Jean-René Giraud explains how the development of hybrid solutions can allow insurance companies to re-assess their risk management approach in the wake of Solvency II
If you can’t fix it, pass a law!
The Solvency II Directive 2009/138/EC harmonises and codifies insurance regulation across Europe. Since the initial Solvency 73/239/EEC Directive introduced in 1973, more elaborate risk management strategies have been designed and put in practice. Solvency II intends to reflect modern risk management approaches to adjusting the required capital and favour risk-based management processes.
The suggested framework is designed to achieve a number of clear and ambitious objectives:
• Reduce the risks that an insurance company would be unable to meet claims or liabilities;
• Provide early warning so that supervisors can intervene would capital reserves fall sharply;
• Promote confidence in the financial stability of the insurance sector.
Very comparable in its structure to the Basel III set of regulation, the proposed Solvency II framework has three main areas of focus defined as ‘constituting pillars’:
• Pillar 1 consists of quantitative capital requirements;
• Pillar 2 imposes minimal requirements for the supervision, governance and risk management;
• Pillar 3 puts an emphasis on disclosure and transparency.
The first pillar, which is at the heart of this discussion, comprises two capital requirements - namely the Minimum Capital Requirement (MCR) and the now well-discussed Solvency Capital Requirement (SCR).
The MCR reflects the minimum level of required capital below which supervisory action would systematically be triggered while the SCR represents additional capital to firms to absorb significant unforeseen losses.
Solvency Capital Requirement (SCR) is determined using either a standard formula given by the regulator or an internal model developed by the insurance company, subject to approval by the appropriate authorities.
Negotiations for the implementation of the directive are still taking place and the deadline for the directive to come into force has been postponed several times. The trend towards a ‘quantitative capital adequacy’ approach is however no more put into question, forcing the industry to rethink its approach to managing the business risks carried by the evolving business models.
If one can regret a very painful negotiation process causing unnecessary management, organisational and technology hurdle and costs, the industry is now clearly moving in the direction of more harmonisation with the principles now in place within the banking industry, not even mentioning its possible application to the pensions space.
Watch out for adverse consequences
Regulation developed in response to a systemic crisis very often carries the germs of adverse behaviour and consequences. It is important to weight the expected benefits with those unwanted downsides.
The Solvency II Directive is no exception as it clearly tightens requirements regarding how much capital insurers will need to hold. In the wake of these new rules, insurance companies have already started to rethink their risk management process, adjusting the risk profile of their portfolio so as to align it with their current reserves, hence the declining proportion of stocks held within institutional portfolios.
It is all the more problematic as insurance companies are facing an unprecedented interest rate challenge. How should insurers cover the long-term payout promises with historically low interest rates, keeping in mind the short term impact on mark-to-market valuation of fixed income assets in climbing interest rate environments?
Reinvesting in risky assets would be necessary and beneficial to all stakeholders in the long run, but these assets are subject to ‘punitive’ capital charges under Solvency II.
To help insurance companies address the issue, Koris International suggests structuring the risk management process around a robust dynamic risk control framework that maximises the benefits of the exposure to different sources of risk premium. By contrast with standard asset allocation methods, this type of strategy respects risk constraints such as limits to cumulative absolute or relative losses set ex-ante, regardless of the market situation, with contained and well documented model risks.
Innovation wanted
Koris International’s asset allocation models respond to the need for systematic control of financial risks as a basis of the sustainability of an investment program. They are based on dynamic risk-budgeting techniques, which have proven to be much more effective than conventional risk management practices. Obviously, our increased knowledge and understanding of the limitation of portfolio insurance techniques has allowed us to significantly improve the output of such systematic investment programmes.
The basis of Koris International’s asset allocation approach can be found in the 2004 research paper written by Amenc, Malaise, and Martellini that introduced a dynamic approach to Core-Satellite investment using passive underlying investment vehicles.
Dynamic risk control technologies ensure that the cumulative performance of the overall portfolio will respect a given level of risk budget set ex ante, while providing access to the upside potential of risky asset classes.
Dr Daniel Mantilla-Garcia and Hugo Lestiboudois at Koris International recently introduced improvements of dynamic risk budgeting techniques to address the need for more cost-efficient loss-controlled strategies.
On that basis, Koris developed an enhanced DCS solution aiming at producing asymmetric payoffs with liquid investment vehicles, with the advantage of cutting the fat tails on the left side of the return distribution while capturing risk premia in bull markets (positive skewness).
One of the key parameters influencing the dynamic of our approach to managing risks is the M factor (or Multiplier Factor), which, by default, is fixed. The M factor controls the speed at which the allocation is directed to the satellite when the risk budget increases. A significant improvement to the method involves introducing a varying factor to this multiplier, taking into consideration, amongst other elements, states of volatility as well as market stress and liquidity indicators.
Back to realities, and basic rulemaking
The regulator however considers this approach as a dynamic hedging strategy, which is not a valid risk reduction technique under the Solvency II standard formula. Assuming that the portfolio could theoretically invest up to 100 per cent in emerging market equities, it would fall within the punitive ‘other equities’ charge.
If we agree with the arguments put forward by the regulator, we do however regret the blind approach taken to assessing risks without taking into consideration the capacity of the asset manager to manage and contain risks below the levels of static portfolio allocations.
Supplementing our strategy with an additional protection based on a Gap Put issued by an investment bank, whose cost fluctuates depending on the actual exposure to the DCS portfolio while also taking into consideration the level of dynamic protection put in place, allows however to engineer an elegant proposition that encompasses the following benefits:
• Hedging strategy explicitly permitted under the Solvency II standard formula,
• Compliant with Pillars I and II (required for partial internal models),
• Optimal insurance cost,
• Substantial cut in capital requirements (SCR), and
• Attractive Return/SCR ratio.
Wrap up and take away
Despite a hectic path towards more modern regulation of the insurance world, we strongly believe the industry globally is now fast embracing investment approaches consistent with capital adequacy rules seen across the whole financial sector.
The development of hybrid solutions based on those sophisticated but still very robust asset management techniques in addition to transparent structuration mechanisms are without any doubt paving the way to a new generation of investment vehicles allowing insurance companies to re-assess their capacity to access market risk premia.
Written by Jean-René Giraud, cofounder and acting CEO of Koris International
