The implications of Solvency II | KPMG | Malta

The implications of Solvency II on the investment strategies of insurance undertakings

The implications of Solvency II

The full implementation of Solvency II and its implications on the investment strategy of insurance undertakings.

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With the full implementation of Solvency II, insurance undertakings are becoming more aware of its implications on the investment strategy of the undertaking.

Through the introduction of stringent capital requirements, the Solvency II Directive will create a more risk-focused approach, aimed at better protecting policyholders from future financial difficulties. While the investment policy had no impact on the solvency ratio under the Solvency I regime, the investment policy in terms of the asset allocation and asset duration will have a substantial impact on the capital requirements under Solvency II. Moreover, Solvency I only catered for the effect of liability-driven risk, completely ignoring investment risk, whilst Solvency II acknowledges that the required capital is dependent on the specific asset allocation structure undertaken by the Company.

The Solvency Capital Requirement (SCR), is a risk-based calculation, whereby inherent risks in an undertaking’s assets and liabilities are taken into account in order to arrive at the undertaking’s capital requirement. The SCR calculation is based on the sum of a number of capital charges relating to separate risk modules. One of the risk modules is the market risk module. The market risk capital charge takes into consideration the value-at-risk of the undertaking’s exposure in financial assets under a stressed scenario. While Solvency II imposes no requirements as to the maximum amount which can be invested in each sub-module, the calculation of the capital charge takes into consideration the correlation between sub-modules across the entire market risk module.

Under Solvency II, existing rules on counterparty and asset exposures will be replaced by the prudent person principle. This applies to financial assets, with the exception of unit-linked assets and requires undertakings to invest assets held for regulatory purposes, such as those held to cover expected liabilities and capital requirements, in a way to ensure the portfolio’s security, quality, liquidity and profitability. The prudent person principle also requires undertakings to keep their unlisted investments to a prudent amount and that derivatives are only used for risk reduction purposes. Undertakings must also ensure that their portfolio is adequately diversified, and that assets held are liquid and hence readily available.

Given that the market risk module is highly dependent on an undertaking’s investment portfolio, the optimal investment strategy which minimises the required solvency margin while also achieving the investment objectives of the undertaking should be implemented. In this respect, there is a high dependency between the required capital under Solvency II, the proportion of highly volatile investments such as equity and real estate in the investment portfolio and the duration of the assets. In fact, the SCR can be minimised by reducing the allocation to risky assets and by matching the duration of investments to liabilities.

Asset-liability management is of great importance under Solvency II as it ensures that undertakings have sufficient assets to meet liabilities of a specific duration, when liabilities fall due. Undertakings should aim for an investment policy which minimises the required capital, through asset-liability matching, while still optimising their risk/return trade-off.

While Solvency II further requires that an undertaking’s capital exceeds the required capital, a positive capital surplus does not necessarily eliminate future risks. Furthermore, analysis of the long-term effect of several alternative investment strategies has shown that, while reducing the allocation to risky assets has a limited effect on the solvency risks, changing the asset duration is more efficient. In this respect, optimising the asset duration whilst maintaining the asset allocation constant, resulted in a higher return at a lower risk. Once the optimal duration is determined, the asset allocation can then be varied accordingly, keeping the duration at its optimal value.

This implies that an undertaking’s risk/return trade-off under Solvency II is highly dependent on its investment portfolio, mainly in terms of the strategic asset allocation and the asset duration. Moreover, the addition of alternative investments, such as hedge funds, to the asset allocation under Solvency I led to an improvement of the performance of an undertaking’s investment portfolio in terms of both risk and return. However, the capital charges applicable to such investments under the Solvency II regime are likely to increase risk exposures and hence make hedge funds an unattractive class of investments for insurance undertakings.

Although the capital calculation depends on an undertaking’s entire investment portfolio, an understanding of the capital drivers which impact investment decisions is crucial. This is mainly due to the high volatility of the required capital on the basis of the characteristics of the investment portfolio being implemented.

© 2017 KPMG, a Malta civil partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

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