How is Solvency II impacting the choices of the reinsurance company asset managers?
These are challenging times for the asset managers of reinsurance companies. Low interest rates, growing geopolitical fragmentation, inflationary pressures and continued uncertainty around central bank and governmental policy are all affecting investments and influencing the allocation of portfolios.
Adding to all these factors has been the introduction of Solvency II, which has inserted regulatory and capital challenges to these other factors.
“Solvency II has had an impact, how much of an impact depends on several factors, including which jurisdiction in Europe the reinsurer operates in. In the UK the capital regime for reinsurers has seen some change, but it hasn’t been as a dramatic as many other countries where there has been a more fundamental change from the previous regimes to Solvency II,” says Andrew Epsom, a principal in the insurance investment team at Mercer.
Many reinsurers hold the bulk of their investments in fixed-income assets. And the need to maintain external credit ratings has driven an investment strategy that prizes a high ratio of liquidity in the portfolio.
Drive for liquidity
Shazia Azim, Partner at PwC, says: “Because of the way the insurance world works what the reinsurers have focussed on over the last few years has been pots of capital. A certain pot will be very liquid, because that is what they need to have in order to meet obligations or settle claims.
“The rest of the portfolio has been largely driven by whether they want a long-tail book or a short-tail book. Reinsurers have always had a pot that they’ve kept for pure return. They’ve then had various strategies, hedge fund strategies, alternative asset strategies, equity strategies in order to obtain that greater return.”
Under the standard formula of Solvency II’s Pillar 1, which determines how much capital reinsurers need to hold for a particular asset class with some asset classes that looked upon more favourably than others.
Azim says: “If the return charges are too high against the capital under Solvency II then you just don’t do them. A lot of the opaque strategies like hedge funds and private equity funds are really difficult to do under Solvency II. They’re very expensive, particularly if you don’t have an internal model.”
Epsom adds: “Hedge funds, mortgage-backed securities (MBS) and asset-backed securities (ABS) are asset classes that under Solvency II can look unattractive relative to what you may think the economic rationale might be for investing in that particular asset class.”
He continues: “We have seen moves from some reinsurers out of ABS and MBS because the capital they need to hold makes them look unattractive. For hedge funds it all depends if you can get the look-through to the underlying securities. With most hedge funds you can’t get the look-through to the underlying assets and if you can’t then under Solvency II this incurs a significant capital charge. You will then need to hold around 50% of the value of the hedge fund as additional capital, which means it look less attractive to hold.”
The balancing act
There is also more onus on reinsurers to match assets to liabilities under Solvency II. The regulatory regime requires asset-liability matching and will highlight areas of mismatch caused by currency exposures or the maturity of assets.
Epsom says: “There is now a greater focus on risk management and reinsurers being able to demonstrate that they can manage investment risks appropriately. That means that if they are now invested in more complicated asset classes, which many reinsurers have moved into as a reaction the low-yield environment, certain aspects of Solvency II have acted as an impediment to this.
He adds: “There is a higher hurdle now for reinsurance companies to show that they can recognise the risks in their investment strategy and appropriately monitor and manage these risks – set out under the Prudent Person Principle. There is often quite a challenge for reinsurers to demonstrate to regulators that they can comply with the Prudent Person Principle for the more complicated asset classes.”
The introduction of Solvency II has prompted reinsurers and insurers to invest heavily so they can meet the reporting requirements of the regime. It has also caused carriers to use more third party asset managers in addition to in-house teams.
However, asset managers must also focus on a range of other issues including low-interest rates, economic and political uncertainty and depressed yields along with increasing inflationary pressures.
This means prioritising key areas around their investment portfolios. Investment operating models must be reviewed and optimised to help reinsurers deliver superior net returns. Reinsurers must protect the downside by considering risk holistically across assets and liabilities and appropriately manage these risks.
They should also consider adopting more efficient implementation can provide a notable added value and consider alternative risk quantification measures that complement traditional risk measures.
“Low interest rates and bond yields have been the main drivers that have caused reinsurers to revise their investment strategies,” concludes Epsom.