Developing structured solutions for Solvency II

Looming on the horizon for insurance companies is a cloud of new complexities brought about by Solvency II regulations, set to come into force in January 2013. As insurers revisit their investment strategies, banks have been working to come up with the best Solvency II-friendly product solutions. Sarah Nowakowska reports

A raft of products to meet insurers' needs are being developed

One of the main elements that differentiates the European Solvency II directive from its predecessor is a move towards mark-to-market consistency based on the economic risks insurance companies take. In effect, the riskier the investment, the more costly the regulatory capital requirement will be for the insurer, as the new regulation seeks to increase policyholders' protection by having insurance companies take into account the asset side on their balance sheet. As a result, insurers should take a closer look at their assets and liabilities, which could lead some to exit costly exposures in favour of more Solvency II-friendly alternatives to avoid highly taxing capital charges.

"As insurance companies calibrate their Solvency II models, they are re-visiting their investment strategies," says Stephen Pearce-Higgins, global head of banks, insurance and pension fund structuring at UBS in London.

With risk linked to regulatory capital charges, one of the key issues for insurance companies will be to remove as much unrewarded risk as they can to reduce the charges, says Pearce-Higgins, while striking a balance with preserving returns on their investments. The capital protection structured products are able to provide investors, and which would serve to reduce the risk taken on investments, could therefore become an attractive option.

Indeed, while government bonds, for instance, will be favoured with a capital charge of zero under the new regulation, direct equity investments will attract highly punitive charges, with the standard formula requiring that 39% be set aside as equity capital, plus or minus 10% depending on the performance of world markets over the past three years.

The prohibitively high charges linked to certain direct investments deemed risky or highly volatile demand alternative ways of investing in them that can not only reduce the charges, but also offer sufficient return.

 

Structured solutions

The capital protection structured products offer so that regulatory capital charges are reduced is leading banks to work on structured solutions tailored to the insurance companies' needs. "There are a lot of capital-friendly alternatives, such as collars to wrap around investment portfolios and capital-protected notes, both of which we have spent a long time looking to maximise expected returns on regulatory capital," says Pearce-Higgins.

In terms of downside protection, tail hedging and dynamic rebalancing of risk dominate banks' strategies to tackle the issue of high capital requirements. UBS's capital-friendly strategies include a four-pronged approach looking at tactical, systematic, third-party-managed hedges and holistic investment strategies, which aim to minimise unrewarded tail risk in particular. One systematic hedging product the bank believes will be attractive to clients is its Forward Europe 1 Year Volatility Index, which invests in variance by taking exposure to forward EuroStoxx 50 volatility and which may provide protection against extreme tail events.

Dynamic rebalancing of risk, on the other hand, is a strategy adopted by banks such as Credit Suisse, whose CPPI platform offers a constant proportion investment approach that protects investors' capital by changing the amount of investment in risky assets over time, so if the risky assets start to lose money when equity prices fall, they can be invested in safer assets such as government bonds. Similarly, Bank of America Merrill Lynch (BAML) and BNP Paribas' solutions offer insurance companies constant risk protection by providing limits to the downside risk of the investment value over a certain time horizon. "We are working on a strategy that limits the downside risk over a rolling one-year time horizon to a certain percentage of the current value," explains Karl Fuehrer, director in the equity and fund solutions group at BAML in London. "This is quite important under Solvency II, as insurers will have to prove they are solvent with a high probability over a one-year horizon."

BNP Paribas' GuardInvest open-ended Ucits III fund aims to offer partial exposure to the rise in European large cap equities while limiting possible losses to 10% per year using dynamic protection, meaning the exposure level to the European equity market depends on the protection levels attained in the preceding year. "Products that allow you to get rid of the tails and keep the belly of the distribution for the returns will be much more efficient under Solvency II," says Bertrand Delarue, head of institutional product engineering at BNP Paribas in Paris. "We essentially limit the drawdown of the investment over one-year horizons and we reset the level from which the drawdown is calculated every quarter. The money is invested in a risk-controlled index that controls the index volatility. It makes it possible to have a near 10% solvency capital requirement as opposed to up to 49% investing in equities directly."

Highlighting the fact that under Solvency II the traditional endowment with-profits products become very costly, the bank offers alternatives that encourage the use of options and unit-linked solutions with guaranties, which can come in the form of pure structured products, variable annuities or CPPI-type solutions.

"We're pushing classical structured notes with coupons linked to the interest rate, or boosted notes with upside potential as an alternative to endowments," says Pierre Vaysse, structurer on insurance solutions at BNP Paribas in Paris. "There are two ways to do it: you either do a long-term capital structure with a coupon linked to interest rates, or a shorter-term structure with cliquet guaranty and dynamic allocation as an alternative to endowment, which costs [insurers] too much under Solvency II."

The fundamental principle of Solvency II - that products on the balance sheet must be looked at on an economic basis - also highlights the importance of credit quality of the product that insurers invest into, which could lead to Ucits-compliant funds becoming a preferred investment vehicle where investments are fully collateralised with no or limited credit risk exposure.

"There can be a substantial difference in terms of capital requirements, depending on whether the structure entails credit risk or not," says Remi Genlot, managing director in the equity and fund solutions group at BAML. "This tends to favour fully collateralised structures with no credit risk exposure to banks, or a limited one."

Like equities, hedge funds are a capital-intensive asset class under Solvency II that will call for structured solutions. One way to obtain protection in a cost-effective manner would be to access the alternative investment asset class through Ucits, because it lends itself well to structured products, he adds.

The other critical issue banks need to consider when structuring is the cost of protection, and whether that protection comes at the price of returns. "By having a [capital] protection, you also reduce your expected return, because the protection has a cost," says Antoine De Sarrau, vice-president in equity restructuring at Credit Suisse in London.

To strike a balance between purchasing a protection that reduces the capital charge without paying so much for it that it ends up offsetting its benefit completely, BAML is tailoring solutions adapted to each particular asset class depending on the insurance company's objective. Having to balance cost protection with returns also means that, although structured products are an asset category insurance companies will consider, the extent of their use will also require an assessment of suitability and comparison of risk-based return on capital with other asset classes, according to Tom Keatinge, managing director in the insurance capital management team at JP Morgan in London.

"Solvency II is a market-consistent framework and allocates capital based on the economic risks - this drives a focus on return on capital," says Keatinge. "This perspective is important, and should be assessed when considering asset allocation to structured products."

Effectively, the requirement that insurers must match their assets and liabilities to avoid an increase in capital charges under Solvency II in the event of any mismatch is also putting pressure on the need for return on investments to preserve their ability to generate profits in the future. "Companies cannot afford to significantly cut yields, which could put their market share at risk," says Ludovic Antony, director of global solutions for financial institutions, at Société Générale Corporate & Investment Banking (SG CIB) in London.

 

Working closer together

One area SG CIB is investigating revolves around finding instruments that combine the protection insurers need while avoiding over-hedging to offer investments that are liquid enough. The bank recently carried out a study on the best way to invest in equities under Solvency II so as to reduce capital charges without culling too much of the yield. It found that investing in medium- to long-term capital guaranteed products with indexation to equity performance was the most efficient, because the long-term guarantee provided significant capital relief while enabling the companies to benefit from positive equity performances. The report concluded that an average risk-adjusted performance was significantly better than a direct equity investment.

As insurance companies will need to post capital against the risks they take, this is likely to push them to hedge, says Antony, while on the rate side, the bank observed that one of the major systemic risks for the insurance industry was that the market was generally short of long-dated interest rate guarantees, something that could create market dislocations under the form of increased implied volatility and pressure on long-term rates, if companies decided to hedge their shortfalls to reduce their Solvency II capital requirement.

"We have worked with State Treasury Departments to help them issue long-dated government bonds embedding swaptions, which match the convexity of insurer liabilities," says Anthony. "This is something that is likely to reduce tensions in the interest rate market."

The bank has also observed the issue of instruments that enable insurance companies to purchase government bonds forward that enable companies to lock currently high forward yields on government issues while protecting them against a decrease in interest rates, which works towards reducing capital charges for interest rate risk.

According to SG CIB, insurance companies are looking at asset exchanges to increase their yields in a Solvency II efficient way, by entering into transactions with banks whereby insurance companies exchange their government bonds that can be used by the banks to refinance their activities. The exchanges are collateralised so insurance companies run very little risk compared with their initial investment, which translates into a very low Solvency II capital requirement, against a significant yield pick-up over government bond yields.

This development highlights a trend, and may encourage closer collaboration between the two industries. As banks continue developing more sophisticated structured solutions for insurers, the capacity for products to balance lower capital requirements and return on investment will be key to their success when the regulations are finally introduced.