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Lessons to learn from Solvency II - Olav Jones - OECD-Risklab-APG Workshop on pension fund regulation and long-term investment
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Lessons to learn from Solvency II - Olav Jones - OECD-Risklab-APG Workshop on pension fund regulation and long-term investment

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This presentation by Olav Jones, Insurance Europe, was made at the OECD-Risklab-APG Workshop on pension fund regulation and long-term investment held in Amsterdam on 7 April 2014. Discussions focused …

This presentation by Olav Jones, Insurance Europe, was made at the OECD-Risklab-APG Workshop on pension fund regulation and long-term investment held in Amsterdam on 7 April 2014. Discussions focused on: long-term pension investment strategies under risk-based regulation; riskiness and procyclicality in pension asset allocation; and, regulatory challenges for long-term illiquid assets.

For more information, please visit:
http://www.oecd.org/daf/fin/private-pensions/OECD-APG-workshop-pension-fund-regulation-LTI.htm

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  • 1. Lessons to learn from Solvency II Olav Jones 7 April 2014 OECD/APG Workshop
  • 2. Good regulation is important for a healthy industry The insurance industry supports the original aims of Solvency II: Policyholder protection Transparency and high standards of risk management Harmonise regulations Support a strong and efficient European insurance industry 2 In its final form Solvency II will not be perfect. It can, however, achieve its goals but it will also have some unintended consequences on long-term products and investments
  • 3. Solvency II realised late into development how big an impact long-term liabilities can have 3 Because of long-term liabilities: 1. Insurance companies can reduce or eliminate their exposure to actual losses due to temporary falls in asset prices 2. Even if a change (eg shift to low interest rates) may be permanent, insurance companies usually have many years to address the issue
  • 4. Why this matters? Allowing insurers to continue with long-term approach is vital Policyholders Get access to products that protect them from market volatility Get additional yield available from long-term and illiquid assets For the wider economy Largest institutional investor (€8.4trn), with a long-term, patient investor perspective Stable funding for economic growth Stability and counter-cyclical role during crisis 4
  • 5. Why long-term investment can change the nature of risk For long-term investors very different from traders NOT exposed to interim changes in market value of the bonds ARE exposed to actual bond defaults These are very different: eg for portfolio of 20yr AA bonds: Value loss from 2007 to 2008 > 30% Actual defaults only < 0.4% This affects Solvency measurement in two ways: 1. Solvency Capital Requirement (SCR) set unnecessarily high 2. Available Capital will be very volatile due to market movements to which the company is not exposed – this will force companies to hold unnecessary and very large capital buffers 5
  • 6. Balance Sheet volatility if Solvency II had no long- term measures 6 Simplified insurance company – with 5, 10 & 15 year portfolios (liabilities and “AA” rated assets, perfectly cash-flow matched). We assume no change in the asset/liability profile over time
  • 7. Solvency II uses spreads as the basis for calibrating credit risk and so long duration bonds have a very high SCR 7 Long-term investment is especially impacted (1)
  • 8. Care needs to be taken when comparing business models It’s nevertheless interesting to compare how credit risk is assessed in other regimes 8 Long-term investment is especially impacted (2)
  • 9. 9 Long-term and immediate solvency problems are not the same (1) Solvency problems: can be due to current market conditions => might only be temporary the long-term nature of the business means that there may be many years to allow for solving There is a difference between: Immediate shortfalls (eg €200m due to a windstorm) Future shortfalls (eg €200m due to current low interest rates)
  • 10. 10 Long-term and immediate solvency problems are not the same (2) In this example the problem will only arise in 20 years time If interest rates rise before then the problem can reduce or disappear
  • 11. Solutions used for SII avoid the worst unintended consequences but still penalise long-term business 11 Adjustment What it is meant to achieve Matching Adjustment Recognise that in certain cases insurers can eliminate exposure to asset price volatility (but is exposed to risk of actual default) Volatility Adjustment Recognise that even where conditions for Matching Adjustment are not met, companies are not fully exposed to asset volatility Extrapolation Recognise that risk free curve needs to be extended because liabilities can be longer than available market data Transitional measures Recognise that long-term nature of business means that insurance companies both need and have time to adapt from previous regime, products and market situations to new one Extension of recovery period Give more time to deal with exceptional situations, such as falls in financial markets
  • 12. Key lessons from SII Take care with theoretical approaches – financial theory was designed for traders and has not yet been extended to take into account long-term investors – it is the outcome that matters Do not let the measures create volatility Recognise the real impact long-term liabilities have on market risk Recognise the difference between exposure to changes in credit spreads and changes in level of defaults is fundamental Be very concerned about unintended consequences 12