Managing Insurance Assets Under Solvency II

Transcription

1 Managing Insurance Assets Under Solvency II Canadian Institute of Actuaries Investment Seminar Fred Weinberger, Managing Director, BlackRock 3 November, 2011 This presentation is for information purposes and not intended to be a solicitation or offer of securities. NOT FOR PUBLIC DISTRIBUTION

2 Agenda Overview of Solvency II Market risk the asset side Capital efficient investing Limitations of Standard Formula Strategic implications of Solvency II 1

3 What is Solvency II? European-wide solvency regulation upgrade for insurance companies Key aims: Policyholder protection through better risk management Better capital management Pillars 1 & 2 Better transparency for investors; common standard Pillar 3 New Risk & Capital Framework Pillar 1 Demonstrating adequate financial resources. Standard formula or internal/partial internal model Pillar 2 Demonstrating an adequate system of governance, including effective risk management system and prospective risk identification through the Own Risk and Solvency Assessment (ORSA) Pillar 3 Public disclosure and regulatory reporting requirements 2

4 Pillar 1 Solvency Capital Requirement (SCR) Both capital and the SCR are based on a fair-value view of the business Pillar 1 overview: Risk-based, bottom-up economic solvency measure, based on fair value Incorporates whole business view - various types of risk with allowance for diversification benefits Market value of assets Market consistent, best estimate liabilities. If no market price use risk margin approach based on 6% cost of capital Limited scope for regulatory discretion which levels the playing field harmonisation was key driver of Solvency II Solvency Capital Requirement (SCR) set at 99.5% confidence interval over rolling 1 year timeframe Indirect regulatory intervention on breach of SCR Direct regulatory intervention (loss of license) on breach of Minimum Capital Requirement (MCR) 25-45% of SCR 3

5 Example insurance asset and liability structure Assets Liabilities Free Surplus SCR MCR Assets at market value Risk margin Best estimate liability 4

6 Best estimate liability the discount rate / illiquidity premium What is the appropriate risk-free discount rate? Initially local government bond rates Insurers lobbied for swaps and got what they wanted, just as long swap rates traded through government So they lobbied again Three potential adjustments, all works-in-progress: Liquidity premium generic premium capture capture varies by liability type, always less than 50% of spread Matching premium an alternative to the liquidity premium which is specific to a separately managed portfolio of assets, backing fully illiquid liabilities Counter-cyclical premium combination of a permanent and a variable liquidity premium when EIOPA declares period of stress A significant concern is whether the liquidity premium will be formulaic or at discretion of regulators Nominal yield Liquidity premium Risk premium for losses Expected losses Risk-free rate 5

7 QIS5 Standard Model SCR inputs SCR Adj BSCR Op Market Health Default Life Non-life Intang Interest rate SLT Health CAT Non-SLT Health Mortality Premium Reserve Equity Property Spread Mortality Longevity Disability Morbidity Premium Reserve Lapse Longevity Disability Morbidity Lapse Lapse CAT Currency Concentration Illiquidity Lapse Expenses Revision Expenses Revision CAT = included in the adjustment for the lossabsorbing capacity of technical provisions under the modular approach Source: QIS5 Technical Specifications 6

8 QIS 5 results: Distribution of SCR coverage <75% 8.8% 75% - 100% 6.1% 15% less than 100% 100% - 120% 8.3% 120% - 150% 11.4% 150% - 200% 200% - 250% 12.2% 17.1% 29% around market average of 165% 250% - 300% 9.5% 300%- 350% 350%- 400% 5.3% 7.4% > 400% 13.9% Source: EIOPA Report on QIS 5, March

9 QIS 5 results: Distribution of MCR coverage <75% 75% - 100% 100% - 120% 2.0% 2.7% 4.2% 5% less than 100% 120% - 150% 6.9% 150% - 200% 200% - 250% 16.2% 15.9% 250% - 300% 300%- 350% 350%- 400% 7.0% 8.8% 10.7% > 400% 25.7% Source: EIOPA Report on QIS 5, March

10 Equivalence Equivalence is a key issue for all insurers, regardless of whether they are European domiciled or not REINSURANCE EQUIVALENCE If a country is equivalent for reinsurance then EU companies can count its policies as protection, without additional collateral NON-EU SUBSIDIARIES If an EU firm has an equivalent non-eu subsidiary, it can count that subsidiary on its local basis for the group calculation NON-EU GROUPS If a non-eu group is equivalent then: It can do the group solvency calculation on a local basis It can be the lead regulator But all local stand alone EU calculations must be done on a Solvency II basis 9

11 Agenda Overview of Solvency II Market risk Capital efficient investing Limitations of Standard Formula Strategic Implications of Solvency II 10

12 Standard model market risk SCR Adj BSCR Op Market Health Default Life Non-life Intang Interest rate SLT Health CAT Non-SLT Health Mortality Premium Reserve Equity Property Spread Mortality Longevity Disability Morbidity Premium Reserve Lapse Longevity Disability Morbidity Lapse Lapse CAT Currency Concentration Illiquidity Lapse Expenses Revision Expenses Revision CAT = included in the adjustment for the lossabsorbing capacity of technical provisions under the modular approach Source: QIS5 Technical Specifications 11

13 Market risk Market Risk Interest Rate Risk Sensitivity of net worth to changes in the term structure of interest rates ; apply the specified shocks to the underlying interest rate curves in the up and down stress scenarios Currency Risk Investments with cash flows in foreign currencies are sensitive to volatility of currency exchange rates. This module calculates the effect on value of security with a 25% shock in exchange rate 80% 60% 40% 20% 0% -20% -40% -60% -80% -100% 25% exchange rate shock Shock function of rating Up shock Down shock 8.00% Spread Risk 6.00% 4.00% For credit securities, a spread shock is applied to calculate the instantaneous decrease in the value of securities due to widening of credit spreads 2.00% 0.00% AAA AA A BBB BB B or lower NR 12

14 Market risk Market Risk Equity Risk Equity risk is split into 2 parts : 1. Global Equity (OECD or EEA) 2. Other Equity (e.g. EME,HF, PE,) Global Equity stress 39% Other Equity stress 49% There is a pro / counter cyclicality adjustment of up to +/- 10% Property Risk Primarily focused on physical property assets 25% decrease in value of investments Concentration Risk Covers concentration risk in equity, spread and property risk modules. Rating AA-AAA A BBB <BB Concentration threshold: 3% 3% 1.5% 1.5% 13

15 Asset correlation matrix market down example Corr Mkt Down Interest Equity Property Spread Currency Concentration Illiquidity premium Interest 1 ` Equity Property Spread Currency Concentration Illiquidity premium Source: CEIOPS QIS 5 Technical specifications 14

16 Agenda Overview of Solvency II Market Risk Capital efficient investing Limitations of Standard Formula Strategic Implications of Solvency II 15

17 Capital efficient investing Capital efficiency can be defined as achieving the highest return on the company s capital while satisfying the overall SCR budget and any other constraints In principle, the company s underwriting and asset allocation decisions, and the consequent allocation of the SCR budget to the different activities, can be jointly optimized to provide the highest return on company capital There may be limited latitude for adjusting the level of certain activities within a given budgeting cycle As a practical matter, whether the result of an overall optimization or otherwise, investment managers will likely be provided with a market risk budget for which they would seek to maximize the portfolio s return 16

18 Asset capital charges Solvency II explicitly identifies asset risks and requires capital to be held against them This is a departure from Solvency 1, where asset risks were not explicitly captured in the solvency capital requirement Asset Class Capital Charge Credit Rating Spread Widening Duration (years) Floor Cap Credit (3 year) 3.5% AAA AA 0.90% 1.10% Credit (5 year) 5.8% A 1.40% 1 23 Credit (7 year) 8.1% BBB BB 2.50% 4.50% Credit (10 year) 11.5% B or lower Unrated 7.50% 3.00% Property 25.0% Private Equity Equity Other 49.0% 39.0% 49.0% But NO solvency capital required for: - EEA-issued or EEA-guaranteed debt in local currency - Central banks, development banks and international organizations - AA or better non-eea governments/central banks 17

19 Capital efficiency : return on self-capital (RoSC)? Many analysts have defined capital efficiency by an asset s return on self-capital Return on self-capital is calculated as follows: Subject asset Liability = Risk-free asset RoSC = R F + Spread x Leverage Risk-free asset Capital Based on the earlier capital charges and reasonable yield and return assumptions, we have calculated the returns on self-capital for several asset classes as shown in the chart 20.7% 10.8% 9.9% 12.9% Equities Property Corporate Bond Portfolio (D=7) Corporate Bond Portfolio (D=3) A common conclusion is that short-dated corporate bonds are the most capital efficient asset 18

20 RoSC is usually not a decision factor As a consequence of these rankings, some observers have argued that the market prices will adjust due to higher demand for more capital efficient assets Most often high RoSC assets are those with low capital charges, as we have seen Thus, based on the efficiency argument, spreads of longer-dated to shorter-dated corporates should widen While there may indeed be greater demand for shorter-dated corporates for insurers that are capital constrained, the motivation would be the lower absolute capital charge, and not the higher RoSC On the other hand, for companies with sufficient capital, the issue is not the ranking by return on selfcapital, but rather the relevant metric would be return on market risk budget 19

21 Capital efficiency is contextual In fact, capital efficiency does not usually adhere to individual asset classes, and ranking by RoSC should not drive behavior Rather the best asset mix should fill two budgets simultaneously, the market risk budget and full investment; this is usually not achieved with individual assets Thus the capital efficient portfolio is tuned to the market risk budget, which in the larger scheme is an expression of risk preferences and, ideally, results from a joint optimization with the underwriting side The chart below illustrates the returns on market risk budget for individual assets and for portfolio combinations tuned the market risk budget Return on market risk budget Short Corporate 20% Portfolio of both Equities 10.8% Portfolio fully invested before filling market risk budget Market risk budget filled before portfolio fully invested 0% 3.5% Market risk budget as a % of liabilities 39% 20

22 RoSCs are not a valid basis of comparison Taking the argument another step, comparisons based on RoSCs are not even theoretically valid RoSCs are in fact a comparison of apples and oranges, because they compare assets with different levels of market risk and hence different market risk capital charges This can be seen by analogy to the Markowitz efficiency analysis Efficiency comparisons are not made between assets at different risk levels on the efficient frontier, they are all efficient, and investors with different risk appetites will choose differently One caveat: analogously to the capital market line, if leverage is permitted, then RoSC is a useful ranking tool and the highest RoSC asset will be the most efficient individual asset for all investors Markowitz Efficient Frontier Capital Market Line Equities Return Risk Free Rate Short Corporate Slope = Sharpe Ratio Analogous to RoSC Risk 21

23 An alternate approach to capital efficiency: risk-adjusted return Other analysts rank the efficiency of assets by risk-adjusted returns Risk adjusted return is calculated as : RAR = Return/Yield of asset (less expected losses) (cost of capital x capital charge) Assuming a cost of capital of 6%, for the same return assumptions as earlier, the RARs for the assets are as below: 3.3% 1.9% 1.2% 0.9% Equities Property Corporate Bond Portfolio (D=7) Corporate Bond Portfolio (D=3) The asset rankings with RAR are almost the reverse of RoSC This might prove to be a dilemma, but because both approaches are apples and oranges comparisons, neither is a useful decision metric 22

24 Agenda Overview of Solvency II Pillar 1 Market Risk Capital efficient investing Limitations of Standard Formula Strategic Implications of Solvency II 23

25 The significance of market risk Non-life BSCR Life BSCR Composite BSCR Market 33% Life 24% Non-life 17% Non-life 52% Life 1% Health 7% Counterparty 7% Health 1% Counterparty 8% Market 67% Life 15% Health 4% Counterparty 7% Market 57% Source EIOPA QIS 5 Final Report Source EIOPA QIS 5 Final Report Source EIOPA QIS 5 Final Report The challenge of managing market risk Markets cannot be assumed to always be efficient Models are an abstraction of a much more complex reality Physics envy - do not confuse the expected behavior of a model with the realities of the market Reliance on regulation and modelling to manage market risk falls short 24

26 The crisis and fixed income why static models fail Duration-adjusted excess returns by sector (in basis points) YTD 2011 Barclays Agg Agency MBS ABS CMBS N/A Credit High Yield** Emerging Markets*** Source Barclays Capital Best Period Worst Period Second Worst Period Fixed Income Monthly Return Moments 8/31/1999-9/31/2009 (in%) Moment US AGG TSY AGY CORP MBS ABS CMBS Mean St Dev Kurtosis Pre-Lehman Kurtosis Full Sample Source Risk Management Lessons Worth Remembering form the Credit Crisis of , Bennett Golub and Conan Crum 25

27 Correlation Comparison January Days After Lehman May 2011 S & P V I X I m p l i e d V o l D A X 3 0 F T S E N I K K E I T a iw a n T W S E T s y 2 Y T s y 1 0 Y E M B IG D E M 2 Y D E M 1 0 Y G S C I D J - U B S C o m m o d it y T R H F R X G l o b a l H F M a c q u G l o b I n f r a s ( U S D ) D J G lo b S e le c t R e a l E s t D J G lo b P r iv E q t y ( U S D ) S P L e v e r a g e L o a n I d x D J C D X. N A. I G. 5 L D J C D X. N A. H Y. 5 L IT R A X X. E U. 5 L IT R A X X. X O. 5 L S&P VIX Implied Vol DAX FTSE NIKKEI Taiwan TWSE Tsy 2Y Tsy 10Y EMBIG DEM 2Y DEM 10Y GSCI DJ-UBS Commodity TR HFRX Global HF Macqu Glob Infras (USD) DJ Glob Select Real Est DJ Glob Priv Eqty (USD) SP Leverage Loan Idx DJ CDX.NA.IG.5L DJ CDX.NA.HY.5L ITRAXX.EU.5L ITRAXX.XO.5L S & P V IX Im p lie d V o l D A X 3 0 F T S E N IK K E I T a iw a n T W S E T sy 2 Y T sy 1 0 Y E M B IG D E M 2 Y D E M 1 0 Y G S C I D J -U B S C o m m o d ity T R H F R X G lo b a l H F M a c q u G lo b In fra s (U S D ) D J G lo b Se le c t R e a l E s t D J G lo b P riv E q ty (U S D ) S P L e v e ra g e L o a n Id x D J C D X.N A.IG.5 L D J C D X.N A.H Y.5 L IT R A X X.E U.5 L IT R A X X.X O.5 L S & P V I X I m p l i e d V o l D A X 3 0 F T S E N I K K E I T a i w a n T W S E T s y 2 Y T s y 1 0 Y E M B I G D E M 2 Y D E M 1 0 Y G S C I D J - U B S C o m m o d i t y T R H F R X G l o b a l H F M a c q u G l o b I n f r a s ( U S D ) D J G l o b S e l e c t R e a l E s t D J G l o b P r i v E q t y ( U S D ) S P L e v e r a g e L o a n I d x D J C D X. N A. I G. 5 D J C D X. N A. H Y. 5 I T R A X X. E U. 5 I T R A X X. X O Computed based on exponentially weighted (WKS) BRS values 26

28 Even government risk is different Stating the obvious, all EEA government bonds have zero risk charges, but not the same risk Portfolio benchmarks The basis of the discount rate applied to liabilities is the swaps curve. Insurers will need to decide how they manage their assets. Many insurers do not currently allow swaps in their portfolios. Finding an asset benchmark which follows the swaps benchmark is tricky, and there is no comfort that an asset benchmark would move in the same direction as a swaps based benchmark over time. Italian government yields versus swaps - significant yield pick-up potential in government bonds Less advantage in holding government bonds in Germany compared to a liability swap benchmark 27

29 Responding to shortcomings of the Standard Formula internal models The standard formula is one size fits all is static, unlike the world in which we operate promotes investment in government debt penalizes riskier assets relatively heavily interest rate risk also heavily penalized In essence, by virtue of being standard the Standard Formula does not sit comfortably with many insurers view of the risks Insurers will build internal models to address these issues and to gain more control over their solvency management Internal models must be approved by the regulator and must pass the Use Test Use Test requires model to be embedded in the business (governance, risk management, decision-making, capital assessment) This will result in consistent business and solvency frameworks ORSA allows for the business to be managed using different timeframes, confidence levels and metrics (e.g. tail VAR) but the ORSA must either be demonstrably equivalent to, or tougher than, the 1 year solvency test. Otherwise, the 1 year statistic will need to be calculated and solvency specifically demonstrated against it 28

30 Agenda Overview of Solvency II Pillar 1 Market Risk Capital efficient investing Limitations of Standard Formula Strategic implications of Solvency II 29

31 Strategic implications of Solvency II Impact on insurance business models Products and liabilities A shift away from traditional participating life Increase in unit-linked and variable annuity-type products Search for a new traditional product Non-life capital requirements especially harsh under QIS5 ALM and risk management Hedging (in particular interest rate risk) to remove unrewarded risk More dynamic ALM management greater use of derivatives to manage downside risk and duration More reinsurance, both internal and external Need to invest in technical and human resources Assets Shortening of physical investment portfolio (duration obtained via derivatives) Short-dated corporate bonds the assets class of choice Less incentive to own equities under QIS5 Insurers likely to consider exit from illiquid investments such as private equity ahead of Solvency II Source: Morgan Stanley Research / Oliver Wyman 30

32 Swiss Life new business mix moving towards capital efficient products By consistently focusing on pension products with variable guarantees and on risk products^, the group has improved margins and reduced its capital requirements in new business. New business product mix (excluding PPLI*) 53% 52% 40% 21% 16% 14% 31% 34% 39% Traditional / guaranteed business Modern / Unit-linked Risk products^ * PPLI: Private Placement Life Insurance ^ Risk products refer to pure insurance risk (i.e. mortality / morbidity / longevity) products Source: Deutsche Bank, company statements 31

33 How much has it cost? Total budget for Solvency II (including technology spend), approved or otherwise. Source: Deloitte Solvency II Survey 2011 Insurers responses to evolving roles (60 UK insurers) 32

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