conventional single-asset strategies that offer a similar return.
The new EU rules create problems as well as opportunities for insurers, though. In particular, Solvency II takes a tough stance on asset-backed securities. It requires a capital charge of 100 percent for a BB-rated, ten-year ABS security, compared with 35 percent for a comparable bond.
“Charges on ABS have been set too high for political reasons,” says Porteous, who explains that regulators have imposed high capital charges because ABS backed by subprime U.S. mortgages played such a prominent role in the global financial crisis. “Insurers are quite happy with the asset class, but when Solvency II kicks in, the charges will be penal, so they’re already getting out,” says Porteous.
The biggest problem for insurers is the restriction that the new rules place on investing in asset-backed securities in the first place, says Brealey. “Solvency II has introduced quite onerous requirements for the acquisition of ABS,” he says. Insurers can invest in ABS only if they fulfill several quality requirements. These include a stipulation that originators must hold onto 5 percent of the assets to align their interests with those of the investors. Most U.S. ABS currently being issued don’t fulfill this risk-retention requirement, leaving European insurers unable to buy. Insurers in Britain have asked regulators if they can hold onto ABS that ran afoul of these rules but were purchased before Solvency II comes into effect; they have yet to receive any clarification. To complicate the picture, Porteous of SLI believes the European Commission and EIOPA, the EU’s insurance and pensions supervisor, may agree to a reduction in ABS capital charges — but that if they do, the reduction will not happen before January 1.
The doubt over the status of ABS underlines a sense of confusion, even as the directive’s entry into force gets nearer by the day. “Solvency II is less than six months away, but there’s still all this uncertainty,” says Porteous. Brealey of Conning says that many European reinsurers, who hold up to a quarter of their funds in ABS, plan to sell their ineligible ABS this autumn, when trading picks up after the summer vacation period.