Following on from the crisis of 2008, the Investment Management industry has been buffeted by a raft of further regulation and oversight designed to make the industry more transparent and ensure it can face the next wave of market stress, in whatever form that might come. Solvency II is one such initiative. Of course it is directed toward Insurance. With the investment Management industry being faced with the challenges presented by the likes of Central Counterparty Clearing and updates to UCITS and MIFID regulation, it is understandable that senior management time and focus on an initiative which appears to be largely tangentially linked may have been somewhat limited. However, the impact of S2 permeates deep into the core of our industry. In this article we seek to explore some of the issues Solvency II presents from the perspective of the downstream providers to insurers – be that external fund managers, external back offices, external data providers, custodians or any other third parties who provide data to the insurers – and suggest areas on which the impacted companies should focus.
Solvency II is the new solvency directive for all EU insurers, the objective of which is to provide consumer protection for policy-holders and assess the overall solvency of insurance companies using risk based principles. It is expected to lead to greater harmonisation across financial sectors and standardisation of supervisory methods across Europe. Its goal is to provide a framework for insurers to actively manage risk based on a set of risk-based principles and it changes how they measure and manage value, capital and risk. Under current regulation investment strategy has no impact on solvency ratios; under Solvency II a capital charge will be applied to assets as well as liabilities which means that asset allocation and asset duration will now have a significant impact on capital requirements. Insurers will now have to bring detailed analysis of assets into their capital requirement calculations which previously only took liabilities into account.
The directive is based on three pillars.
Pillar 1 deals with quantitative requirements whereby insurers will be required to value their assets and liabilities, calculate their solvency ratio and from there calculate their capital requirement and assess capital adequacy. Insurers will be required to satisfy a Minimum Capital Requirement (MCR) but will also be expected to run their business in such a way as to satisfy the Solvency Capital Requirement (SCR) which is a higher requirement. A breach of the SCR will invoke regulatory investigation whereas a breach of the MCR could result in licence revocation. The capital requirement may be calculated using either the standard formula or an internally developed model which must be approved by the regulator. Assets are to be marked to market (or marked to a model where this is not possible). Liabilities are valued at a probability weighted best estimate which is then discounted and a risk margin added to calculate the technical provision.
Pillar 2 looks at the qualitative requirements and focuses on internal controls, risk management processes, governance and the supervisory review process. Insurers are expected to conduct an Own Risk and Solvency Assessment (ORSA) based on their risk profile, risk appetite and business strategy. The ORSA is submitted to the supervisor along with details of internal systems and controls which are subject to the supervisory review process. Following this review the supervisor may determine that a firm should hold additional capital against any risks not adequately covered in Pillar 1.
Pillar 3 sets out the disclosure and transparency requirements for insurers. There are both quarterly and annual requirements. Quarterly reporting is due within 6 weeks of quarter end, reducing to 4 weeks by 2015.
Currently there is a table here, how will this work on a portrait mobile device? How do we need to adapt it?
It’s the Data, Stupid
Solvency II will impact investment managers in a number of ways. Clearly there is an increased requirement for data at a security level to be provided more frequently and faster than before. The data requirements of Solvency II are huge. Not only is asset data, reference data and pricing data required on a “by security” basis but also data such as financial ratios and average dividend yields. Figures to be reported are often on a monthly basis, to be reported either quarterly or annually. However some of the averages requested are monthly averages which means that there is actually a requirement to gather the data daily, potentially impacting both cost of data and resource requirement, for example average stock loans over the month will require data to be gathered on a daily basis to calculate the average.
In addition to the data which is obtained, maintained, stored and updated automatically, there is now a requirement to report on data which may not be held systematically. ISDA and CSA terms may need to be reported on as are property and legal details such as addresses of properties as these details will feed into Pillar II requirements. Obtaining such data as a one off exercise is likely to be a burden (depending on your level of investment in such instruments). To report on this data quarterly will require processes to be carefully thought out. If data cannot be held systematically this is a major manual undertaking each quarter, not just from a reporting perspective but also with regard to ongoing data maintenance. Adequate procedures and controls must be put in place to ensure that all changes or amendments to non-system held data are captured and updated. There may also be a need for a quality assurance type role to validate any data amendments. Careful consideration will need to be given to how this is enforced and monitored.
Additionally, look-through capability to underlying instruments in collective investments is required. This covers collective investment funds, hedge funds, hedge funds of funds and structured products including LLP’s and other such vehicles. This is a challenge for internally managed funds but an even greater challenge for externally managed funds. If security level data cannot be provided by the manager itself then the fund’s custodian or back office may need to be approached. This creates an additional level of complexity and will require arms length data providers to review their existing data collection and provision processes. Once a data source has been identified for the look-through, the next challenge is delivery of the data within the required timeframes. Asset managers are likely to be required to submit Solvency II data within a week of quarter end to enable the insurer to fulfil their Pillar 1 obligations to the regulator. Within what timeframes will they require data to be provided from third parties to enable them to meet the insurers deadlines? It is also likely that not all required data will be able to be provided by the third party managers, back offices or custodians and that the holdings data provided will need to be enriched with data items such as dividend information from data vendors. This needs to be factored into the timeframes to enable all data to be delivered to the insurer on time and will inevitably lead to additional costs, certainly from data vendors and potentially from custodians and back offices.
With an increase in the amount of data required with increased frequency and in reduced timeframes for delivery, asset managers can expect not only an increased service charge from their third parties but also a need to review and renegotiate SLA’s. There may also be licensing issues with regard to publication or re-use of certain data, for example data sourced from vendors such as Bloomberg. All parties and third parties involved in any way ought not to underestimate the scale of this data exercise and should therefore start work as early as possible to give themselves time to ensure they optimise their ability to deliver to their clients.
The additional demands and cost of provision of those demands brought about by Solvency II may well result in some managers opting to exit the market. Those who implement good, efficient, transparent processes will flourish and position themselves well to gather assets and win new business from insurers both from new mandates and business that smaller managers have been unable to support due to the increased demands and associated costs of Solvency II. In order to be successful managers will need to implement robust processes and procedures to put themselves ahead of their competitors.
Whilst data provision is a large and important part of the Solvency II initiative, investment managers should not be focussing all of their attention in that direction. The new solvency requirements and valuation of assets and liabilities mean that investment decisions will now need to consider return after risk and the capital cost of risk. Additionally, asset allocation will need to take into account the risk profile of the liabilities being covered and be adjusted accordingly. Different asset types will attract different capital charges in the solvency calculations which will make certain investments less attractive as the insurers aim to keep capital charges to a minimum.
The standard SCR calculation is made up of the following categories of risk:
Credit risk / counterparty default
The front office will need to be involved in the detail of both market risk and credit/counterparty default risk.
Market risk is made up of six sub-modules which are:
Interest rate risk
Credit spread risk
Allocation to equities is likely to be lower due to higher capital charges. An “equity shock” factor is applied to the equity risk calculation – this factor is lower for “global” equities, defined as equities listed in EEA or OECD countries, than it is for “other” equities which includes emerging market equities and hedge funds. This makes global equities more attractive than the “other” category and may well invite a switch of insurer funds into countries and regions which meet the criteria.
Hedge funds and funds of funds may suffer unless they can provide sufficient transparency that their underlying holdings can be fed into another risk module (such as global equity).
Property will also attract a higher capital charge which may result in lower allocations to this asset class, potentially exacerbating already existing and well known valuation issues.
Gilts will become more attractive than corporate bonds which are subject to a higher capital charge and higher duration gilts yielding more than swaps are likely to be preferred to low duration gilts. As is to be expected, government AAA rated bonds issued by an EEA or OECD government in its local currency are the most attractive as they have the lowest capital requirement. Lower allocations are likely to be given to structured credit as it too will attract a higher capital requirement – the same goes for CDS and other credit derivatives. Given that swap curves are the basis for the basic risk-free yield curve used to discount liabilities, an increased use of swaps is expected. If this is indeed the case and swap volumes are increased, consideration will need to be given to how this may impact plans for investment managers, external managers, TPA’s and custodians for developing capability to engage with Central Counterparties (CCP’s). Higher priority may need to be given to such projects dependent on the anticipated level of use of swaps. At the same time, managers will need to investigate the costs and issues implicit in the fact that increased cash levels will be required to pay collateral calls in the CCP world as part of their ongoing projects dealing with the advent of CCP’s.
Solvency II will require a multi streamed programme of work covering risk, investment and IT infrastructure and more. Solvency II signals a fundamental shift towards a comprehensive enterprise risk management (ERM) culture within the insurance world with risk becoming an inherent part of an investment process which will now focus on risk management rather than measurement. However, the impact of the initiative will not be restricted solely to the insurers themselves. There will be considerable demands made of service providers downstream of insurers to ensure that they can make available data as and when needed. The gathering, maintenance and storage of data will need to be reviewed to ensure that accurate and complete data is held and made available in a timely fashion. Further, data architecture along the entire length of the supply chain will need to be developed with robust transmission mechanisms in between. Asset allocation is also likely to come under scrutiny with potentially fundamental changes made to the asset mix.
With so much regulatory change in the process of being loaded onto the investment managers’ world, there can be no doubt that we are all in for continued interesting times. As ever, such changes represent considerable challenges but also opportunities for those best prepared to meet them.