Impacts of IFRS and Solvency II Constraints on Institutional Asset Management

Transcription

1 EDHEC Institutional Days Paris, November 22nd 2006, Impacts of IFRS and Solvency II Constraints on Institutional Asset Management Philippe Foulquier EDHEC Financial Analysis and Accounting Research Centre EDHEC Institutional Days & ETF Summit

2 Outline Introduction I. ALM with bond portfolio and IFRS II. ALM with derivatives and IFRS III. ALM with bonds and derivatives under IFRS IV. Management of the performance under IFRS V. ALM and Solvency II VI. Conclusion 2

3 Introduction The increasing amount and heightened complexity of risks have caused a necessary adaptation of regulations: - Accounting standards (IFRS) and - Prudential rules (Solvency II) Target: a better perception of all companies, notably with regard to the risks being run On the verge of a major evolution with huge impacts on asset management and ALM 3

4 Introduction First step: IFRS phase I (2005) - Compulsory only for groups that invite savings from general public - Fair Value for most assets but Cost for liabilities => Unsettling mismatches and new accounting volatility in P&L and B/S => New constraints in AM and ALM Second step: IFRS phase II (around 2008) - Extension to liabilities risks - Integration of options and guarantees (LAT IFRS phase I and EEV) - and adaptation of assets accounting (from IFRS phase I) 4

5 Introduction Third step: Solvency II (around 2010) - Concerns all European insurance companies - Target: reinforces the requirements for evaluating and managing risks - Larger field of application: Financial market, ALM, credit, underwriting, and operational risks Risk modelling & valuation (distribution, correlation, extreme risks) Risk management (derivatives, reinsurance, diversification) => Increasing financialisation and sophistication of AM and ALM => Optimisation of economic capital management 5

6 Introduction The objective of our presentation: - Demonstrate that the cumbersome systems implemented by IFRS Temporary creation of new asset categories Hedge accounting Shadow accounting Fair Value Option (FVO) - to handle accounting mismatches (incommensurable with real exposure) - and QIS 2 (about the standard formula framework in Solvency II) => Inefficient but also in contradiction with initial targets of IFRS and Solvency II => Penalise the adoption of modern AM and ALM techniques to reduce exposure to risks 6

7 Reminder: LDI solutions Lionel Martellini The theory and (best) practices of LDI (previous session) - The hedging of a liability can generally be done using 3 strategies: By constituting a bond portfolio By using derivatives By a combination of these two approaches - Thanks to different supports: long-term bonds, derivatives, mutual funds, structured products or a combination of these supports - Dual objectives: Management of liability risk exposure Effective management of asset performance 7

8 Aims of the presentation Regarding the techniques for dynamic asset management in presence of liabilities: - What are the impacts of IFRS and Solvency II for the financial risk management of institutional investors? - How can you deal with the volatility generated by the accounting mismatches in the P&L and/or in the B/S? - Are there any solutions to manage hedge and macro hedge issues? - Is shadow accounting an efficient compromise for ALM view? - Is the HTM category a smokescreen? 8

9 Outline Introduction I. ALM with bond portfolio and IFRS II. ALM with derivatives and IFRS III. ALM with bonds and derivatives under IFRS IV. Management of the performance under IFRS V. ALM and Solvency II VI. Conclusion 9

10 I. ALM with bond portfolio and IFRS Cash flow matching and immunisation thanks to bond portfolio - Financial challenges: Appropriate maturity (liability risks) Management of the hidden options Insufficient financial profitability 10

11 I. ALM with bond portfolio and IFRS Cash flow matching and immunisation thanks to bond portfolios - Accounting and Solvency challenges: Management of HTM AFS HTT categories Volatility of shareholders equity and/or income statement Management of the shareholders equity regarding Solvency II 11

12 I. ALM with bond portfolio and IFRS Asset classification and insurance company strategy - Protection of policyholders return in competitive insurance market - Liquidity & financial market volatility management ALM constraints A large share of bonds are generally held until maturity BUT IFRS approach is to value assets at fair value at each reporting date, with change in the P&L (HTT) or B/S (AFS) WITHOUT any offset from liabilities side (valued at cost) => Accounting mismatches = artificial volatility (pure accounting) HENCE IFRS create HTM Held to maturity category (for transition phase only ) 12

13 I. ALM with bond portfolio and IFRS Asset classification and insurance company strategy - HTM category: to reduce accounting mismatch and volatility because assets are reported at fair value while liabilities remain at cost - BUT accounting consequences if a HTM bond is sold are so harsh that they dissuaded most insurance companies from using this category => Dynamic management of interest rate and active management of credit risk are impossible with HTM - Insurance companies choose mainly AFS => Artificial volatility (pure accounting) on shareholders equity actual risk being run by company => Strong pressure on Solvency ratio <=> IFRS reduce the financial management of liability risk hedging over several years or decades to a scenario whereby assets are immediately liquidated 13

14 Outline Introduction I. ALM with bond portfolio and IFRS II. ALM with derivatives and IFRS III. ALM with bonds and derivatives under IFRS IV. Management of the performance under IFRS V. ALM and Solvency II VI. Conclusion 14

15 II. ALM with derivatives and IFRS Classification of derivatives and insurance company strategy - Derivative instruments allow: Implementation of better cash flow matching Management of non-linear risks (hidden options) - BUT derivatives under IFRS generate strong volatility in the P&L Consolidation of derivatives in the B/S (before IFRS = off-b/s) With change in value through the profit or loss statement Although hedged item (change in value of liability) remains at cost <=> Accounting mismatches => strong volatility in the P&L 15

16 II. ALM with derivatives and IFRS Classification of derivatives and insurance company strategy - Example of the use of swap transaction in the design of liabilityhedging portfolios An insurance company entered a swap Will pay a single zero-coupon payment based on: - a breakeven rate assumed to be 2.9% - in an attempt to protect future liability cash flow (EUR55.76m in real terms to be paid in 20 years) against interest and inflation risks. Interest rate in 2006: 4.51% Assumptions in 2026: - inflation rate decreases from 2.9% to 2% in and interest rate increases from 4.51% to 5% in

17 II. ALM with derivatives and IFRS Classification of derivatives and insurance company strategy - Example of the use of swap transactions in the design of liability-hedging portfolios Financial impact: Change in asset value (ZC + swap) = change in liability value => perfect asset-liability matching Accounting impact: Change in swap value through the P&L: EUR- 6m Change in ZC value through equity: EUR-3.7m Change in liabilities (at cost): EUR0m Accounting impact on shareholders' equity With hedging: -23.8% Without hedging: -9% in a more favourable rate environment (lower present value of liabilities)! The arbitrage between efficient long-term hedging and the volatility of the P&L on a quarterly basis therefore appears to be a tricky challenge 17

18 II. ALM with derivatives and IFRS Classification of derivatives and insurance company strategy - Regarding this artificial volatility, IASB suggested: Hedge accounting option Shadow accounting option But does not allow macro hedge (unlike banks) 18

19 II. ALM with derivatives and IFRS Classification of derivatives and insurance company strategy - Example of the use of swap transactions in the design of liability-hedging portfolios when we assume the hedge will be fully effective Financial impact: Change in asset value (ZC + swap) = change in liability value => perfect asset-liability matching Accounting impact: No impact on the P&L Change in swap value through equity: EUR- 6m Change in ZC value through equity: EUR-3.7m Change in liabilities (at cost): EUR0m Accounting impact on shareholders' equity: With hedging: -23.8% Without hedging: -9% It is at odds with the initial goal of IFRS to promote efficient risk management 19

20 II. ALM with derivatives and IFRS Classification of derivatives and insurance company strategy - Shadow accounting option The Board was not able to introduce a current market-based discount rate for insurance liabilities in phase I Shadow accounting allows accounting mismatches to be reduced because a company can recognise unrealised gains or losses on an asset that affect the measurements of insurance liabilities in the same way as realised gains or losses do. BUT it is only for life policies with a discretionary participation feature and only for the policyholder s share Recently, from the releases during the last semester, we have seen that it was not sufficient to avoid high unrealistic volatility in the P&L and the financial market can react badly towards the stock price following a general downgrade of Full Year EPS. 20

21 II. ALM with derivatives and IFRS Classification of derivatives and insurance company strategy - Macro hedge versus shadow accounting Hedge accounting for hedges of net open positions is not allowed (e.g. the net of all fixed-rate assets and fixed-rate liabilities with similar maturities) because it is not possible to associate hedging gains and losses with a specific item being hedged However, it is possible to work around this by designating a share of the underlying items as the hedged item The macro hedging approach of banks (economic interest rate risk management is done on a net basis) has not been expanded to the asset and liability management of insurance companies because the Board allows shadow accounting BUT in Phase II, shadow accounting could disappear and the negotiations on the macro hedge are continuing 21

22 Outline Introduction I. ALM with bond portfolio and IFRS II. ALM with derivatives and IFRS III. ALM with bonds and derivatives under IFRS IV. Management of the performance under IFRS V. ALM and Solvency II VI. Conclusion 22

23 III. ALM with bonds and derivatives under IFRS Derivatives & bond classification and insurance co. strategy - Bond portfolio complemented by derivative instruments In order to manage the duration of the bond portfolio Companies maintain their mixed (bonds-derivative) strategy at the cost of major efforts in communication because this solution combines the two accounting mismatches mentioned for each of the last two strategies But we have seen that the financial community is not always inclined to delve into the depths of derivatives accounting and penalises the stock price when the explanation is too complex or too opaque 23

24 Outline Introduction I. ALM with bond portfolio and IFRS II. ALM with derivatives and IFRS III. ALM with bonds and derivatives IFRS IV. Management of the performance under IFRS V. ALM and Solvency II VI. Conclusion 24

25 IV. Management of the performance under IFRS Separation theorem and insurance strategies - Dual objectives: Management of liability risk exposure (sections I, II, III) Effectively managing asset performance (sections IV) - Lionel Martellini The Theory and (Best) Practices of Liability-Driven Investment (previous session) Use of the core satellite approach to manage performance Optimising management and defining the asset risks is tackled in the core portfolio Two ways: - Risk diversification techniques to determine optimal asset allocations decisions or, - Insurance portfolio techniques (derivatives or dynamic asset allocation strategy generating convex payoffs) 25

26 IV. Management of the performance under IFRS First strategy: Risk diversification techniques - Risk management thanks to an optimal allocation decision Example: a certain % of stocks and bonds defined as the optimal reference Requires frequent transactions in order to match the reference portfolio - Financial analysis Superiority of this rebalancing strategy when we compare to a buyand-hold strategy in terms of its ability to reduce volatility and/or (C)VaR (extreme risks) of the portfolio performance 26

27 IV. Management of the performance under IFRS First strategy: Risk diversification techniques - Accounting analysis Before IFRS, implemented by mutual funds (not being consolidated => no volatility on the P&L) With IFRS, major mutual fund holdings are consolidated and changes in value generate: - Higher volatility on the income statement (HTT) or the B/S (AFS) - Minority mutual fund holding changes are recognised in the P&L Effective strategy in financial terms is penalised by accounting volatility This is at odds with the initial goal of IFRS to promote efficient risk management 27

28 IV. Management of the performance under IFRS First strategy: Risk diversification techniques - Example thanks to a simulation Comparison between 2 strategies (from Jan to Dec. 2005): - Buy-and-hold strategy with a direct investment in the global DJ Eurostoxx index and - Strategy designed to determine the optimal allocation of the different sector indices that make up the DJ Eurostoxx in order to minimise the portfolio s extreme risk (C)VaR with no constraint on profitability Financial analysis from Jan 1993 through Dec 2005 Average Return Maximum Drawdown Volatility Weekly 5% VaR Weekly 5% CVaR DJ EURO STOXX PF MinCVaR 11.62% 13.82% 62.99% 48.33% 19.13% 16.76% 4.36% 3.81% 7.10% 6.39% 28

29 IV. Management of the performance under IFRS First strategy: Risk diversification techniques - Example thanks to a simulation Accounting analysis Comparison of the impact on the profit or loss statement according to the two strategies From Jan 1993 Average Maximum Volatility Weekly 5% Weekly 5% through Dec 2005 Return Drawdown VaR CVaR DJ Euro Stoxx (Buy and Hold Strategy) 11.62% (*) 0% 0% 0% 0% AFS category PF MinCVaR Optimal Allocation Strategy 13.82% 48.33% 16.76% 3.81% 6.39% Fair Value Through Profit or Loss category (*) if we assume that at the end of the period, the equity portfolio is sold. 29

30 IV. Management of the performance under IFRS First strategy: Risk diversification techniques - Example thanks to a simulation Accounting analysis 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% change in % of the fair value per quarter recognised in profit or loss statement Buy and hold strategy Optimal Allocation Strategy 30

31 IV. Management of the performance under IFRS First strategy: Risk diversification techniques - Example thanks to a simulation Accounting analysis Comparison of the impact on shareholders equity according to the two strategies From Jan 1993 Average Maximum Volatility Weekly 5% Weekly 5% through Dec 2005 Return Drawdown VaR CVaR DJ Euro Stoxx (Buy and Hold Strategy) 11.62% (*) 62.99% 19.13% 4.86% 7.10% AFS category PF MinCVaR Optimal Allocation Strategy 13.82% 48.33% 16.76% 3.81% 6.39% Fair Value Through Profit or Loss category (*) if we assume that at the end of the period, the equity portfolio is sold. 31

32 IV. Management of the performance under IFRS First strategy: Risk diversification techniques - Example thanks to a simulation Accounting analysis 40% 30% change in % of the fair value per quarter recognised in shareholders' equity Buy and hold strategy 20% 10% 0% -10% % -30% Optimal Allocation Strategy 32

33 IV. Management of the performance under IFRS Second strategy: Portfolio insurance techniques - Consider optimal hedging With view to generating non-linear return As a protection against the risk of losses or underperformance - Thanks to: Derivatives Structured products (hybrid instrument: underlying and derivatives) Dynamic asset allocation strategy - Effective strategy in financial terms is penalised by accounting volatility This is at odds with the initial goal of IFRS to promote efficient risk management 33

34 Outline Introduction I. ALM with bond portfolio and IFRS II. ALM with derivatives and IFRS III. ALM with bonds and derivatives IFRS IV. Management of the performance under IFRS V. ALM and Solvency II VI. Conclusion 34

35 V. ALM and Solvency II Solvency II is a significant step forward in terms of risk management - The European Union has undertaken an ambitious project named Solvency II - in the decade to completely overhaul the current prudential rules - With Solvency II, the EU wishes to establish solvency requirements that are better adapted to the risks that are actually taken on by the insurance firms and encourage the latter to better evaluate and control their risks. - An important stage: publication of QIS 2 by the CEIOPS about standard formula - Granularity of the standard formula meets the targets set by Solvency II: balance between sensitivity to risk factors and complexity 35

36 V. ALM and Solvency II BUT choices on concepts and calibration are hazardous and could be inconsistent with the target of healthy management - Solvency II suggests measuring risk using a VaR of 99.5% - But the calibration of risk model factors in QIS 2 is so demanding that it appears hazardous - and dangerous because it would lead to strong incentives for mismanagement of risks or opportunistic arbitrage rather than efficient ALM and asset management. - Examples: equity volatility, relative equity volatility in comparison with bond volatility, the explicit absence of consideration for dynamic allocation strategies This is at odds with the initial goal of Solvency II to promote efficient risk management 36

37 Outline Introduction I. ALM with bond portfolio and IFRS II. ALM with derivatives and IFRS III. ALM with bonds and derivatives IFRS IV. Management of the performance under IFRS V. ALM and Solvency II VI. Conclusion 37

38 VI. Conclusion IFRS and Solvency II targets are very healthy - Provide a better perception of all companies, notably with regard to the risks being run - The idea to employ a fair value for assets and liabilities by including all of their risk factors is naturally a significant step forward for financial managers. however the IFRS transitional solutions are unsatisfactory - Accounts are more complex, arbitrary and unclear - Increases accounting volatility which heavily penalises relevant ALM, risk and asset management practices - At odds with the initial goal of IFRS to promote efficient risk management 38

39 VI. Conclusion The new financial approach to accounting must not replace financial analysis - Financial soundness must remain independent from the chosen accounting approach - Analysis of ALM, asset allocation and risk management policy must play the central role in the evaluation of a company s risks and - not the mathematical result that is reached by comparing and contrasting accounting figures, even if they are termed fair value EDHEC regrets the approach chosen by the CEIOP in QIS 2 (1) - Not only does it not correspond to the state of the art in global and optimal management of risk and insurance capital - But, at the current stage, it could lead to strong incentives for mismanagement of risks or opportunistic arbitrage rather than efficient ALM and asset management. (1) See Noël Amenc, Philippe Foulquier, Lionel Martellini and Samuel Sender, The Impact of IFRS and Solvency II on Asset Liability Management and Asset Management in Insurance Companies, EDHEC Publications, November and Philippe Foulquier and Samuel Sender, QIS2: Modelling that is at odds with the prudential objectives of Solvency II, November 2006, EDHEC Position Paper.