Balancing risk, return and capital requirements the effect of solvency II on asset allocation and investment strategy

Balancing Risk, Return
and Capital Requirements
The Effect of Solvency II on Asset Allocation
and Investment Strategy
Written by


  Balancing risk, return and capital requirements

Foreword:
Beyond Performance
Despite several deferrals of the implementation deadline, Solvency II has already
proved a major catalyst for change with insurers spending considerable time
and resource on preparing for D-day. At BlackRock®, we share this focus as we
help insurers meet the outcomes they need in this rapidly shifting environment.
Specifically, we are investing heavily in our infrastructure and people to help you
navigate this crucial transition successfully.
Yet this tremendous effort by the industry masks significant uncertainty: be it in
terms of the final shape of the directive or how Solvency II will affect asset allocation,
investment strategies and capital markets – all against a backdrop of a continued
sovereign debt crisis. Faced with this murky picture, insurers, not surprisingly, find it
hard to have full confidence in their preparedness.
To help bring some clarity around the remaining key challenges, BlackRock has
commissioned the Economist Intelligence Unit to conduct a comprehensive study
among European insurers. The findings offer a real insight into the challenges
associated with each of the three pillars and the implications for insurers’ product
offering and the wider capital markets. Interestingly, the research highlights a
degree of discrepancy between market perception and what your peers really think,
particularly in relation to the use of alternatives and their levels of preparedness for
Solvency II governance and disclosure requirements.
Personally speaking, the most important finding was the need to move beyond

performance and seek full alignment of investment expertise and enterprise risk
management. In 2012 and beyond, we will work very closely with our clients to help
them achieve that essential goal. I hope you find the report thought-provoking and,
above all, beneficial, and look forward to hearing your views.
Sincerely,

David Lomas, ACII
Head of Global Financial Institutions Group, BlackRock
email:


Balancing risk, return and capital requirements  [ 1 ]

Contents
Executive Summary and Key Findings

3

About this Report 

6

Introduction

7

The Future for Asset Allocation

8

Return-Seeking Assets

12

A Demanding Data Management Regime

18

Shifting Product Ranges

22

Consequences for Capital Markets

25

Equity and Debt Markets

28

Conclusion

32

BlackRock Commentators 

34

About BlackRock

35

Appendix

36


[ 2 ]  Balancing risk, return and capital requirements


Balancing risk, return and capital requirements  [ 3 ]

Executive Summary
Despite recent uncertainty about whether the
implementation date of Solvency II will be pushed back
a year, insurers are still working on the assumption that
they have just one year to go, and therefore preparations
for the new Directive are well under way.
The Europe-wide legislation will impose stringent new capital requirements across the
insurance industry, creating a more risk-focused approach to better protect policy
holders from future financial crises. Data management will be overhauled, while many
players will be forced to rethink their product range and investment strategies.
Coinciding with this final phase of preparations for Solvency II are some of the most
testing market conditions in living memory. The ongoing sovereign debt crisis has raised
questions regarding the very foundations on which some pillars of Solvency II are built
and as uncertainty over the final shape of the Directive persists, insurers face notable
challenges when building their strategies for the future.
The Economist Intelligence Unit, on behalf of BlackRock, surveyed 223 insurers with
operations in Europe. With the survey sample representing at least half of the European
market in terms of assets under management, the findings offer real insights into how

insurers are managing Solvency II’s data management requirements; the impact of capital
charges on their investment strategies, risk management and product ranges; and their
views on the future for capital markets in a post-Solvency II world.


[ 4 ]  Balancing risk, return and capital requirements

Key Findings
Asset Allocation Shifts have been
Decided but Implementation is on Hold

Allocations to Derivatives will Increase
Under Solvency II

Almost half (46%) of survey respondents say they already
know how they are likely to change their asset allocation,
with just 4% saying they have not made plans. However,
over half (53%) say they are waiting until closer to
implementation of the Directive before making changes to
their asset allocation. Most changes are as expected –
away from equities and towards corporate bonds.

Over half (60%) of survey respondents agree that the
Directive will result in greater use of derivatives to better
match assets and liabilities. While some insurers say they
are already confident in their derivative usage, as assetliability management (ALM) strategies become more
complex and demanding in volatile markets, this will be an
area on which many insurers will need to focus. Over onethird (37%) of insurers agree that Solvency II will make
them more likely to use derivatives in the future, although
only 18% currently use derivatives and just 23% have

definite plans to increase their overall holdings.

Allocations to Alternatives are set to
Increase
Some asset allocation changes are less expected.
Alternatives such as hedge funds and private equity will
benefit from Solvency II, with 32% of survey respondents
saying they will increase their allocations to these asset
classes. Just 9% and 6% respectively say they will
decrease allocations. These increases come despite the
higher capital charges for these assets, with insurers
betting that the higher charges will be worth the higher
potential returns. Almost three-quarters (70%) of survey
respondents expect their asset allocation changes to
result in higher returns.

Meeting Solvency II Data Requirements
is a Major Concern, Whilst Pillar III
Commands the Least Budget
Over 90% of survey respondents are very or somewhat
concerned about meeting the requirements for the
timeliness (96%) and completeness (94%) of data under
Solvency II, as well as the quality of data from third parties
(92%). In particular, pressure is on third parties to provide
the ‘look-through’ on pooled funds required by insurers, with
92% of respondents concerned that they will have to limit
their investment strategy as some assets demand more
rigorous data requirements. Overall, survey respondents say
they are most concerned about Pillar III, yet it is the pillar to
which they are devoting the least budget.

Insurers will Re-Examine Guaranteed
Products, Which may Become
Prohibitively Expensive
For some insurers, the Directive merely accelerates an
ongoing trend away from guaranteed products, but for
others it creates a whole new way of thinking about their
business. Two-thirds of life and composite insurer survey
respondents say they will restructure in order to better
manage their guaranteed funds in house, while almost half
(49%) of life and composite respondents say they will seek
advice on ALM. As a result, insurers will be forced to more
aggressively price their guaranteed products, which will
likely drive consumers into other cheaper but less wellprotected offerings. Annuities too will become potentially
more expensive, as insurers factor in the increased costs
of managing Solvency II market risk into pricing.

Solvency II Could Increase Market
Volatility
Just 5% of survey respondents disagree with the idea that
there will be an increase in volatility in capital markets
because of Solvency II. Insurers are also anxious about the
threat of pro-cyclicality. If capital requirements reduce when
markets are benign and increase during periods of volatility,
losses due to falls in market prices could lead to a wave of
forced selling, which could create further losses. EIOPA
plans to tackle this issue but insurers say the uncertainty
makes planning, particularly at this late stage, a challenge.

Share Prices are Likely to be Hit by
Solvency II
Less than one in 10 (9%) of survey respondents disagree
with the idea that, due to Solvency II, average share prices
will be lower as demand for equities will be lower. And
even fewer (3%) disagree that the equity risk premium will
need to increase significantly to encourage investing in
equities. However the overall supply of equities could be
lower, as only 9% do not believe that companies will favour
issuing debt rather than equity for their funding needs.

Regulators may Have to Rethink
Approach to ‘Risk-Free’ Assets
As the security of government bonds is thrown into doubt,
insurers believe the regulator may have to revisit the 0%
capital charge for sovereign debt. Insurers using their own
internal models already factor in the ‘real’ risk presented
by government debt, but organisations using the standard
model may be exposed. Planned changes to asset
allocation, such as moves from government bonds into
higher-rated corporate debt, support the view that insurers
are assessing the risk and return trade off for themselves.


About this Report
In October and November 2011, the Economist Intelligence Unit, on
behalf of BlackRock, surveyed 223 insurers with operations in Europe
to find out how they were handling the data management requirements
of Solvency II, the impact of capital charges on investment strategies
and product ranges, and their views on the future for capital markets

in a post-Solvency II world.
Respondents comprised of 75 life, 65 non-life, and 57 composite
insurers, while 26 were reinsurance companies. Responses were
collated from insurers with headquarters in all major EU countries.
Businesses were grouped by assets under management (AUM) covering
106 very large insurers with more than €25bn; 23 large insurers with
€10bn-€25bn; 68 with €1bn-€10bn; and 26 with AUM of less than €1bn.
In addition, in-depth interviews were conducted with eight experts from insurance
companies, regulators and trade bodies. Our thanks are due to the following for their
time and insight (listed alphabetically):
Anders Brix, Risk management team, Danica Pension, Denmark.
Britta Burreau, Managing Director, Nordea Life, Sweden.
Frank Eijsink, Global Program Director for Solvency II, ING Life, Netherlands.
David Johnston, Senior Implementation Manager, Financial Services Authority, UK.
Olav Jones, Deputy Director-General, CEA, European insurance and reinsurance
federation.
Isabella Mammerler, Head of European Regulatory Affairs, Swiss Re.
Carlos Montalvo, Executive Director, European Insurance and Occupational Pensions
Authority (EIOPA).
Ann Muldoon, Solvency II Director, Friends Life, UK.
The report was written by Gill Wadsworth and edited by Monica Woodley of the
Economist Intelligence Unit.


Balancing risk, return and capital requirements  [ 7 ]

Introduction
Insurers racing to meet the 2013 implementation date for
sweeping changes to solvency regulations were given a
year’s grace in the autumn of 2011, with regulators setting

a new deadline of January 2014.
Delays to the implementation of Solvency II are nothing new – and a further delay may be in
the works - but the insurance industry is unlikely to view the latest push back as much of a
reprieve in their efforts to comply with the Directive, particularly as by 2013 they will need
to demonstrate how they will meet the final legislation.
The Solvency II Directive imposes stringent new capital requirements, creating a more riskfocused approach designed to better protect policyholders from future financial crises.
The legislation is far-reaching and complex, and has forced insurers to analyse everything
from data management and risk analysis to asset allocation and product ranges.
As insurers continue with their preparations, the ongoing sovereign debt crisis has forced
regulators back into negotiations to agree on a Directive that can withstand such
unexpected changes in fortune.
Against this backdrop of uncertainty, insurers face notable challenges as they strive to
formulate a successful strategy that will stand up to the rigours of a new regulatory regime
and an unpredictable economic future.


[ 8 ]  Balancing risk, return and capital requirements

The Future for Asset Allocation
Now that insurers have the fundamental systems building
blocks in place following the first stages of preparation for
Solvency II, they are turning their attention to investment
strategies and asset allocation. However, the survey reveals
that insurers are not able to prepare to the extent that they
would like as the Directive itself is still being finalised.

What is Your Current Asset Allocation?

Corporate bonds 36%
Government bonds 28%

Cash 3%

Almost half (46%) of respondents to the survey say they
know how their asset allocations will change as a result of
Solvency II, but more than half (53%) say they will wait until
they are nearer to the final implementation date before
effecting any change. Non-life insurers are less confident
than their life counterparts as to how their future asset
allocations will look – 43% compared with 50% – and as
such are more likely to wait until Solvency II is clearer
before taking action.
David Johnston, Senior Implementation Manager at the
UK’s Financial Services Authority, explains: “Until the
Solvency II rules come into force in 2014 the current rules
still apply, so insurers are welcome to make any changes
they want in the interim, within the context of those rules.
But they might not be able to move to their ‘business-asusual post-Solvency II’ end state just yet.”
Where insurers have examined the future for their
investment strategies under the new regime, the overriding
response is to keep asset allocations the same. This is
partly explained by the already conservative asset
allocations the survey respondents report.

Property 4%
Hedge funds 1%
Derivatives 1%
Other alternatives 5%
Total equities 15%
Other assets 7%
Base: All respondents (n=223)

Source: Economist Intelligence Unit

Well before the advent of Solvency II, many insurers had
started de-risking strategies – action which has since
been accelerated by the difficult economic conditions.
Ann Muldoon, Solvency II Director at Friends Life in the
UK, says: “In the UK we already make an assessment of
risk-based capital [Individual Capital Assessment] and
provide this as a private submission to the regulator. This is
already informing our strategic asset allocation decisions.”
She adds that where Solvency II has the potential to
change the individual capital assessment, the insurer will
guide its strategic asset allocation studies accordingly.
Nearly two-thirds (64%) of the survey respondents’ total
asset allocations are to fixed income, with government
debt accounting for 28% and corporate bonds 36%.
Equities account for 15% of total portfolios, while
alternative assets including private equity, hedge funds
and derivatives amount to 7%.
In the fixed income category, just under half (49%) of
respondents plan to keep allocations to corporate bonds
the same, although one-third expect to increase
investment in this asset class. More than one-third (37%)
of life companies say they will increase allocations to
corporate bonds compared with 29% of non-life
companies. Just 18% of respondents overall say they will
decrease corporate bond allocations.


Balancing risk, return and capital requirements  [ 9 ]

While Solvency II is set to favour European Economic Area (EEA) sovereign debt with
proposed 0% capital charges, government debt allocations look likely to remain static for
48% of insurers, while 27% expect to increase and the remaining quarter will decrease.
This may be an indication that insurers expect regulators to rethink the 0% capital charge
in light of the eurozone debt crisis (which is explored further on page 30).
Many insurers operating in countries enduring the worse of the sovereign debt crisis are
cautious about the future for their own region’s government bonds. None of the
Icelandic insurers and just 7% of Italian respondents plan to increase allocations to
government bonds.
In contrast, in the Nordics where governments enjoy relatively healthy debt levels,
conditions are stable and they are outside of the eurozone, insurers say they will increase
investment in government bonds.
More than half (56%) of Swedish insurers say they will increase sovereign debt
allocations, with just over one-fifth (22%) expecting to decrease. Respondents in
Denmark tell a similar story, with half saying they will increase domestic government
bonds and just one-quarter expecting to decrease investment in this asset class.

Thinking About the Likely Effects Of Solvency II, in Light of the Regulation’s Capital
Requirements, how are Your Holdings in Government Bonds Likely to Change?
46%
39%

35%

27%

32%

28%

22%

21%
16%
7%

0%

0%

18%
25%

21%

21%
27%

29%

38%
Pan-Europe

Iberia

Nordics

Switzerland France

UK

Belgium Netherlands Germany

Holdings will decrease
Base: All respondents (n=223)
Source: Economist Intelligence Unit

36%
Italy

Holdings will increase

“Under
Solvency II
there is a
possibility that
a large number
of insurers may
be forced to
sell assets in
times of
financial stress”
Italian non-life
insurer,
AUM >€25bn


[ 10 ]  Balancing risk, return and capital requirements

The Future for Asset Allocation Continued

However Scandinavian insurers face a supply constraint when increasing their
government debt allocations as the region’s countries are small, relatively well off and do
not need to issue large amounts of bonds.
Britta Burreau, Managing Director at Nordea Life in Sweden says: “[Sweden] has a small
economy and we are already experiencing a shortage of government bonds. The long
10-year interest rates have been forced down due to huge demand and this could worsen
under Solvency II.”
Anders Brix, part of the Risk Management team at Danica Pension in Denmark, shares
Nordea’s concerns and anticipates further problems with low interest rates as a result of
Solvency II’s market-consistent economic valuation, which forces insurers to mark-tomarket assets and liabilities. “Solvency II is generally good for risk management, but we
are concerned about what can happen if or when all insurers will have to value their
liabilities at market value, since the interest rate markets may not be able to supply enough
interest rate sensitivity. This may depress interest rates further and hence create more
demand for interest rate sensitivity,” Mr Brix says.
The concern about availability of local bonds is highlighted in the survey with 55% of
Nordic insurers saying they will shift from local to global bonds, compared with an
average of 40% for all respondents.
Elsewhere in fixed income, the survey reveals an increased appetite for corporate bonds.
One-third of respondents say they will increase investment in this asset class, with life
insurers more likely to increase (37%) than non-life (29%). Just 18% of respondents
overall say they will decrease corporate bond allocations.


Balancing risk, return and capital requirements  [ 11 ]

Thinking About the Likely Effects of Solvency II, in Light of the Regulation’s Capital
Requirements, how are Your Holdings in Corporate Bonds Likely to Change?
48%
43%
37%

33%

29%

33%

33%

36%

31%

0%

13%
18%

18%

21%

18%

14%
22%

22%

21%

27%
Pan-Europe

Iberia

Nordics

Switzerland France

UK

Holdings will decrease

Belgium Netherlands Germany

Italy

Holdings will increase

Base: All respondents (n=223)
Source: Economist Intelligence Unit

Norwegian insurers exhibit the most interest in growing corporate bonds allocations.
Three-quarters say they will take this action. Italian insurers also favour company debt
under Solvency II, with more than two-fifths looking to increase investment.
The survey also highlights a shift from longer-term to shorter-term debt, as the former
will be more expensive to hold under Solvency II. Forty-four percent of respondents say
they will favour short-term debt under the Directive, with more than half of UK insurers
expecting to make this move.

[ 12 ]  Balancing risk, return and capital requirements

Return-Seeking Assets
Twice as many respondents believe that Solvency II will ‘severely hamper their ability to take
investment risk’ than those who do not. This is even more extreme among the largest
insurers, with more than three times the number saying they will be restricted versus those
who will not.

Solvency II will Severely Hamper our Ability to Take Investment Risk –
Do you Agree or Disagree? (Responses by Assets Under Management)
Insurers with >€10bn AUM

Insurers with <€10bn AUM

Agree 41%

Agree 33%

Neutral 46%

Neutral 38%

Disagree 13%

Disagree 29%

Base: All insurers with >€10bn (n=129) All insurers with <€10bn AUM (n=94)
Source: Economist Intelligence Unit

Carlos Montalvo, Executive Director of EIOPA, says Solvency II is not designed to hamper
insurers’ ability to take investment risk, but rather to ensure a direct link between the
assets in which they invest their underlying risks and the assigned capital charge.
He adds: “[Solvency II] may, therefore, have an impact on the investment policies and
products offered by some insurers, but this change is to be encouraged where it promotes
effectively managed insurance companies and improves policyholder protection.”
However, the extent to which insurers are concerned about restricted investment risk is
reflected in their expected changes in investment strategy is limited. One-third of
respondents say their investment risk budgets will increase under Solvency II, with only
15% actively disagreeing.
Looking at assets that will carry a higher capital charge, as they are considered riskier,
more than half of respondents to the survey say they will keep equity allocations the
same across all regions, although US equities are the most likely (62%) to remain static.
French and Italian insurers are the most likely to increase allocations to European
equities (37% and 39% respectively), while just over one-third (34%) of German insurers
are set to decrease allocations to stock markets in this region.
Allocations to alternatives, which also carry a high capital charge under Solvency II,
actually look likely to increase once the Directive is in place. Just under one‑third (32%)


Balancing risk, return and capital requirements  [ 13 ]

BlackRock View: Matt Botein, Managing Director, BlackRock
Alternative Investors (BAI)
The survey results show insurance companies are expecting to increase
their usage of alternative investments strategies as they look to prudently
improve diversification in their portfolios and meet their investment needs.
Their implementation process involves balancing (and optimizing) the
impact of potentially higher capital charges for certain asset classes with

the economic benefits of superior risk adjusted returns. This is even more
urgent today as the challenging market environment makes stable and
uncorrelated returns increasingly appealing.
Transparency and a greater focus on risk management are key
considerations insurers will take into account as they allocate capital to
alternative asset classes under this new regulatory regime.
Therefore, an attractive solution can be based on
diversified hedge fund strategies that meet the
disclosure and reporting requirements of Solvency II,
while being a good complement to their existing
portfolios. Also, strategies that generate transparent,
long term stable cash flows with bond like characteristics
and uncorrelated returns will be well received by
those insurance companies planning to add or
increase their allocation to alternatives.

say they will increase allocations to private equity and hedge funds, with allocations
expected to decrease at just 6% and 9% of insurers respectively. Non-life companies had
a slightly bigger appetite for hedge funds than life, with 46% saying they will increase
investment compared with 33% of their life counterparts.
In terms of assets under management, the very largest insurers (with AUM greater than
€25bn) are the most likely to increase allocations to hedge funds (36%), with 26-27% of
other insurers expecting to allocate more funds to this asset class under Solvency II.
French, Nordic and Iberian insurers are among the most likely to increase hedge fund
allocations. Italian respondents are the most likely (23%) to decrease investment in this
asset class, while Dutch insurers are the most likely (71%) to keep hedge fund allocations
the same and are also among the highest number to keep private equity static.


[ 14 ]  Balancing risk, return and capital requirements

Return-Seeking Assets Continued
Thinking About the Likely Effects of Solvency II, in Light of the Regulation’s
Capital Requirements, how are Your Holdings in Each of the Asset Classes Below
Likely to Change?
Private Equity
62%
56%

36%

32%

29%

32%

36%

38%

8%

7%

6%

UK

Belgium Netherlands Germany

27%

0%
0%

0%

5%

6%

0%

0%

18%
Pan-Europe

Iberia

Nordics Switzerland France

Holdings will decrease

Italy

Holdings will increase

Hedge Funds

55%

42%

39%
32%

33%

32%

29%

31%
22%
14%

0%
6%

9%

5%

5%

10%

11%

14%

13%
23%

Pan-Europe

Iberia

Nordics Switzerland France

UK

Belgium Netherlands Germany

Holdings will decrease
Base: All respondents (n=223)
Source: Economist Intelligence Unit

Italy

Holdings will increase


Balancing risk, return and capital requirements  [ 15 ]

Frank Eijsink, Global Program Director for Solvency II at ING Life in the Netherlands, says:
“There are two aspects to consider: the capital that you need to set aside for investing in
risky assets and the volatility of that asset price. Although hedge funds and private equity
funds have low volatility in the asset price, you do have to set aside a significant amount of

capital for those investments.”
The increase in risk budget, alongside greater allocations to alternatives, leaves
respondents confident of higher investment returns post-Solvency II. Seventy percent say
returns will either significantly (23%) or slightly (47%) increase under the new regime,
while no insurers say returns will significantly decrease.

How do you Expect the Changes to Your Asset Allocation to Affect the Overall
Returns of your Portfolio?
Returns are likely to
significantly increase

23%

Returns are likely to
slightly increase

47%

Returns are likely to
stay the same

23%

Returns are likely to
decrease slightly

6%

Returns are likely to
0%

decrease significantly
0

10

20

30

40

50

Base: All respondents (n=223)
Source: Economist Intelligence Unit
Figures do not add to 100% due to rounding

Derivatives, too, are set to gain ground in the post-Solvency II world, with more than
one‑fifth (23%) of survey respondents saying they will increase derivative usage.
However, given just 18% report current derivative investment (although we do not know
what shape that derivative investment takes, and therefore its impact on portfolios), any
rise is from a relative low starting point.


[ 16 ]  Balancing risk, return and capital requirements

Return-Seeking Assets Continued
Thinking About the Likely Effects of Solvency II, in Light of the Regulation’s Capital
Requirements, how are Your Holdings of Derivatives Likely to Change?
62%

37%
29%

27%
23%

29%

19%

19%
13%

7%

0%

3%
9%

11%

0%

5%

14%

18%

Pan-Europe

Iberia

Nordics

Switzerland

0%

France

UK

13%

Belgium Netherlands Germany

Holdings will decrease

Italy

Holdings will increase

Base: All respondents (n=223)
Source: Economist Intelligence Unit

Just 4% of respondents disagree that Solvency II will cause more insurers to use
downside protection to mitigate capital charges, explaining some of the increase in
derivative use.

Danish insurers are the most likely to increase derivative use, with 75% saying they will
invest in these instruments in the future. Italian insurers also exhibit high levels of
interest, with 62% expecting to increase derivative investment.
Where insurers are planning on increasing the use of derivatives, they will need to
demonstrate they have the appropriate systems to be able to capture the impact on the
business through their own risk and self assessment (ORSA) process under Solvency II.
Ms Muldoon of Friends Life is of the view that this poses no problem for UK firms that
have been using derivatives for many years and already have systems in place to measure
and monitor risks, such as counterparty exposure.
However, EIOPA is clear in its expectations when it comes to derivatives and all other
‘risky’ asset classes. Mr Montalvo of EOIPA says: “Insurers will be required to have effective
risk management systems enabling them to manage, inter alia, the counterparty risk
presented by an exposure to derivatives. EIOPA will work closely with national competent
authorities to ensure that the Directive is appropriately implemented and supervised.”


Balancing risk, return and capital requirements  [ 17 ]

BlackRock View: Nigel Foster, Managing Director,
Derivative Solutions Group
The findings point to a greater need for derivatives under Solvency II to
better match liabilities, provide capital guarantees and manage volatility.
This increased use of derivatives is set against a background of higher
standards of transparency and additional capital being deployed under
Solvency II. Demanding as these requirements are on their own, the
introduction of these standards comes at a point when derivative markets
as a whole are in a state of flux, thus further increasing complexity.
A new derivative market infrastructure is coming into being driven in part by
shortcomings identified in the financial crisis associated with the collapse
of Lehman Brothers and the taxpayers’ rescue of AIG. Under legislation such

as the US Dodd Frank Act derivatives are to be more closely controlled, in
particular private OTC transactions. In addition, to counter the risk of
default we have seen the introduction of mandatory standards in the form of
counterparty and collateral arrangements. All of this is new, and in addition
to the Solvency II requirements. Furthermore, the notion of default risk now
plays a part in pricing that hitherto it did not.
What this means is that Solvency II is not alone in
‘raising the bar’ for derivatives. Taken together, the
level of expertise and control required, call for a
radical rethinking of derivative capabilities and
practices. As a result, even the largest insurers will
need to choose between ‘upping their game’, dropping
out of the business lines that demand most derivative
expertise or partnering with those providers
that have the scale and resources to do the
job properly.


[ 18 ]  Balancing risk, return and capital requirements

A Demanding Data Management Regime
The comprehensive data management and governance regime imposed by Solvency II’s
third pillar has proved one of the most controversial elements of the Directive, and the
survey reveals many insurers are struggling to come to terms with the requirements.
Respondents claim high levels of readiness for all three pillars. When asked what they
thought about the structure and requirements of each of the three Pillars of the Directive,
97% say they are very well or quite well prepared for Pillar I, 95% feel the same about
Pillar II and 89% for Pillar III.

Thinking About the Structure and Requirements of the Solvency II Directive, how

Well Prepared do you Feel for Each of the Three Pillars?
Pillar 1: Capital requirements

51%

Pillar 2: Governance & Risk

41%

54%

37%

Pillar 3: Reporting
0

20

3% 1%

46%

5%

51%
40

60

11%

80

Very well prepared

Quite well prepared

Not very prepared

Not at all prepared

100

Base: All respondents (n=223)
Source: Economist Intelligence Unit
Figures do not add to 100% due to rounding

However, the confidence in preparations for Pillar III was not borne out by responses to
more detailed questions on Solvency II’s data requirements.
In spite of more than half (55%) of respondents claiming to have the necessary data to
meet the requirements of Solvency II, 97% say they are either ‘very’ or ‘somewhat
concerned’ about meeting the requirements for quality of data; 96% say they have
concerns about timeliness; and 94% say the completeness of data requirements are a
cause of anxiety.


Balancing risk, return and capital requirements  [ 19 ]

Thinking About Each of the Specific Reporting Requirements Under Pillar III,
how Concerned are you About Each of the Following Areas?
Meeting the requirements

for quality of data

34%

63%

Meeting the requirements
for completeness of data

36%

58%

Meeting the requirements
for timeliness of data

40%

55%

Data from third-parties
will not be sufficient

0

20
Very concerned

40

60

Somewhat concerned

5%

8%

54%

39%

6%

8%

46%

46%

Limiting my investment strategy
as some assets will not adequately
meet data requirements

3%

80

100

Not concerned

Base: All respondents (n=223)
Source: Economist Intelligence Unit
Figures do not add to 100% due to rounding

Among the concerns expressed by respondents to the survey, one large Swiss insurer
says: “The description and mitigation of risk exposure by risk category required under Pillar
III…this is a time-consuming process.”
At the same time, survey respondents are dedicating the smallest amounts of their
overall budgets to Pillar III, which accounts for less than one-third (30%) of resource
dedicated to Solvency II.

BlackRock View: Coenraad Vrolijk, Managing Director,
Financial Market Advisory Business & Co-Chair, BlackRock
Solvency II initiative
With slowly moving portfolios, insurers have never had to provide this level of
transparency, at such timely notice, on their assets in the past. The focus
over the past years has been very much on the science of modelling
risks. However, with deadlines drawing closer, attention
has shifted to the operational challenges of making
multiple managers across multiple jurisdictions and
multiple legal entities all report accurately, consistently
and quickly. Individual insurers who are unable to provide
the required transparency and are still operating in excel
spreadsheets may find their credibility severely
challenged across the remainder of the pillars.

“The biggest
challenge is the

development of IT
architecture,
processes and data,
[which] may be
required to gather
the necessary
information”
Spanish non-life
insurer, AUM >€25bn

“The biggest
challenge is to plan
how data will flow
from internal
reporting systems
to the regulatory
reporting system”
UK non-life insurer,
€1–10bn AUM


[ 20 ]  Balancing risk, return and capital requirements

A Demanding
Data Management Regime Continued
“Sometimes, it
is difficult for an
organisation to
obtain data that is
at the same time

appropriate,
complete, and
accurate”
Norwegian life insurer,
>€25bn AUM

What is your Overall Budget for Solvency II? How is your Budget for Solvency II
Apportioned Between each of the Three Pillars?
Overall Solvency II Spend

Share by Pillar

€0-1 mn 16%
€1-5 mn 33%
€5-10 mn 23%
€10-25 mn 14%
€25-50 mn 5%
€50-75 mn 5%
€75-100 mn 1%

Pillar I 36%

>€100 mn 1%

Pillar II 34%

Don’t know 3%

Pillar III 30%

Base: All respondents (n=223)
Source: Economist Intelligence Unit
Figures do not add to 100% due to rounding

One of the clearest examples of a mismatch between perceived readiness for Pillar III and
actual understanding of the new requirements drawn out by the survey, relates to ‘lookthrough’. Solvency II introduces ‘look-through’ across all assets classes, which forces
insurers to understand the risk of every investment they hold, even if it is a pooled
vehicle. One French survey respondent says: “I think under Solvency II the main challenge
will be on quality reporting to the individual line item in pooled investment funds.”
But only one-third of respondents are confident they understand how the relationship
between pooled fund look-through and return will be altered under Solvency II. Non‑life
insurers show below-average understanding of how look-through applies to pooled funds;
just 22% agree they know how the relationships will work. Meanwhile, just 42% of life
companies agree they understand the relationship between look-through and pooled
funds under Solvency II.
Ms Muldoon of Friends Life says: “The main areas of look-through relate to unit-linked
business and repackaged loans [asset-backed securities]. For unit-linked business,
insurers should take steps to ensure that they understand the asset mix of their external
fund links.”
The problem with the imposition of look-through lies where insurers employ fund
management providers and third parties that may be unable to deliver adequate data for
particular funds. Ninety-two percent of respondents are very or somewhat concerned
that data from third parties will be insufficient under Solvency II. The highest instances of
concern are among the very largest insurers (with more than €25bn in AUM), with 55%
saying they are very concerned, as these are most likely to employ the largest number of
third parties and use more complex investment strategies.


Balancing risk, return and capital requirements  [ 21 ]

“The current wording [in the Directive] requires a look-through approach to reporting and
solvency calculations which means that for any fund an insurer invests in - be it a credit
default obligation, mutual fund or property fund - they should be able to list all the
underlying assets one by one. Not many providers have systems that allow you to do that,
and if that rule comes in, investors may have to go direct or just invest in funds that are less
complicated to monitor,” says Mr Jones of the CEA.
Ms Burreau of Nordea Life comments: “We share these concerns and we are working with
our distributors and asset managers to improve processes, data quality and frequency.”
She adds: “You have substantial insight in your own processes but when you outsource
them you don’t have the same insight and control, so as long as certain elements of the
process are outsourced, there will still be potential risks.”
A large number (92%) of respondents say they are very or somewhat concerned that the
reporting requirements of Pillar III will limit their investment strategy as some assets will
not adequately meet data requirements. This will be a particular concern for those
insurers who have indicated they plan to increase holdings in assets such as hedge funds.
These assets are traditionally more opaque than other pooled funds but investors will
need to work with third-party providers to ensure they have a clear view of their holdings
under Solvency II.
Some large insurers have done substantial work to get their own houses in order. For
example, Danica, the Danish life insurer, says it has “a good warehouse which can support
the Pillar III requirements”, while Friends Life says it is also developing a warehouse to
meet the Solvency II demands.
While insurers have work to do to comply with Pillar III, they have dedicated significant
time and resources to meeting the Solvency II demands as a whole. Over half of
respondents have currently committed at least €5m to the project, while two respondents
had allocated budgets of over €100m.
Mr Jones of the CEA believes that insurers’ preparedness for Solvency II has been
reflected in the high level of responses to the European Insurance and Occupational
Pensions Authority (EIOPA) fifth quantitative impact study (QIS5).
Mr Jones comments: “The industry has been working extremely hard to be ready for

Solvency II and that is no mean feat. The level of participation [in QIS5] was almost 70% of
all the companies expected to fall under the scope of Solvency II. They have shown their
ability to do the calculations already and while there are other legislative requirements and
an urgent need for final methodologies and reporting requirements, insurers do feel they
are on track.”


[ 22 ]  Balancing risk, return and capital requirements

Shifting Product Ranges
As insurers plan for changes to investment strategies and data requirements as a result
of Solvency II, so too must they come to terms with how the regulations will influence
their product ranges. The Directive is designed to weed out badly designed products or
ones that fail to adequately price risk, yet at the same time this improved transparency
incentivises insurers to transfer more expensive, long-term risk back to the policyholder
– most likely not the intention of the regulator.
Less than one-fifth (18%) disagree Solvency II will force them to review their product
ranges, with life insurers more affected than non-life. Two-fifths of life insurers strongly
agree they will need to rethink their offerings, while just one-fifth of non-life feels the same.

Solvency II may Force us to Review our Product Range – do you Agree or Disagree?
34%

Pan-Europe: All Insurers

48%

39%

Life

44%

20%

Non-Life

0

12%

57%
36%

Reinsurers

14%

47%

44%

Composite

18%

20

23%

32%
40

32%
60

Agree

80
Neither

100
Disagree

Base: All respondents (n=223)
Source: Economist Intelligence Unit

The predominant concern is for life insurers offering long-term guaranteed products,
since exposure to interest-rate risk makes these products expensive, unless they can
reduce the asset liability mismatch. Just under two-thirds of life insurers say they will
restructure to better manage asset and liabilities, while nearly half (49%) say they will
seek external advice on ALM.


Balancing risk, return and capital requirements  [ 23 ]

How Will you Manage your Guaranteed Funds Business Under Solvency II?
We will re-structure to better manage assets/
liabilities of funds in-house
We will seek advice on ALM

65%
50%
22%

We will continue as we are

20%

We will increase yields

17%

We are still considering options

16%

We will outsource management of these mandates

13%

We will drop guarantees
We will close the business altogether

5%

We will look to sell this part of the business

4%

We will close to new business

3%
0

20

40

60

80

Base: All Life or Composite Insurer respondents (n=149) (Multi-code allowed)
Source: Economist Intelligence Unit

The impact of the Directive will vary between countries; in Italy, for example, many
insurers have a large number of unit-linked products or they tend to renew guarantees
periodically. As such, their market risk does not seem as high as that of insurers in the UK
or Sweden, for example, where there are long-tail annuity products or guaranteed
products that have higher capital requirements under Solvency II. Consequently, almost
two-thirds (63%) of Italian life and composite insurers say they will continue to run their
guaranteed products as they are, compared with 22% of life and composite respondents
overall. However, there may be a mismatch between the market value of the guarantees
provided on savings products and the book value at which assets are carried, and it is not
clear at this point if Solvency II will allow insurers to continue to carry assets and
liabilities at book value.
In markets where there are in-built buffers against higher capital requirements, such as
the Netherlands, insurers benefit from a reduction in interest-rate risk as guarantees are
linked to government bond indices.

However, Mr Eijsink of ING says insurers will need to develop products that offer
guarantees in a different way and see what works in their market. He points to examples
including variable annuities: “These are not popular in Europe and I am not sure the market
is ready for them yet. Insurers will have to be creative in finding several products and see
what works best by experimenting.”
In Sweden, the Directive could see solvency ratios plummet with capital requirements
rising sharply, and while the country’s insurers are generally well-funded, 44% say they
will restructure to better manage assets and liabilities, and the same number will review
their product ranges.