White Paper June 2016

White Paper June 2016 Liquidity funds under Solvency II Authored by: Andries Hoekema, Global Head of Insurance Segment Farah Bouzida, Financial Engineer For professional clients only

Liquidity funds under Solvency II Constraints and risks In practice SCR attribution Comparing liquidity funds to cash deposits Authors Page 3 Page 6 Page 7 Page 8 Page 10 Introduction Liquidity funds have been receiving increased attention from insurance companies as some banks in developed markets reduce their appetite for shortdated funding from Non-Bank Financial Institutions ( NBFIs ). In many cases, banks now only offer significantly lower deposit rates to institutional investors or even refuse to take deposits from NBFIs. In contrast, Liquidity funds offer daily liquidity and often considerably better yields by investing in a combination of short-dated assets, government bonds and cash. We will first describe the look-through approach, then highlight how the main market risk sub-modules and default risk determine regulatory capital for a liquidity fund under Solvency II. Finally, we will provide a quantitative comparison between a liquidity fund and cash deposits with banks, demonstrating that a liquidity fund should be markedly less capitalintensive than bank deposits unless an insurer pursues a highly optimised deposit strategy, which will produce significant operational challenges and may negatively affect the achievable deposit yields. European insurance companies will want to understand the impact of Solvency II on their existing investment in liquidity funds, and those considering making a switch to liquidity funds will want to understand the implications of such a move under the regulation. In this paper we show that a welldiversified liquidity fund can offer a significantly lower Solvency II capital requirement compared to cash deposits placed with banks. This is driven by the use of the look-through approach in Solvency II and the fact that the regulatory capital cost of very shortdated assets under the Market Risk module (which applies to the large majority of assets in a typical liquidity fund) is significantly smaller than the capital cost of cash deposits under the Counterparty Default Risk Module. 2

Liquidity funds under Solvency II Constraints and risks Look-through approach Where possible, Solvency II uses the look-through approach: this means regulatory capital is based on the actual holdings inside a fund. Where this information is not available, the target asset allocation of the fund may be used as a proxy, as long as this target allocation is defined at a sufficiently granular level in the fund documentation to allow Solvency Capital Requirement (SCR) numbers to be calculated, and as long as the manager strictly adheres to the asset allocation. No more than 20% of the assets of an insurer may be subject to SCR calculations using the target allocation method. For liquidity funds, the portfolio composition is typically available to investors in full detail and in a timely manner, so insurance investors will be able to use the look-through approach. For the purposes of this paper, we will assume full look-through. The use of the look-through approach does mean that regulatory capital for liquidity funds will fluctuate as the portfolio composition changes. However, the tight investment criteria to which these funds are typically subject should keep such fluctuations within reasonable boundaries. Exhibit 1: Solvency II risk components relevant to liquidity funds Regulatory adjustment SCR BSCR* SCR operational Market SCR Default SCR Intangible SCR Life SCR Interest rate Equity Property Spread Currency Concentration Mortality Longevity Disability Lapse Expense Revision Catastrophe *Basic Solvency Capital Requirement Source: HSBC Global Asset Management, May 2016 The components of risk under Solvency II that are relevant for liquidity funds are: Interest Rate Risk Currency Risk Spread Risk Concentration Risk Counterparty Default Risk Which of these risk components are relevant in practice will depend on the composition of the portfolio of the fund. For example, most of the typical asset groups within a money market fund are subject to currency risk, spread risk, interest rate risk and concentration risk, but some of them are also subject to the counterparty default risk module. We discuss the drivers of SCR in more detail below based on the Solvency II Standard Model. For insurers with an internal model approved by their regulator, the calculations may differ in certain respects. Interest Rate Risk Interest rate risk is calculated by applying a percentage shock to the rates of the Solvency II basic discount curve and revaluing all interest-rate sensitive assets and liabilities using the new curve. Two new curves are created: one using an upward shock and one using a downward shock. The percentage shock can be as high as 75% of the current interest rate for very short-term rates and reduces to 20% for very long-term rates. If rates are negative, the downward shock is set at zero. For the upward shock scenario, the minimum shock level is set at one percentage point. The SCR for interest rate risk is the largest of the scenario losses from the upward shock and from the downward shock. Given that the SCR for interest rate risk is calculated across all interest-rate sensitive assets and liabilities, the correct SCR to be attributed to liquidity funds would be the incremental amount of SCR that results from owning these funds. This will depend on the composition of the insurer s book of business and the asset mix. For life insurers, the downward shock tends to be the most relevant as the interest-rate sensitivity of the liabilities outweighs that of the assets. For pure non-life insurers, the interest-rate sensitivity on the asset side can be the most important. 3

In the case of a life insurer, the incremental SCRinterest rate for holding liquidity funds is likely to be zero in the current market as the downward shock is dominant and currently set to zero for shorter maturities because of negative rates 1. For a non-life insurer with more interest-rate sensitivity on the asset side of the balance sheet, the incremental SCRinterest rate could be approximated as: Incremental SCR interest rate 1% 60 365 0.165% With the following assumptions: the invested cash was previously not subject to any SCR for interest rate risk the weighted average maturity of the liquidity fund s assets is 60 days (including any cash balances) the short-term rate shock is at its minimum of 1% Currency Risk Most large providers of liquidity funds including us provide funds in EUR and GBP (as well as other main currencies). These funds invest in assets denominated in their respective currency. In the context of liquidity funds, SCR for currency risk will only play a role for insurers subject to Solvency II regulations and whose home currency is not EUR or GBP. Only the spread risk positions are subject to the Spread Risk SCR, and they are typically subject to a minimum short-term rating of A-1 (S&P), P-1 (Moody s) or F1 (Fitch). This equates these positions to Credit Quality Step 1 (CQS1) or CQS2 under Solvency II. The Spread Risk SCR of a CQS1 position with a duration of less than 5 years is 1.1% times duration; for CQS2, it is 1.4% times duration. Concentration Risk SCRconcentration is applied if exposure to a single corporate group exceeds a given threshold. For single-name exposure to names of CQS2 or higher credit quality, the threshold is 3% of the asset base. Exposures to EU sovereigns, the ECB, supranational organisations and multilateral development banks are given a concentration risk factor of zero: these exposures form a part of the asset base over which any excess exposure is calculated, but they do not incur any concentration risk charge even if the exposure exceeds 3% of the asset base. Given that liquidity funds typically hold a very diverse set of exposures, and that the liquidity funds themselves will only be a part of a wider insurance investment portfolio that is itself further diversified, it should be expected that a position in liquidity funds does not give rise to SCRconcentration. Spread Risk SCRspread is a capital requirement for sensitivity to credit spread movements. It is calculated as a risk factor that is a function of the credit quality and the duration of each position. The duration is set at a minimum of 1 2, which means that for most positions in a money market fund the spread risk will be overestimated. Liquidity funds are typically allowed to hold a limited amount of paper with a duration over 1 year, which will be assessed at their actual duration. For example, our Euro liquidity fund 3 held one position with a maturity of 385 days, for 0.2% of the overall portfolio. Credit quality is the other main driver of the Spread Risk SCR. A typical liquidity fund holds three groups of positions: Spread Risk positions: commercial paper (CP), certificates of deposit (CD), corporate bonds Sovereign positions: government bonds Cash deposits Whilst SCRconcentration is unlikely to be a driver for liquidity funds, it can be a very real issue for insurers that use a small number of relationship banks to place their cash. For example, according to data from the Banque de France, French non-life insurers held 8% of their assets in cash and deposits" as at the end of 2015. Given the SCRconcentration threshold of 3% of the asset base, insurers would need to think carefully about how to split this 8% of cash among deposit banks in order to avoid incurring a charge for concentration risk. 1 In addition, the downward interest rate shock scenario will produce a mark-to-market gain on most of the positions in a liquidity fund. Whilst this will be small because of the short duration of these positions, it will reduce the SCRmarket for an insurer. For the purposes of this paper, we have assumed an SCRinterest rate of zero for the downward shock scenario. 2 This is an example of an element where internal models may differ from the Solvency II Standard Model: under an internal model, the duration floor of 1 should not apply. 3 HSBC Euro liquidity fund as at 19 February 2016 4

Counterparty Default Risk Most of the assets in a typical liquidity fund are subject to the Market Risk module of Solvency II. Of the assets that are typically eligible for a liquidity fund to invest in, only cash deposits are subject to the Counterparty Default Risk module. In this module, two types of exposure are recognised: Type 1, which includes, among others, cash at bank, reinsurance contracts and derivatives, and Type 2, which includes residential mortgages and a few other categories. It is worth noting that only cash balances are subject to the Counterparty Default Risk module: time deposits are incorporated into the Spread Risk module, even if they only have a day left to maturity. In the Counterparty Default Risk calculation, cash balances are grouped by CQS rating level and a Total Loss Given Default (TLGD) is calculated for each rating level. This is equal to the total amount of cash balances for that rating level: the Loss Given Default for cash deposits is assumed to be 100%. Through a series of steps the TLGDs for each rating level and their respective Probabilities of Default (PDs) are combined to arrive at an SCR for counterparty default risk. The formula for SCRdefault provides a diversification benefit for the use of multiple deposit institutions, especially within a same rating level. For example, at Solvency II rating levels CQS1 and CQS2 (the relevant ratings for liquidity funds), spreading deposits equally across five banks of the same rating level instead of placing everything with one bank will reduce SCRdefault by more than half. 5

France UK US Belgium Germany Japan Netherlands Sweden Australia China New Zealand Qatar Canada Finland Liquidity funds under Solvency II In practice We have taken a typical Euro liquidity portfolio 3 to calculate indicative Solvency II SCR numbers for this fund. The diagrams below provide an indication of the composition of the fund by issuer type, country of issuer, and asset type. Exhibit 2: allocation per issuer type In terms of the relevant risk categories under Solvency II, the distribution is as shown in Exhibit 5. Exhibit 5: Solvency II Risk Categories Spread Risk (70%) Bank (53.9%) Bank - Asset-backed commercial paper (8.3%) Corporation (14.3%) Counterparty Default Risk (20%) Sovereign (i.e. 0 Spread Risk) (10%) Agency (10.4%) Government (13.1%) Exhibit 3: allocation per country 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% This representation excludes interest rate risk. In principle, all of the assets of the liquidity fund are subject to SCR for Interest Rate Risk but, as indicated earlier, the actual marginal impact on Solvency II capital will depend on the overall interestrate sensitivity of an insurer s balance sheet. For a life insurer, the marginal SCR for interest rate risk can be zero; for a non-life insurer, it can be approximated at around 0.165%. Exhibit 4: allocation per asset type CP - fixed rate (36.2%) Deposit (20.1%) CD - fixed rate (18.1%) Treasury (9.9%) CD - floating rate (7.7%) Bond (5.4%) Government (1.4%) CP - floating rate (0.6%) 3 HSBC Euro Liquidity Fund as at 19 February 2016 6

SCRdefault SCRspread SCRinterest rate Diversification benefit SCR total SCRdefault SCRspread SCRinterest rate Diversification benefit SCR total Liquidity funds under Solvency II SCR attribution SCR attribution: life insurer Based on the portfolio composition of our representative Euro liquidity fund 3 and assuming the investor is a life insurer for which the downward interest-rate shock produces the highest overall SCRinterest rate, the indicative SCR for the liquidity fund is 1.218%. Exhibit 6 shows how this overall number can be attributed to the various SCR components. Exhibit 6: Indicative SCR attribution: life insurer SCR attribution: non-life insurer Based on the same fund 3 and using the estimate of 0.165% for SCRinterest rate, the indicative SCR for the liquidity fund is 1.232%. The attribution of this SCR to the various risk categories is shown in Exhibit 7. Exhibit 7: Indicative SCR attribution: non-life insurer 1.80% 1.80% 1.60% 1.40% 1.20% 1.00% 0.882% 0.000% 0.312% 1.60% 1.40% 1.20% 1.00% 0.882% 0.165% 0.464% 0.80% 0.80% 0.60% 1.218% 0.60% 1.232% 0.40% 0.20% 0.649% 0.40% 0.20% 0.649% 0.00% 0.00% For a life insurer, we assume that the contribution to SCRinterest rate of the liquidity fund is zero, as indicated earlier. SCRspread represents the largest requirement of regulatory capital, but it should be remembered that 70% of the portfolio is subject to the spread risk module and only 20% is subject to the counterparty default module. On a per-euro basis, the 20% of cash balances in the fund are around three times as capital-intensive as the 70% of non-sovereign exposures. Interestingly, the total SCR including interest rate risk is only slightly higher than the total SCR without interest rate risk. This is because an additional diversification benefit is applied within the calculation of SCRmarket, between spread risk and interest rate risk. The graph also shows the diversification benefit that is embedded in the Solvency II calculations. In this case, the diversification benefit represents the result of combining the SCR from the Counterparty Default Risk module and the Market Risk module (with spread risk the only driver of SCR for Market Risk). 3 HSBC Euro Liquidity Fund as at 19 February 2016 7

Liquidity funds under Solvency II Comparing liquidity funds to cash deposits The calculations above provide a good indication of the regulatory capital cost of liquidity funds under Solvency II. We have also explained how the regulatory capital for Cash at Bank as calculated through the Counterparty Default Risk module is very much driven by the rating of the bank, and how there is a diversification benefit for placing cash with more than one bank at a given rating level. We will now investigate how the SCR charges for deposits compare to the SCR for our representative Euro liquidity fund 3 as the number of deposit banks increases. We will focus on CQS1 and CQS2 Solvency II rating levels, as these are the rating levels at which a liquidity fund will typically place deposits according to its investment guidelines. Exhibit 8 shows the evolution of SCRdefault as an insurer places cash with an increasing number of counterparties. We have assumed that in each case the cash is evenly spread across all counterparties. We have looked at three scenarios: 100% CQS1 counterparties (equivalent to A-1+/P- 1/F1+ by S&P/Moody s/fitch); 100% CQS2 counterparties (equivalent to A-1/P- 2/F1 by S&P/Moody s/fitch); 50% CQS1 and 50% CQS2. 4 Exhibit 8: SCRdefault: diversification effect of using additional deposit banks 6% 5% 4% 3% 2% Each of the lines in the graph can be compared to the SCR for the liquidity fund of 1.232% (for a nonlife insurer) or 1.218% (for a life insurer). It can be seen from the graph that in order to achieve an SCR lower than the SCR for the liquidity fund, an insurer needs to find at least 4 CQS1 deposit institutions and spread the deposits evenly across them. The cash would need to be spread across more than 18 CQS2 deposit banks to get to a lower SCR than the liquidity fund. Interestingly, from around 8 banks at CQS2 rating, it makes more sense to add further CQS2 banks than to replace half of them with better-rated CQS1 banks. The Solvency II formula ascribes more value to diversification across names than to improving the credit quality of the existing group of deposit banks. The graph clearly shows that unless an insurer is able to source a significant number of CQS1 rated banks and restricts itself to placing cash with these CQS1 banks in equal amounts, the regulatory capital cost of deposits will exceed that of investing in a liquidity fund. It would be very difficult to try to achieve an SCR close to 1% using only CQS2 rated banks, and practically impossible to achieve it with a 50/50 mix of CQS1 and CQS2 rated banks. It should be noted that the assumption of funds being evenly spread across banks is important: it maximises the diversification impact of adding further deposit banks. In this context, the composition of deposits within the fund 3 was not particularly efficient for Solvency II purposes: it had placed 42% of its 20% cash allocation with one CQS1 bank, and the remainder with CQS2 banks in a split of 55% and 3% respectively. This produced a stand-alone SCRdefault of 3.24% as part of the overall SCR of 1.218%/1.232%. 5 Changing the split to 50% CQS1 and 25% each for the CQS2 banks would have reduced the SCRdefault to 2.49% and the overall SCR to 1.113%/1.117%. 1% 0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 100% CQS1 100% CQS2 50% CQS1/50% CQS2 Liquidity Fund 3 HSBC Euro Liquidity Fund as at 19 February 2016 4 In the 50%/50% case, calculations have been made only for even numbers of deposit banks and consequently the data points in the graph for odd numbers of banks represent linear interpolations. 5 The SCRdefault of 3.24% is applied to the 20% of the portfolio that is invested in deposits with banks, and so contributes 0.65% to the overall SCR. 8

The fund analysed in our example benefits from the highest underlying credit quality for money market funds but optimising for Solvency II capital is not an investment objective. Nevertheless, the liquidity fund attracts relatively low Solvency II capital. Our analysis shows that in order to achieve competitive regulatory capital levels using bank deposits, an insurer would need to pursue a highly optimised strategy, focusing only on a significant number of the highest-rated banks or alternatively on a very large number of highly rated banks. In addition, funds would need to be spread evenly across those banks. These requirements could have an adverse impact on the deposit yields that can be achieved. Conclusion Solvency II uses the look-through principle wherever possible, and it is clear from our calculations that liquidity funds benefit from this in comparison to cash deposits. The fact that insurers can look through to a highly diversified portfolio of assets inside the liquidity fund, whilst retaining more or less the same level of liquidity as a cash deposit with a bank, plays a large part in achieving lower capital charges under Solvency II. An insurer that places cash with a few A- 1+ and A-1 rated banks could face SCR charges of 3% or more. By comparison, a liquidity fund should attract SCR charges of a little over 1%. To achieve a similar SCR by placing deposits, an insurer would need to find at least 4 A-1+ rated banks and spread its deposits evenly across them, or more than 18 A-1 rated banks. This places significant practical constraints on such a strategy as a means of optimising the regulatory capital cost of liquidity under Solvency II. 9

Authors? Andries Hoekema Global Head of Insurance Segment HSBC Global Asset Management Farah Bouzida Financial Engineer HSBC Global Asset Management Andries Hoekema has been Global Head of Insurance Segment at HSBC Global Asset Management since the beginning of 2016. Andries has been with HSBC Group in a variety of roles since 2006, predominantly in Global Markets. Having started in Structured Credit Product Marketing, during the past five years his roles have included cross-asset Strategic Solutions coverage of institutional clients in the Netherlands and latterly Institutional Equity Derivatives coverage of insurance companies and pension funds in the Netherlands and Nordic countries. Prior to joining HSBC, Andries spent 9 years at Rabobank International, predominantly in the structuring and marketing of Structured Credit products. He has a Ph.D in Business Engineering from the University of Twente in the Netherlands. Farah Bouzida (Paris) is a Financial Engineer within the Multi Asset Research team after starting as a Portfolio Manager within the Risk Managed Solutions & Structured Products team. Farah has been working in the industry since 1999 and, prior to joining HSBC in 2007, she worked in the Middle Office OTC & Complex Product team and then as a Portfolio Manager Structured Investment Solutions at AXA Investment Manager. Farah graduated with a degree in Applied Mathematics with a specialisation in Statistics and Probabilities from the Université Mohammed V, Rabat (Maroc), and holds a Postgraduate degree in Applied Mathematics with a specialisation in Finance from the Université Paris Dauphine (France) and the engineering school ENSAE (France). 10

Important information? For Professional Clients only and should not be distributed to or relied upon by Retail Clients. The material contained herein is for information only and does not constitute legal, tax or investment advice or a recommendation to any reader of this material to buy or sell investments. You must not, therefore, rely on the content of this document when making any investment decisions. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe to any investment. Any views expressed were held at the time of preparation, reflected our understanding of the regulatory environment; and are subject to change without notice. The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested. The HSBC Euro Liquidity Fund is a sub-fund of HSBC Global Liquidity Funds plc, an open-ended Investment company with variable capital and segregated liability between sub-funds, which is incorporated under the laws of Ireland and authorised by the Central Bank of Ireland. The company is constituted as an umbrella fund, with segregated liability between sub-funds. UK based investors in HSBC Global Liquidity Funds plc are advised that they may not be afforded some of the protections conveyed by the provisions of the Financial Services and Markets Act 2000. The Company is recognised in the United Kingdom by the Financial Conduct Authority under section 264 of the Act. The shares in HSBC Global Liquidity Funds plc have not been and will not be publicly offered for sale in the United States of America, its territories or possessions and all areas subject to its jurisdiction, or to United States Persons. All applications are made on the basis of the current HSBC Global Liquidity Funds plc Prospectus, Key Investor Information Document, Supplementary Information Document (SID) and most recent annual and semi-annual reports, which can be obtained upon request free of charge from HSBC Global Asset Management (UK) Limited, 8 Canada Square, Canary Wharf, London, E14 5HQ. UK, or the local distributors. Investors and potential investors should read and note the risk warnings in the prospectus and relevant KIID and additionally, in the case of retail clients, the information contained in the supporting SID. It is important to remember that there is no guarantee that a stable net asset value will be maintained. HSBC Global Asset Management (UK) Limited provides information to Institutions, Professional Advisers and their clients on the investment products and services of the HSBC Group. Approved for issue in the UK by HSBC Global Asset Management (UK) Limited, who are authorised and regulated by the Financial Conduct Authority. www.assetmanagement.hsbc.com/uk Copyright HSBC Global Asset Management (UK) Limited 2016. All rights reserved. 16-I-00007 06/2016 FP16-1137 Exp 06/06/17 11