27 June 2012

Risk.net: Managing Solvency II's equity capital charge

“Life insurers want to maintain a significant allocation to equities for competitive reasons”, says Etienne Comon, London-based head of insurance strategy in Europe for Goldman Sachs Asset Management (GSAM). “They want life policies to be attractive to retail customers so they need to offer some upside potential: including equity within the asset portfolio is definitely one engine of this growth.”

Holding equities is about to get more expensive, though. Under the latest calibration of the Solvency II insurance framework, the standard equity capital charge is 39 per cent for global equities and 49 per cent for other equities. Comon says this means having even a fairly small amount of equity on the books can make quite a difference to the solvency position of a firm.

Of course, the 39 per cent charge relates to calibration under Solvency II’s standard formula. Those insurers that seek internal model approval may have some additional room for manoeuvre, although Comon expects this will be limited. “Improving internal models has only limited benefits in terms of reducing the equity capital charge, because the equity charge under the standard formula isn’t totally out of line with economic reality. Moreover, there’s a lot of complexity in trying to capture diversification effects within equity portfolios”, he says.

Comon says that any approach should be driven by better risk management, rather than simply the desire for capital benefits. “Our view is to focus on the long-term economics of the balance sheet, first by reducing volatility and then making sure that the insurer crystallises the benefits of the right risk management in terms of better SCR [solvency capital requirement].”

Yet some insurers, such as Allianz, take a fairly dim view of making decisions about risk management purely for the sake of obtaining a lower capital charge. “If I didn’t like my equity exposure, my initial response would be to sell the equity”, says Tom Wilson, the Munich-based chief risk officer of German insurance giant Allianz, which has €641 billion (£515.8 billion) assets under management.

“Introducing a dynamic hedging strategy just to reduce the equity charge would probably be too costly in terms of management fees and could potentially be illiquid,” he says. “One of the things that has served the insurance industry well in the past is not having a culture of arbitrage.”

Not everyone agrees that the equity capital charge under Solvency II will have a significant impact on the insurance industry, largely because many countries have already introduced strict rules for equity allocation. “Those [regions] that traditionally have very high equity allocations – such as the UK, Scandinavia, the Netherlands – already have a stress-based regulatory framework in place, while those places that don’t – such as Germany or Italy – also have a lower allocation of equities”, says Tom Leake, London-based European head of equities structuring at Deutsche Bank.

Leake believes life insurers have other things to worry about beyond simply trying to get lower capital requirements, such as maintaining a healthy risk profile in a currently volatile market. “We haven’t yet seen any trades executed within the equity space that are done purely because of Solvency II”, he says. “First of all, the rules are still fluid and insurers want to wait until they are properly settled. Also, while in some trades it might be possible to recoup the premium purely out of the capital savings, this doesn’t tend to be the case with equities.”

“We think that managing your assets so as to reduce the implied volatility premium that you have to pay is a very good idea”, he says. “Changing asset exposure through volatility targeting allows options to be purchased that are much more efficiently priced.”

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