By Martin Haycock
It has been a long time coming, but the European Union Solvency II Directive finally came into force for European insurers on 1 January this year.
Under this new regulatory framework companies must now report on their financial investments, business risks, and a number of other corporate activities in order to create a more standardised market and provide stronger protection in the event of another financial crisis.
A key development under the Solvency II directive is the introduction of the Solvency Capital Requirement (SCR). Insurers must ensure their capital levels remain above the SCR at all times or the regulator will intervene to ensure appropriate measures are taken.
Equities vs convertibles
Under the directive different asset classes are subject to varying capital requirements, with the SCR for convertible bonds being substantially lower than that of equities. For instance, equities from countries belonging to the Organisation for Economic Co-Operation and Development (OECD) require a capital level of 39%, whilst those from non-OECD countries require a 49% level. In contrast, the capital requirement for a comparable investment grade hybrid convertible bond portfolio is only around half of these rates.
The SCR for convertible bonds is calculated using four factors; equity risk, interest rate risk, credit spread risk and currency risk. The main drivers are equity and credit risk, and as convertible bonds typically have a short duration, the effect of interest rate risk is somewhat diminished.
Credit risk is not so strongly penalised in view of an anomaly in the ‘non-rated segment’ – about 40% of convertible bonds in the investment universe are unrated. Unrated corporate bonds require a capital charge in the rating range between BBB and BB thus benefiting bonds in the high yield segment.
The relatively modest capital requirements of convertible bonds are a key factor in favour of the asset class. In particular, insurers with a limited SCR budget are more likely to consider investing in convertible bonds while still participating in the equity market.
The demands placed on asset managers have also risen notably during the preparations for implementing Solvency II. This relates not only to structuring investment strategies for insurance companies, but also to processing the high volumes of data under Solvency II’s reporting requirements. Hence, already in the course of the last year the demand for tailored fund solutions on the part of insurers has increased strongly.
The overall SCR calculation is based on a mix of both assets and liabilities, meaning a modest capital requirement is not the only consideration for insurers. Special investment funds (SIFs), in contrast to regular mutual funds, allow for the timely and flexible implementation of increasingly important guidelines regarding the duration and credit quality of portfolios.
An example of this is duration matching, as demonstrated through the following Solvency II principle: the shorter the duration and the higher the credit quality of the investment, the lower the SCR. This calculation can lead to false incentives, when in reality the insurer actually benefits more if it matches the duration of the assets to the duration of the liabilities, making it possible to offset the capital requirements on both sides. In the case of a life insurer with a longer liability duration, a combination with a longer duration on the investments results in a significantly lower capital requirement.
Volatility
Whilst the Solvency II standard model only takes into consideration the risk factors highlighted earlier (equity, interest rate, credit quality and currency), many large insurers also use their own internal models which factor in volatility risk.
Convertible bond portfolios are one of the few investment instruments to offset the volatility exposure of insurers’ liabilities through their inexpensive, long-term options and an actively managed stable delta.
In this respect convertible bonds offer the potential for optimisation which cannot be achieved through any other asset class.
Performance
Finally, a long term analysis of the performance of convertible bonds compared to equities and corporate bonds further cements the asset class’ strength as an investment tool.
From December 1996 to the end of February this year, convertible bonds exhibited an average annual return of 6.40%. In contrast, the average yearly performance of the MSCI World AC equity index comes in at only 5.91%, with corporate bonds even lower at 5.22%.
In the face of a wave of change from the Solvency II Directive one thing seems clear in the sector: convertible bonds are a clear choice for insurers trying to navigate their best path going forward.
Martin Haycock is product manager, convertible bonds at Fisch Asset Management
