Solvency II: A New Investment Approach Pierre Moulin, Head of Financial Engineering October 2011
04/10/2011 2 Solvency II in a nutshell A new directive with a far more economic approach compared to Solvency I Excess capital Surplus Excess capital Surplus Assets booked under market value for equities, historical costs for bonds Solvency margin Technical provisions Prudence principle Simplistic solvency margin calculation: percentage of provisions/ premiums and claims Main characteristic: Variable rules from one jurisdiction to another. Discounting of liability cashflows at a prudent discount rate Assets booked under market value SCR MCR Risk Margin Technical provisions Best Estimate SCR: impact of stress-tests on Net Asset Value (NAV) 99.5% VaR Inclusion of nonhedgable risks Stochastic simulations of future cash flows, discounted using a market rate based on the swap curve Solvency I Solvency II Within Solvency II, all assets and Under liabilities this new are regulation accounted n, in both market assets value, and and liabilities all underlying real risks need to be covered by its corresponding capital requirement.
3 Key elements of the reform Total Balance sheet approach Partnership between liability specialists (actuaries) and the asset specialists (fund managers) will be key to develop Market value for both assets and liabilities Translated into higher volatility of assets & liabilities Antagonist objectives between local accounting & Solvency II need to be conciliate Wide range of risks to be covered by regulatory capital Value at Risk (99.5%) approach to determine the required capital based on stress tests Market risk expected to account for the majority of SCR (around two thirds) Direct link between asset allocation & regulatory capital Added value of diversification under Solvency II demonstrated Key role to play for reporting Higher influence of asset allocation on the regulatory capital and by consequence the excess capital. Key for insurers to align their asset allocation to the new regulatory context Better duration matching Increase in downside protection Full transparency on holdings
4 Reporting under Solvency II: A key competitive advantage Insurance companies will have to comply with new quarterly and annual reporting constraints from 1st January 2014 onwards Therefore, they need accurate information in a timely manner from their investment managers Demand for two types of reporting depending on the use of standard or internal model by the insurer If the insurer uses the standard model If the insurer uses an internal model Need for a report detailing SCR per market risk (see example next page) Once collected from each manager, the insurer will be able to sum all SCR per market risk. Then, the resulting SCRs from each market risk will be combined with the standard correlation matrix to obtain the total market SCR Need for a report detailing on a line per line basis specific information (e.g. for a bond portfolio: ISIN code, duration, maturity, rating, ) under an ad-hoc template Once collected from different managers, all the info will be used to calculate the global market SCR around the lines defined in the internal model
5 Reporting example SCR Breakdow n by asset type and by currency type Asset type Fixed Incom e Governm ent Corporate % Interest Up 3.5% 0.1% -0.1% 0.1% 2.5% 1.0% 0.1% -0.1% Interest Dow n Equity 4.1% Convertible Credit 0.1% Equity* Property Currency 0.4% Others 0.5% 0.3% Equity uncludes Equity options and futures - Equity assetclass is stressed w ith :49% for "globalequity" and 59% for "others equity" Total 100% 4.2% -3.8% 1 18.2% 4.1% -3.7% 9.9% 17.7% -0.4% RealEstate Cash Global 3.7% 87.3% Global 68.2% 14.4% Conc. -5.3% 0.2% 0.3% SCR Contribution Others 19.1% 4.1% -0.2% 0.1% 4.9% 5.1% 0.2% -0.4% 0.1% -5.5% 11.0% 5.1% 0.1% 0.1% 0.2% 0.2% 0.3% 23.4% 5.0% 28.8% M od.dur. Contrib. 0.1 0.1 3.7 18.5% 3.8 Cost in capitalper 100 investm ent SCR per market risk 20% SCR by Risk 0.6% SCR Currency breakdown by Currency (top 15) Solvency IIFactsheet -BNPP L1 Bond Convertible W orld - 29 april2011 15% 10% 5% 0% -5% -0.4% Currency up Interest Interest Credit Equity* Property Currency Conc. Up Down -0.6% Currency Down 0.4% 0.2% -0.2% SCR per maturity USD GBP BRL HKD NOK SEK INR THB TWD ZAR CNY KRW CAD CZK MYR M aturity bucket No m aturity * ]0 ;1 year] ]1 ;2 years] ]2 ;3 years] ]3 ;4 years] ]4;5 years] ]5;6 years] ]6 ;7 years] ]7 ;8 years] ]8 ;9 years] ]9 ;10 years] ]10 ;+ years] Interest Up 9% 0.19% 0.84% 0.73% 1.22% Interest Dow n -8% -0.17% -0.72% -0.61% This section analyses the fixed incom e risk SCR Breakdow n by m aturity bucket Credit -0.45% 0.10% 0.45% 0.57% 2.38% 7% 2.69% 1.10% -0.42% 1.18% -1.34% 1.56% Concentration Exposure (in % ) 1% 9.28% 2.88% 10.61% 12.66% 26.86% 16.38% 8.58% 6.59% SCR Contribution M od.duration Contribution 5.25% 0.23% 1.22% 2.48% 7.06% 0.2 0.3 0.9 5.04% 0.7 2.34% 0.4 2.19% 0.4 2.99% 1.0 TOTAL 4.2% -3.8% 1 0.3% 10 28.8% 3.8 30% 25% 20% 15% 10% 5% 0% 0 0.56% 0.53% Cost in capitalis expressed in portfolio base currency - * No m aturity includes equity,property,currency ] 0 ; 1 year] ] 1 ; 2 years] ] 2 ; 3 years] ] 3 ; 4 years] ] 4; 5 years] ] 5; 6 years] ] 6 ; 7 years] ] 7 ; 8 years] 0.21% ] 8 ; 9 years] ] 9 ; 10 years] 6.16% ] 10 ; + years] 8% 7% 6% 5% 4% 3% 2% 1% 0% Exposure (in %) SCR Contribution
6 How to measure the attractiveness of the different asset classes Solvency II SCR is somewhat consistent with Using one or the other metric gives broadly comparable results Nevertheless, ranking the different asset class ses can not be done solely based on a risk measure (SCR or VAR) but by comparing their expected return with their capital charge Choice of expected return is key a VAR (99.5) based on historical data s Blue bar: excess return based on historical return Pink bar: excess return based on expected return from our smart benchmark This demonstrates the first order impact of expected excess returns in evaluating the attractiveness of asset classes Black and white conclusions on asset classes attractiveness under S2 have to be mitigated Especially at the level of the entire portfolio
7 How to combine them to build an optimal SAA Under Solvency II, different approaches exist: Optimization based on initial SCR or on VAR (99.5) Initial SCR Risk-Return with Risk = initial SCR Optimization relative to 99.5% value at risk Optimization relative to SCR 40% 35% 30% 25% 20% 15% 10% 5% 0% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% Average excess returns Risk-Return with Risk = Surplus in the worst cases (defined by the 99.5% quantile appropriate to Solvency 2) Surplus after 1 year above the threshold indicated in 99.5% of the cases 100% 95% 90% 85% 80% 75% 70% 65% 60% 55% 50% Optimization relative to 99.5% value at risk Optimization relative to SCR 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% Average excess returns Direct optimization relative to the SCR naturally leads to the lowest initial SCR (graph on the left). But looking at the situation one year later shows that having a lower initial SCR does not lead to a higher surplus one year later in the worse scenarios (right graph) Suggests that only optimizing relative to the initial SCR is not sufficient: one has to take into account the (most realistic probable) evolution of the surplus over time Insurance companies should be prudent in only considering SCR as the risk parameter for asset allocation choices
8 Our solution to manage the balance sheet under Solvency II A dual portfolio structure Solvency I Solvency II Excess capital Regulatory capital Surplus Assets facing surplus = return portfolio Excess capital Regulatory capital Surplus Assets considered as a whole Technical provisions Assets facing technical provisions = matching portfolio Technical provisions Common asset allocation determined for the whole portfolio Separate reasoning for the assets facing the surplus: possibility to seek more risk Similar approach to the one used for the pension fund industry through LDI investing. The objective of such structure is to limit the SCR generated by the matching portfolio to reserve all the SCR for assets delivering return to shareholders (the return portfolio)
9 with the aim to maximize value for shareholders and protect solvency 2 key indicators looked at by insurance companies Surplus = (part of) the value held by shareholders Maximize the expected return on surplus while limiting the loss in the worst cases leading to 2 types of objectives Excess = the regulator indicator to assess the solvency Ensuring the Excess capital remains above its initial value after the optimization of the return portfolioo Solvency II Assets facing Excess capital Surplus: Performance SCR Portfolio SCR MCR Risk Margin Assets facing technical Technical provisions: provisions Hedging Best Portfolio Estimate Surplus Risk Return objective through optimisation of return portfolio Prudential objective through protection mechanisms Simplistic assumption of no SCR from matching portfolio
10 Strategies to meet the prudential objective Different ways to protect the excess capital Ex ante protection Ex Post protection Strategy Option strategies consisting in buying a put and selling a call with zero net premium Dynamic risk management consisting in adjusting the ris sk of the portfolio in order to protect the excess capital Advantages/Disadvantages Initial SCR saving (e.g. of 50% in case of a portfolio made of 100% equity and a put of 80%) Reduction of max drawdown for surplus and excess capital Opportunity costs due to loss of upside linked to the sale of the call A way to turn equity more solvency II friendly No initial SCR saving Protection of the excess capital Reduction of max drawdown for surplus Opportunity costs due to lower participation to upside Such protection mechanisms constitute optimal solutions to meet short term regulatory constraints while building a return portfolio enabling to meet long term shareholders return requirement
11 To conclude Copernican revolution for Insurance companies and their service providers Comparable to the one experienced by pension funds few years ago in Northern Europe Full mart to market, ALM approach : need to think out of the box. BNPPIP philosophy : Provide the basic requirements in terms of transparency Think top/ down to speak the same language as the insurers Avoid too simplistic messages such as «no equity anymore» for Insurers Avoid «regulatory arbitrage» type of message Provide solutions in the spirit of the regulatio on : protect capital in worse case scenarios while creating value for insurance companies stakeholders
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