Structured products, securitisation solutions for insurers regarding the capital ratio required under Solvency 2?

modernes Hochhaus, Deutschland

From now on, European insurers must follow the Solvency 2 Directive and start complying with it. We have moved from a provisioning approach to a risk-based approach. The transition from Solvency 1 to 2 is also defined by the transition from an accounting to a “cash” vision. The principles-based approach in Solvency 1 is giving way to a rules-based approach, while the transition to Solvency 2 requires insurers to think differently. The notion of continuous time with the “mark to market” imposes a constraint that financiers are used to managing with a probabilistic vision and not insurers. In this case, the main concern is not the solvency but the liquidity of the bank at all times, which explains the use of Var and “back-testing”. A short-term vision that is by nature opposed to the insurance business cycle is now in place. Indeed, under Solvency 2 with Var and “backtesting” calculations, insurers are required to have a positive amount of equity capital in one year with a confidence interval of 99.5% under any scenario of stress or shock on the markets.

We are more in a logic of insurance but of market finance. This will completely change the insurance business cycle. The transition to continuous time first of all causes a first new problem for insurers, which is how to manage such volatility and which model to use in the calculations of the different pillars and ratios. This leads us to a certain diversity since each insurer can develop its own models

Continuous time imposes a valuation of positions, we have a change of priorities that is more like that of a bank. We focus only on capital investment and no longer on the core business of insurance. Solvency 2 has a major impact on insurance investment policies. Due to valuation constraints, insurers will reduce their equity exposure and especially on the most volatile ones such as mid and small caps and SMEs. This will cause a much lower return and therefore higher premiums at the expense of the insured.

Equity exposure will fall very sharply as insurers will no longer be able to expose themselves to excessively high levels of volatility. The level of volatility defining the capital capacity of insurance companies, if the regulator considers that the insurance is exposed to more volatility than before, it is entitled to increase the capital capacity. This will therefore totally challenge equity exposure, questioning the equity capital needed to deal with specific market crises. In addition, this brake on investment in the equity market and especially in mid- and small caps will have an impact on growth and the real economy.

We will focus mainly on the short term with Solvency 2. This new valuation of equity overweighs short-term cyclical events, while insurers take positions and commit themselves to medium and long term and have to face medium and long term structural events. The accounting balance sheet changes from a function of recording past flows to a function of evaluating expected future flows. Solvency no longer requires only risk management but also risk monitoring.

Another aspect that always follows the continuous passage is the complexity of the models used and the ability to evaluate the parameters of the components. In the case of the calculation of the “best estimate” we have to do stochastic simulations in large numbers to get the best estimate. These flows are then discounted using the risk-free yield curve. In addition, the current negative rate environment brings a new “challenge” in the search for returns.

Insurers will have to develop extensive management and use products and strategies to maintain the same levels of returns. Optimizing the volatility return ratio with the proportion of equity capital to have will become decisive because if an insurer is too exposed, the regulator will impose an increase in its equity capital. So the major issue for the insurer will be how to balance performance and safety.

We can note that structured products can provide an answer to negative rates and the search for returns as well as to the problem of equity capital. Different legal forms are possible for the issuance of a structured product, for example a “European medium term not” (EMNT). This legal form is considered as a receivable and we can have structured products considered as a simple receivable with an optional strategy under any possible underlying. It is a better alternative to capture the performance of an index or share price rather than having the index or share in question in terms of risk exposure and therefore capital requirements.

Securitisation of receivables is particularly interesting for insurers because they are committed to the long term. Through securitisation they can commit to debt and control their exposures and returns. Being considered as bonds, depending on the tranches chosen, we will still have a capital requirement that is always lower than that of equities, for example, but with higher returns than that of an equivalent bond. However, we can question the fact that pension funds also had the same logic during the subprime crisis. Are we going with solvency 2 towards a European subprime crisis?

 

Rachid MAMDOUH

Rachid MAMDOUH


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