EDHEC Analysis: Impact of Solvency II on Bond Management

The Solvency II regime, which will come into effect in 2014, will have a significant impact on the way insurance companies, as well as financial markets, perceive risk, according to the EDHEC Financial Analysis and Accounting Research Centre. One of the major changes under Solvency II is the treatment of market risks, which represent an additional capital cost that now needs to be incorporated into the analysis of insurers’ investment choices.

In the study, entitled ‘The Impact of Solvency II on Bond Management’, the EDHEC analyses the impact of Solvency II on insurers’ bond management practices. The authors consider the appropriateness of the bond solvency capital requirement (SCR) as a risk measure, the effects of this risk measure on bond management within a return-volatility-value-at-risk-SCR universe, and whether Solvency II will give rise to a new bond hierarchy and arbitrage opportunities.

The study demonstrates that it is possible for investors to evaluate bond SCR by using only two variables – residual maturity and rating. Moreover, the study reveals that real credit spread is not strongly correlated to SCR due to the flat-rate treatment of spread risk under Solvency II (which assigns a single risk factor to each rating and does not account for internal variances in ratings). Given the additional marginal cost that could be considered excessive in proportion to the return generated, bonds rated BBB or lower could end up being neglected by investors, potentially resulting in significant implications for the financing needs of the economy.

Furthermore, the study shows that overall SCR, as defined by the Solvency II standard formula, is an appropriate measure of risk for fixed-rate bonds. However, given their specificities, SCR does not fully reflect the risk associated with long-maturity investment grade bonds, high yield and unrated bonds. Due to the features of bond SCR (strong correlation with volatility and historical VaR), bond management, currently based on the return-VaR-volatility triple factor, should evolve under Solvency II more towards a management approach based solely on the bond return-SCR pair. Finally, an analysis of the efficiency of risk-taking measured by the bond return/SCR ratio shows that the standard formula favours low duration bonds, particularly high yield bonds. This management, within the constraints of SCR, could lead to a shortening of durations, given the calibration and current term structure of interest rates.

It is now accepted that Solvency II will change the asset allocation of insurance companies. Controversy surrounded the decision of a number of players to significantly reduce their equity allocation component. The study focuses on an alternative source of market financing. It shows that the current calibration of Solvency II is likely to prompt insurers to distance themselves from investing in long-term bonds, particularly those with ratings of BBB or lower. Naturally, this raises many questions on the future financing of the economy by the insurance industry. Solvency II could therefore dry up a major source of corporate funding and thus counter the growth and financing objectives of the economy.

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