Policymakers Mispriced Asset Risks, Fund Firms Argue

Asset managers are urging European policymakers to alter the rules stipulating that insurers stockpile cash if they invest in assets labelled as risky.

In 2018, the European Commission will review Solvency II, the E.U. regulation implemented at the of 2016. Critics claim the reforms miscalculated the risk profile of some fixed income assets, triggering punitive capital charges to holders of asset-backed securities, and failed to distinguish between different types of Eurozone sovereign bonds.

The rules aimed to give insurance investors and regulators a better idea of the risks in their portfolios and to limit reckless risk-taking. However, market analysts say the decision to restrict insurers’ asset allocations to riskier assets, given the low-yield environment, pushed insurers to raise the prices on some of their products.

Life insurers selling long-term investment products such as annuities have been particularly hard hit, analysts say.

Sophie Debehogne, an investment specialist at BNP Paribas Asset Management, said the regulations have switched asset allocators’ focus from liabilities to risk, but also forced insurers to rethink return sources. “The required return on life insurance contracts is such that yield requirements are too high for bonds in today’s lower yield environment,” she said.

While insurers — like most yield seekers — sought to diversify their portfolios, the Solvency II restrictions effectively ruled out some assets which could have provided higher, albeit riskier, returns, according to Debehogne.

[II Deep Dive: As Solvency II Looms Insurers Are Diversifying]

Some say policymakers now need to revisit the capital charges applied to some of these assets, nearly a decade on from the global financial crisis. Among them is Heneg Parthenay, head of insurance at Insight Investment.

The rules around holding asset-backed securities and structured credit have been particularly punitive, Parthenay argued. “I think some of these calibrations are too onerous. With ABS, they have put such a high penal capital charge in place that the message is, ‘don’t touch it.’”

Parthenay is not alone. Daniel Banks, a director at investment consultant P-Solve, told Institutional Investor that Solvency II’s capital tariffs “may not correspond to the true economic risk of an asset class.”

“Anything that is securitized is massively penalized under Solvency II. That is not ideal,” Banks said.

The rules were introduced after the financial crisis, and policymakers pointed to the collapse in asset-backed securities prices and widening spreads as motivating risk tariffs on these assets.

But some researchers say that this interpretation was faulty. Despite the crisis-era liquidity crunch, expected defaults didn’t materialize in the way that regulators predicted.

Alexander Batchvarov, Bank of America Merrill Lynch’s head of international structured finance research, argued that price volatility in the ABS market is “not significantly different” from any other fixed-income market. “The calibration of capital has led to the distortion of allocation of investments,” Batchvarov said. “It is outrageous how Solvency II has been so incorrectly calibrated. It is unbelievable.”

Despite the criticisms, most asset managers agree that the rules have enhances insurers’ understanding of investment portfolio risk.

Last month, Gabriel Bernardino, chairman of the European Insurance and Occupational Pensions Authority, spoke at the EIOPA annual conference on the topic. He said the rules had made European insurers “much stronger,” as capital is now “better aligned” to their risk exposures.

Bernardino did acknowledge the wisdom of reviewing the regulatory reforms. “It makes perfect sense to evaluate and review the recent reforms in order to mitigate any unintended consequences and increase proportionality,” he said.