25 February 2015

Financial Times: Assessing Solvency II’s 'look-through' approach

Solvency II has important implications for insurance capital management and is scheduled to take effect on January 1 2016. It introduces a risk-based capital framework and harmonised EU-wide insurance regulation built around three pillars: valuation and capital requirements; risk and governance; and reporting and disclosure.

All will necessitate input from insurance asset managers, but it creates three main long-term investment challenges.

First is the need to improve investment returns to satisfy long-term policyholder guarantees and generate profits in a low-yield environment and a “lower for long” return outlook. The eurozone’s fragile economic recovery, deflationary risks, medium-term risk of secular stagnation and weak growth in advanced economies have led many institutional investors to consider “low for long” yields and low growth as a likely prospect.

Solvency II’s “look-through” approach assesses underlying investments (including derivative positions) and their risk classification, potentially providing an opportunity to better reflect economic risk and lower capital requirements for such investment strategies.

The second problem for insurers is how to avoid procyclicality and short-termism during phases of significant market and capital volatility. Under Solvency II, an insurer’s own risk and solvency assessment (Orsa) incorporates a forward-looking consideration of various macroeconomic and market-stress scenarios, for example an analysis of “low for long” risks, effects of QE, interest rate normalisation, inflation expectations, currency fluctuations, sovereign debt risks and political risks. An effective Orsa will assist an insurer’s understanding of its overall solvency requirements and focus its strategic decision making to optimise insurance asset allocations by targeting strong risk-adjusted return opportunities. As such, the results will influence portfolio management decisions, liquidity and hedging strategies.

Solvency II’s long-term guarantee measures require careful application of judgment to avoid disproportionate risk aversion to investing in long-term assets. In addition, the application of investment “prudent person principles”, effective controls such as credit quality assessment processes and robust asset valuation frameworks will reduce the risk of mispricing of long-term investment risk, accumulation of unacceptable risks and significant volatility in solvency ratios.

The third and final issue is the requirement to develop appropriate long-term savings and retirement products that deliver suitable levels of insurance protection and/or investment returns for policyholders.

Solvency I was viewed as insufficiently risk sensitive and weaker in policyholder protection. Solvency II presents an opportunity for insurers and their asset managers to improve transparency and decision making, to optimise exposure to rewarded risks, enhance investment performance and achieve a higher return on capital. Post-implementation, the Solvency II “risk-based” framework will require continuing monitoring to avoid failure in detecting fundamental risks or use of inappropriate models, assumptions or risk calibration that could introduce biases leading to herding or pro-cyclical investment decisions.

Full article on Financial Times (subscription required)

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