28 August 2011

FT: Solvency II optimism breaks out

New regulations will not force European insurers to dump equities and longer-term corporate debt and buy government bonds as many have predicted, according to research from Union Bancaire Privée.

Contrary to what many analysts have said, the Solvency II rules, which apply from 2013, will create chances for arbitrage between asset classes, according to the study. Small tweaks to investment portfolios can also be made to reduce burdensome capital charges.

“Solvency II creates the scope, and the necessity, to exploit arbitrage opportunities between asset classes which carry a different regulatory cost, but a similar investment risk and potential return”, concluded Emmy Labovitch, the study’s author.

Ms Labovitch’s reasoning for the projected increase in arbitrage opportunities is simple. “Solvency II will make people look at their asset allocation and analyse it from the view that their capital is becoming more expensive”, she said.

In theory, requiring insurers to hold more capital to back riskier assets, as Solvency II dictates, ought to mean no arbitrage between asset classes, as the higher returns on risky assets would be diluted by a higher capital charge in perfect proportion. But in practice, that is near impossible as there are distortions baked into the rules and the markets.

As equities, for example, carry a high capital charge under Solvency II (global equity exposure comes at a cost of 39 per cent), convertible bonds can be used to offer equity exposure at a lower cost. “A small injection of convertible bonds, for example, can improve shareholders’ equity for a given equity exposure”, the report said. “Arbitraging between asset classes involves finding the least expensive method . . . of getting the desired asset class exposure.”

Secondly, Ms Labovitch argued that if an asset class was attractive to an insurer, it would remain attractive post-Solvency II, even if it potentially draws a higher capital charge.

Investors must be more careful, however, about selection. If, for example, an insurer wants exposure to floating rate notes, it will make sense to invest in high-quality, short maturity paper, as this will carry a lower capital charge.

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