Firms eye allocation changes in anticipation of Solvency II

With the new European Union directive Solvency II set to take hold in just days, insurance companies and their money managers are adjusting investment portfolios to ensure they can continue to reap the returns they need to make payments to policyholders, while at the same time satisfying the new requirements.

Research published this month by Standard Life Investments found that many insurers are considering significant strategic and tactical asset allocation changes because, when it comes to meeting guaranteed rates to insurance policyholders, their current investment strategies are expected to deliver a future annual return of 2.4%. Based on current levels, they need 2.7% to meet future requirements.

More than 60% of 56 senior insurance investment executives — representing more than e2.4 trillion ($2.64 trillion) of pan-European insurance assets under management — expect to increase allocations to real estate and/or alternative assets; while half expect to reduce sovereign fixed-income exposure, according to the research, which was conducted last summer.

“Solvency II is the most important regulatory change that the insurance industry in Europe has been facing over the past few years — it is a new regulatory component that places a lot of focus on a risk-based system,” said Patrick M. Liedtke, managing director, head of the financial institutions group for Europe, the Middle East and Africa at BlackRock Inc. in London. “Under Solvency II, there is much greater granularity in the way that risks on insurance companies' books, and the capital held against it, is looked at.”

With a global insurance industry of about $24 trillion of assets in total, “any shift quickly amounts to a lot of money,” Mr. Liedtke said.

Money management executives said there already is evidence of money flowing out of sovereign debt and investment-grade credit, and diversifying into other asset classes — something that is looked upon favorably under the directive.

“The solvency system takes into consideration investment into other asset classes, and with diversification you have to hold less capital against certain assets,” Mr. Liedtke said.

Stefan Lummert, head of insurance advisory, Germany and Austria, at J.P. Morgan Asset Management, and based in Frankfurt, said “alternative fixed income is getting very popular.” One of the factors in that increased popularity is that taking advantage of the illiquidity premium of certain assets carries little capital requirement. He highlighted direct lending and mortgages as two areas of interest.

Heneg Parthenay, London-based head of insurance at Insight Investment, said clients have moved cash out of bank deposits and into money market and other cash funds. “This reduces bank counterparty risk and associated capital charges,” Mr. Parthenay said.

Securitization is also a hot topic, Messrs. Parthenay and Lummert said.

Insight Investment has seen divestment from collateral loan obligations, commercial mortgage-backed securities and other securitization products; and reinvestment of those proceeds in leveraged loans and commercial real estate loans.

“The reinvestment into loans was motivated by economic features of the loan market — secured investment, illiquidity/complexity premium, floating rate — and by the capital treatment of these assets,” Mr. Parthenay added.

On the equities side, insurers had invested little compared with the average pension fund. But BlackRock is seeing more interest from insurance companies in what private equity can bring to a portfolio, despite carrying higher capital costs under Solvency II. “Returns are considerably higher than for public equity, and insurance companies find that the advantages of going into it far outweigh that,” Mr. Liedtke said.

Public equity also carries a high capital charge, and this has, in part, prompted moves by insurers to divest from equity and reinvest that cash into diversified growth funds, Mr. Parthenay said. Interest rate hedging programs have also been installed by insurers, to improve asset/liability matching. “These programs are adjusted on a regular basis in line with material changes in the profile of the liabilities,” Mr. Liedtke said.

Emerging markets debt is another area of investment interest, “but under Solvency II that is not easy,” Mr. Liedtke said. The regulations “heavily” penalize an insurance company that has a foreign-exchange rate difference between its liabilities and the assets in which it invests, he said.

But insurers are getting around that issue by investing in hard currency and hedging the FX risk out of the trade. “They can tap into a market that has a much higher yield than you would find in any of the developed markets. Insurers are looking at geographical diversification,” Mr. Liedtke said.

While insurance companies have had time to come to grips with Solvency II — the directive has been in the making for about a decade — Jan. 1 marks the culmination of years of work to structure investments in a way that satisfies the new regulations, and at the same time gives insurance companies the ability to invest in a way that ensures they can continue to deliver performance and returns.

“From Jan. 1, the focus moves from defining what needs to be done, implementing and test-running, to actually living that world,” Mr. Lummert said. “It is a different thing, as it becomes life.”