The impact of Solvency 2 on insurers asset allocation

Since the financial crisis of 2007, control and risk management are coming back to the central concern of financial institutions and regulators. European regulation sets the risk in the heart of the insurers governance via the Solvency 2.

This regulatory development’s main objective is to ensure better protection of the insured by requiring the insurer to quantify more precisely and better manage its risks. It will change the depth of institutional investment strategy.

Implications for asset allocation insurers?

Some implications of the Solvency 2 on insurers asset allocation policy are already well known:
 holding risky assets (equities, hedge funds ...) is penalized, the bond and credit quality are privileged,
 property can be strengthened.

However, the changes induced by Solvency 2 on asset allocation are deeper than it appears.

An incentive to diversify

To calibrate the amount of capital required, the regulator imposes standards shocks which impact severity depends on the asset class (interest rate, credit, equities, property, foreign exchange). Each impact is measured individually and then aggregated to the other using a correlation matrix.

Solvency 2 introduces a reduction of the capital requirement using this correlation matrix between the various standards shocks and the incitement to greater diversification of assets is strong.

Thus, because of a negative correlation between credit risk and liquidity risk, allocate 15% of credit in its assets helps offset the capital charge inherent to liquidity risk.

By applying an optimal injection of diversifying assets, the asset manager is involved in the control of regulatory capital cost of his client.

An Optimization of the volatility hedging ratio

Solvency 2 implies a radical change by introducing a marked to market value of the insurer’s balance sheet assets and liabilities. With the abandonment of the historical valuation, the insurer hedging ratio is heavily impacted by changes in market interest rate, credit or equity.

The recent market volatility illustrates the potential impact of this change. Therefore, it is perfectly legitimate that an insurer sets a threshold below which it does not want its solvency margin decline. The objective is to maintain a cushion of solvency margin above the regulatory minimum regardless of market conditions.

The asset manager then proposes solutions to minimize the volatility hedging ratio and protect the mattress solvency margin set by the client.

An allocation dependent on the level of wealth of the insurance company

Imagine that all insurers apply the standard formula of the Directive for their asset allocation. In this case, the allocations would however differ significantly from one insurer to another. Indeed, in the approach of Solvency 2, the need for regulatory capital is calibrated to the risk of ruin to a one year horizon of each insurance company.

For example, an insurer whose solvency margin is low will have to reduce its risky investments particularly large in terms of capital in the Directive

Asset allocation will be very different depending on:
 the flexibility available to the insurer’s solvency margin,
 the minimum mattress of the hedging ratio he wishes to preserve in all cases,
 the strategy adopted by management to use its flexibility (improving the performance of assets or acquisitions, for example).

To be relevant, the asset manager will advocate a systematic asset allocation adapted to the balance sheet situation and strategy of its clients.