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The Actuary The magazine of the Institute & Faculty of Actuaries

Investment: Driving tests

In the UK a number of regulatory changes have affected the investment behaviour of various institutional investors. Regulation shouldn't necessarily be the main driver of investment strategy — other factors including governance requirements, solvency, objectives and risk appetite/tolerance of the various stakeholders will need to be considered.

However, the impact of regulation continues to be a key influence on investment decisions, leading to meaningful changes to the asset allocations of institutions. These changes alter the price and amount of funding available to companies, such as the cost of capital.

In this article I examine some of the more notable regulatory drivers on the horizon affecting pension schemes and insurance companies.

Pension schemes
In the world of defined benefit (DB) pension schemes, the demise of the minimum funding requirement (MFR) in the mid-noughties gave way to the statutory funding objective (SFO), which helped facilitate a move away from a concentration in UK equities and UK government debt to a broader strategic asset allocation, including an increased exposure to alternative assets. As pension schemes continue their move away from equities, this is set to grow further.

In addition, the growth of liability-driven investment (LDI) is set to continue. Designed to immunise the scheme funding against changes in interest rate and inflation, implementation is usually through derivatives and appropriate bonds.

The impact of the revised International Accounting Standards (IAS) 19 regulations is likely to add another nail to the equities ‘coffin'. Companies will have to use a discount rate based on AA-rated corporate bond yields rather than the expected return on the scheme's assets. This removes one of the incentives to invest in potentially higher-returning asset classes. Investment strategies with a greater sponsor influence may look to further ‘de-risk', moving more of their assets into ‘protection' assets.

In addition, the Pension Protection Fund (PPF) will, from 2012/13, start to use scheme investment risk to calculate the levy payment. Although the implications of this change shouldn't be a key driver in setting the investment strategy, in some cases it will increase the sponsor's focus in trying to minimise the levy payment.

The majority of DB schemes are now well into their journey towards the end game. However, in order to better secure members' pension benefits, the ‘de-risking' process has to be managed more effectively. Whether this means focusing on a scheme's technical provision funding basis or a more prudent ‘self-sufficiency' basis, and eventual buy-out/in of the liabilities, the need for a good governance framework is essential.

This will also increase the desire to invest in assets that are more tightly correlated to the nature of the liabilities, as well as providing some upside potential — for example, infrastructure-type assets. For those schemes with an eye towards eventual buy-in/out, they will need to be mindful of the pricing bases used by insurers. To reduce the basis risk, it is likely regulatory changes taking place in the insurance space may indirectly influence some schemes' asset allocations.

Insurance companies
In the insurance world, the impending Solvency II regulations are just around the corner. Insurers are some of the largest investors in domestic financial markets and any change in their investment behaviour could have a significant effect on the demand/supply of various asset classes, impacting the pricing and cost of capital.

Under Solvency II, capital will need to be held to reflect the short-term volatility in the market value of assets and ensure Value at Risk (VaR) over a one-year time horizon is within prescribed confidence intervals. As Solvency II places greater emphasis on asset liability modelling, any
‘mismatching' will increase the capital requirement for insurers.

The current proposed capital charges aim to reflect the price volatility of each asset class. The explicit charges vary from 49% for private equity right the way through to applying no capital charges for European Economic Area government debt. Whether the capital charges applied to the various asset classes are fair and appropriate is questionable. As of late, the sovereign debt crisis continues to grip parts of Europe, and assigning no capital charge on debt issued by sovereign countries where there are perhaps longer-term structural issues, appears counterintuitive. On the other hand, some asset classes with attractive risk/return profiles are perhaps being treated too harshly under the proposed regime.

Under Solvency II, the liability discount rate used to value the insurers' technical provisions will be ‘swaps plus a liquidity premium' (changing the perceived risk-free rate). This will be a key influence on investment strategy, leading to an increased use of derivatives — for efficient portfolio purposes — in order to better manage the balance sheet volatility.

Another important thing to note is that the liquidity premium is based on a reference index — therefore there is no dependency on the underlying assets of the insurer. Investment in other interest rate hedging tools or funds, such as long gilts, will therefore leave a basis risk. However, with no capital charge on gilts, and long gilt yields being greater than swap rates at present, retaining exposure to gilts should be attractive. Insurers may also look to invest in gilts with a view to setting up reverse repurchase agreements — they could lend the gilts to banks and capture additional yield for providing this liquidity.

Given the capital charge levels, a reduced level of investment in non-EEA debt is likely. In addition, it is expected there will be a greater exposure to short duration credit where the risk-adjusted return, allowing for any capital charge, is higher. However, investment in long-dated credit may be impeded as the capital costs and potential balance sheet volatility (basis risk) make it less attractive.

Low-equity allocations are likely to be maintained given the high capital charges of 30% for global equities (members of the Organisation for Economic Co-operation and Development or EEA) and 40% for other equities.

A ‘symmetric adjustment' will also be applied. This adjustment is designed to avoid procyclicality and will modify the stress test, up or down, by a maximum of 9%, depending on where global equity prices are trading relative to their recent average. Reduced allocation to direct property as a result of higher capital charges (25%) is also expected.

However, investment in real estate debt may be more appealing due to capital efficiency. As things stand, most alternative asset classes do not appear to have fared well under Solvency II. Deemed as ‘other equity', a 49% charge will be applied — not surprisingly a lower allocation to alternative asset classes, including private equity and hedge funds, is likely to result.

An increase in the use of financial engineering is also expected, including total return mandates. The use of swaps for duration matching, as well as changing the risk/return profile of conventional assets, will require investments to beat cash plus the illiquidity premium, so as to minimise the re-investment risk.

A further requirement will be to ‘look through' to underlying assets. The capital charges may impact decisions about efficient asset allocation. Thought should be given to how insurers using an internal model will properly capture these risks. This is likely to increase the attraction of segregated mandates, as well as more transparent investment holdings.

An investment strategy of buy and hold is likely to be less attractive under Solvency II. A move is expected towards a dynamic asset allocation and risk management framework, with increased recalibration, in order to maximise capital efficiency. Otherwise, significant capital may need to be
held against mark-to-market spread risk.

Well-capitalised insurers are expected to have greater scope for adding risk-adjusted value though their investments. However, insurers with weak capital levels may require more assistance. Across insurers, this is likely to lead to a diverse range of investment strategies. In any case, investment governance will need to be improved for all insurers to meet the challenges under Solvency II. Investment decisions will need to take account of risk-adjusted return after the capital cost of risk. This should form part of the insurer's own risk and solvency assessment and enterprise risk management framework.

Regulatory drivers will continue to play a key role in the investment strategy of both pension schemes and insurance companies, leading to changes in asset allocation and capital markets behaviour.

With the impending Solvency II legislation, governance requirements are
enshrined within the three main pillars underpinning the regulations. Investment governance and risk management will play a bigger role so that insurers maximise capital efficiency. Driven by a need for market-consistency and better transparency, it remains to be seen if all parties rise to the challenge.


Umar IlyasUmar Ilyas is a senior investment and risk actuary at Investment Solutions. The views represented in this article are the author's and not necessarily those of his employer