An agreement on revisions to Solvency II, the European Union’s system of regulation and risk-based capital requirements for insurers, has produced a mixture of joy and dismay within the industry. Joy, because the final accord includes a number of measures requested by insurers that will soften capital requirements for many long-term insurance products. Dismay, because many insurance executives had hoped that the seemingly endless negotiations and political wrangling over the rules, which had dragged on for more than a decade, meant they would never come into force.
The Solvency II framework directive, adopted in 2009 but not yet in force, contains capital standards that many industry executives have argued would force major changes in their firms’ investment portfolios, making it difficult for life insurers to fulfill their long-term insurance products and annuities. But after intensive industry lobbying over the past two years, the parties in the so-called trilogue talks — the European Commission, which is the EU executive agency; the European Council, which represents member governments; and the European Parliament — agreed to a package of modifications in November that fulfill many key industry demands, including capital relief measures such as the matching and volatility adjustments, which will reduce insurers’ need to hold more reserves to back their long-term obligations.
“The agreement that was reached, although focused on methods of valuation of liabilities, actually has implications for the investment strategy of insurers that incentivizes them to play their role of long-term investors,” says Gilles Dauphiné, head of insurance and pension solutions strategists at AXA Investment Managers in Paris.
The modifications, including in a new directive called Omnibus II, need formal approval by the parliament and the council in early 2014. Assuming that happens, the entire package will enter into force in January 2016, replacing an outdated patchwork of national insurance rules with a single, detailed system of regulation for the insurance industry, the region’s largest institutional investors with some €8.4 trillion ($11.5 trillion) of assets under management.
The volatility and matching adjustments will prevent short-term changes in the value of assets from flowing through to companies’ balance sheets. The changes are aimed at encouraging insurers to invest in long-maturity, fixed-income assets and loans to match liabilities arising from their fixed annuities businesses. “With the volatility adjustment principle, insurers are expected to have a preference for sovereign debt,” says Dauphiné.
The other major winner coming out of the Solvency II talks is triple B–rated bonds. The European Insurance and Occupational Pensions Authority, the pan-EU agency created by the Solvency II process to supervise the industry, had proposed strict limits on insurers’ holdings of triple B–rated bonds, but negotiators scrapped those limits in the final round of talks last month. “This is very significant for Spanish insurers, which wouldn’t have been able to invest in the country’s triple B–rated bonds, and for U.K. insurers, which have a lot of triple B–rated bonds on their books too,” says Paul Fulcher, head of asset-liability management structuring for insurance and pensions at Nomura International in London.
Still, the final package of rules is not to everyone’s liking. “I have heard in some quarters the regulators believe the industry made out like bandits, but that’s not clear to me,” says Tom Wilson, chief risk officer at Allianz in Munich. “All life insurers will have to rethink their products, and companies will have to rethink their capitalization ratios. It’s also transitional, and you have to work through it. It’s not clear that all insurers are dancing in a field of clover singing ‘Kumbaya.’”
Few had expected the trilogue discussions to conclude in November. “What is surprising is the timing,” says Rotger Franz, an insurance analyst at Société Générale in London. “They speeded things up to get Omnibus II done before the European Parliament elections,” due to be held in May 2014. “Everyone feared the trilogue wouldn’t be finished until the end of the year,” he adds. “Then you would have the elections, which would have delayed Solvency II until we-don’t-know when.”
The removal of uncertainty about the regulatory package has had little impact on the equity market. The Stoxx Europe 600 insurance sector index has remained largely unchanged since the announcement of the agreement in mid-November. Indeed, analysts say that most of the news had already been priced into insurance shares.
In terms of asset allocation, the revised capital standards under Omnibus II favor sovereign bonds, shorter-dated credit and hedged equities. Insurers will be required to hold more capital for unhedged equities, long-dated corporate bonds and alternatives such as structured credit, hedge funds and private equity. The asset class that stands to benefit the most from the agreement is sovereign debt, with a zero percent capital charge — which many in the sector find ludicrous in light of the recent sovereign difficulties in Europe.
Equities are the only asset class to win a transitional period for the application of the new capital standards: Insurers will be able to phase in tougher capital requirements on equities over ten years. Although equities remain a small portion of European insurer portfolios, companies have been looking to increase their holdings of stocks to counter the low-interest-rate environment. Société Générale’s Franz predicts that insurers will increase their equity allocations from 4 percent to 6 percent on average.
As far as other assets go, the lack of a transitional period means that anything not favored by Solvency II rules — including private equity, hedge funds, structured products and infrastructure loans — is likely to see diminished interest from insurers. But according to Nomura’s Fulcher, insurers don’t need to change their asset mix just yet. “They don’t need to scramble for capital due to the transitional measures on the liability side,” he says. “There won’t be a desperate need to sell on December 31, 2015, but you will see new investment decisions being driven by Solvency II.”
