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Solvency II: A new fund strategy

Investment strategies of UK annuity funds are typically focused around buy-and- hold investments in the sterling credit market. This has been driven by the regulatory framework and the desire to cashflow-match long-dated liabilities.

The consequent systemic risk exposure to credit markets was highlighted by the financial crisis, particularly the exposure to financial debt, which constitutes a large proportion of the long-dated bond market. Regulatory solvency positions deteriorated; however, the effects were much more severe on a market-consistent basis, as demonstrated by our research and modelling.

The forthcoming Solvency II regime represents a fundamental change in the reserving and capital calculations for UK annuity funds. We consider some of the potential implications for annuity funds as the direction of travel for the new regime becomes clearer.

Current regulations — background
For regulatory purposes (Pillar 1), annuity liabilities are discounted using the yield on the backing assets, with a prudent risk haircut to allow for defaults. There is no requirement to hold additional capital against credit spread risk.

Like all UK insurers, annuity funds are also required to privately submit an economic balance sheet (Pillar 2/ICA) where the capital requirement is equivalent to a 99.5% one-year VaR. Pillar 2 is a principles-based regime, with liabilities typically valued at risk-free plus an allowance for a liquidity premium based on the assets held. The capital calculation typically includes a spread-widening stress for credit investments but also allows for diversification between asset classes. There will, therefore, be different considerations for a standalone annuity fund to one that is part of a diversified group.

Solvency modelling
The working party modelled the performance over 2006-09 of a typical annuity fund (£2bn), invested in the long-dated sterling credit market. The profile of the liabilities was assumed to remain constant through new business, and bonds were selected at the start of each year to match the duration of the expected (Pillar 2) liabilities. Figure 1 (below) shows the surplus emerging under Pillar 1 and Pillar 2.

Markets were stable over 2006-07, and we see little profit/loss in these years. However, there was a severe blowout in credit spreads over 2008, as can be seen in Figure 2 (below), and this caused the solvency position to deteriorate. While there was much concern raised in the media around the regulatory (i.e. Pillar 1) solvency positions at the end of 2008 (and into early 2009), the regulatory calculation did not reflect the full effect of credit spreads widening. However, significant funding holes emerged under Pillar 2.

Under Pillar 1, most of the spread-widening in the credit markets is absorbed within the liability discount rate. Pillar 1 solvency levels are affected by changes in the average default haircut across the portfolio. This can be the result of actual assumption changes or changes in the composition of the portfolio through, for example, downgrades. In 2008 we doubled the Pillar 1 haircuts.

This was the average practice seen across the industry and attracted significant industry media coverage. However, as they represented only a small proportion of the total spread, the impact on fund solvency remained relatively small.

The Pillar 2 balance sheet is typically more sensitive to spread movements and in our example the liability discount rate was assumed to be risk-free plus 50% of the spread on the bond portfolio. As spreads blew out in 2008, the Pillar 2 balance sheet was fully exposed to 50% of the spread-widening and this led to a significant deterioration in solvency. The spread-widening stress was also increased in view of the market weaknesses.

2009 saw a recovery in the credit markets in terms of spreads narrowing. However, downgrades spiked, with the average annuity portfolio suffering a single notch rating downgrade. UK annuity funds avoided crystallising losses as they were not forced sellers of bonds. While the change in portfolio ratings increased average haircuts, solvency generally improved due to spreads narrowing. This was particularly notable on the Pillar 2 balance sheet.

Solvency II
Under the current draft of Solvency II, the liability discount rate for annuities is swaps plus a liquidity premium. The liquidity premium is based on the iBoxx Sterling Corporate Index and has no dependency on the underlying assets of the annuity fund. As part of the capital requirements there is a spread-widening stress for corporate bonds, which is proportional to the duration of the assets.

Solvency II will replace Pillar 1 as the published capital calculation, but is more closely aligned to Pillar 2. Our model portfolio exhibited concerning levels of volatility on a Pillar 2 basis. If this had been the published balance sheet, an inappropriate measure would have been portrayed to analysts and annuity funds may have been forced sellers of assets.

The current investment strategy of buyand- hold credit is likely to be less attractive under Solvency II given the significant capital required to be held against mark-to-market spread risk.

Shortening credit duration
The punitive treatment of long-dated credit under Solvency II has not gone unrecognised by the annuity companies, and one strategy that has been heavily debated is that of shortening the duration of the credit portfolio. The resulting duration mismatch between the credit assets and the duration of the liabilities can be managed using interest rate swaps.

The working party modelled the performance of such a strategy where the duration of the credit portfolio was reduced by around four years to four-and-a-half years. With credit duration reduced, we would expect greater stability under Pillar 2. However, as we see in Figure 3, the dampening effect was limited in 2008. This was due to the relative under-performance of short-dated credit versus long-dated credit during the financial crisis.

Spreads on short-dated credit widened considerably more over the financial crisis than those on long-dated credit of the same rating. This was driven partly by investors being more concerned about short-term defaults than those over the long term, and partly by the large volume of short-dated subordinated debt issued by financial institutions.

This subordinated debt was structured with options for the issuer to extend the term of the debt and delay payment of both coupons and principal. During the financial crisis some issuers exercised these options, which led to widespread uncertainty around, and hence a lack of demand for, subordinated debt. As a result, credit spreads on these assets widened significantly. Consequently, shortening the credit portfolio did not have the desired effect of reducing the level of credit risk as the annuity fund moved into an underperforming section of the credit market.

Figure 3 (below) shows two bases for the Pillar 2 balance sheet. Under the swaps basis liabilities are discounted using swaps plus 25% of credit spreads, whereas under the gilts basis liabilities are discounted using gilts plus 25% of credit spreads. In 2008, swap rates at the long end dropped below gilt rates. This was a further knock to annuity funds discounting liabilities on a swaps basis, particularly if they were not holders of interest rate swaps.

This highlights the importance of the risk-free rate and its significance on investment strategy to manage balance sheet volatility. The proposed risk-free rate under Solvency II is swaps plus a liquidity premium. This discount rate does not vary between firms — even for those using an internal model — and the liquidity premium is independent of the actual assets held by the insurer.

To minimise balance sheet volatility, annuity firms will need to invest a proportion of the fund in assets that generate a liquidity premium (ie. corporate bonds) and use swaps rather than government bonds to manage duration despite swaps currently looking relatively economically expensive at long durations. To enable an orderly transition without undue impacts on investment markets, suitable transition arrangements will be key. A multiple-year timescale for full implementation is currently under discussion.

Future investment strategies
Solvency II focuses on value at risk over a one-year time horizon. The capital costs and potential balance sheet volatility associated with long-dated credit may force annuity funds to look at a wider range of asset classes. Return on capital and reducing capital volatility will be important metrics in decision-making but the desire to avoid significant reinvestment risk should not be overlooked. Long-dated assets are still likely to be favoured but funds are likely to look at other opportunities to access the liquidity/funding premium in a capital-efficient format.

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Ross Evans and Emily Penn (nee Timmis) are associate directors at RBS, John Roe is head of insurance solutions at Legal & General Investment Management and Stewart Allan is a senior manager at Lloyds. They are all members of the Profession’s impact of regulation and market turbulence on annuity fund investment strategies working party