Study on "Regulatory impact on banks' and insurers' investments"

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REGULATORY IMPACT
ON BANKS’ AND INSURERS’ INVESTMENTS
VLERICK CENTRE FOR FINANCIAL SERVICES
PART OF THE AGEAS CHAIR:
“THE ROLE OF INSURERS FINANCING THE ECONOMY”
PROF. DR. ANDRE THIBEAULT
MATHIAS WAMBEKE
SEPTEMBER 2014

We would like to extend particular thanks
to our research chair partner, Ageas, for their support.

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TABLE OF CONTENTS
Executive summary ................................................................................................................................. 2
Introduction ............................................................................................................................................ 3
1. Basel III implications for banks........................................................................................................ 5
2. Basel III impact on banks’ asset allocation.................................................................................... 10
3. Solvency I vs. Solvency II ............................................................................................................... 18
4. Solvency II impact on insurer’s asset allocation ........................................................................... 34
5. Basel III vs. Solvency II ................................................................................................................... 47
6. Differences in capital requirements for banks and insurers ......................................................... 53
Conclusion ............................................................................................................................................. 70
Annex I - Basel II vs. Basel III ................................................................................................................. 72
Annex II – List of interviewees .............................................................................................................. 79
Annex III – Product cost increase due to Basel III ................................................................................. 80
Annex IV – Solvency II capital charge calculations ................................................................................ 82
Annex V – Comparison between efficient frontier and the average life insurers’ portfolio ................ 84
Sources .................................................................................................................................................. 86
Corresponding author: mathias.wambeke@vlerick.com or mathias.wambeke@assuralia.be, Tel: 0032498134744

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EXECUTIVE SUMMARY
This report identifies how two major regulatory changes in the financial industry, Basel III and Solvency II, will impact asset allocation decisions of banks and insurers. We study the Basel III implications for banks’ asset management through interviews with lending experts, calculations of funding costs and market data on banks’ asset allocation. We furthermore construct an efficient frontier based on 15 asset indices and discuss to which extend Solvency II calibrations influence portfolio selection.
We also compare Basel III and Solvency II capital charges and measure to which extent insurers can benefit from regulatory arbitrage opportunities compared to banks for different asset classes. We find that the incentives provided by Basel III and Solvency II are largely consistent with the business model of banks and insurers. As such, Solvency II directs insurers towards long-term fixed income investments, which match the long-term liabilities of insurance companies. Basel III, on the other hand, favours investments with a shorter maturity.
As an example, we find that insurers, from a regulatory capital viewpoint, have a very clear advantage over banks for residential mortgage loans. This is especially the case for mortgages with a long maturity and mortgages with a low loan-to-value ratio.
We also find that Solvency II calibrations are advantageous compared to Basel III for other long-term loan segments, such as infrastructure loans, long-term export loans and long-term loans to public sector entities. These are granted a beneficial treatment under Solvency II, since insurers are better able to cover their interest rate risk with such long-term loans. This reduced interest rate risk leads to lower regulatory capital requirements for insurers.
We find that sovereign debt is treated favourably under both Basel III and Solvency II. Indeed, sovereign debt rated AA or higher requires no capital under Basel III. Solvency II takes this even a step further, requiring no capital for any sovereign debt exposure from the entire European Union.
The treatment of other, shorter term asset classes is often similar under both regulatory frameworks. As such, we find that capital charges for short- and medium-term corporate exposures are largely comparable under both Basel III and Solvency II. Securitised assets are an exception to this rule: capital charges for securitisations are highly unattractive for insurers compared to banks.
The transactions and partnerships between banks and insurers observed recently in financial markets often corroborate our findings on regulatory incentives provided by Basel III and Solvency II. Furthermore, we see additional potential for insurers to become active in the market for residential mortgage loans.

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INTRODUCTION
The regulatory landscape is changing for the European financial sector. On the banks’ side, the capital requirements regulation (CRR) and capital requirements directive (CRD IV) are being introduced. CRR and CRD IV implement the global Basel III framework, imposing stronger capital and liquidity requirements for banks. Insurers, on the other hand, also face changing capital requirements with the introduction of Solvency II.
These changing regulations can influence how banks and insurers compete or cooperate in certain markets. More specifically, this report studies the influence of Basel III and Solvency II on the investment behaviour of banks and insurers, respectively. We provide an overview of the Basel III framework and assess the implications for banks’ asset management decisions through interviews with lending experts, calculations of funding costs and market data on banks’ asset allocation. We also provide an overview of Solvency II regulations and verify to which extent Solvency II may affect insurers’ asset allocation. We furthermore ask whether Basel III capital requirements for certain asset classes are similar to capital requirements under Solvency II. As such, we check whether insurers may have regulatory arbitrage opportunities over banks for certain asset classes.
The first chapter analyses how Basel III affects banks’ lending activities. We find that the pricing of loans will be highly influenced by capital and liquidity requirements, even to an extent that bank may become uncompetitive for certain products. Certain banks may also face constraints in their lending capacity due to Basel III, which reinforces the trends for deleveraging and disintermediation.
The second chapter of this report identifies how specific assets classes are impacted by new Basel III requirements. We find that banks have clearly reduced their allocation towards securitisations, inter-bank loans and infrastructure loans. We show that several banks have taken steps to reduce the maturity of their portfolio of infrastructure debt. We also find evidence for disintermediation in a wide range of lending segments.
The third chapter assesses the new regulatory framework for the European insurance sector: Solvency II. We present an overview of Solvency II regulations and compare these to the previous Solvency I regime. We show that Solvency II takes into account all relevant risks related to the insurer’s investments, whereas Solvency I did not provide any risk measure for the insurer’s asset side. We also provide an overview of capital charges under the Solvency II standard formula for a range of asset classes.
The fourth chapter assesses the implications of Solvency II on the asset allocation of insurance companies. We build an efficient frontier based on 15 asset indices and calculate the market risk

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capital charges for the portfolios of this efficient frontier. We furthermore calculate the market risk capital for the portfolio of an average European life insurer and assess whether this portfolio complies with a likely budget for market risk capital.
The fifth chapter compares the Basel III and Solvency II framework, focussing on regulations for the investment side of banks and insurers. We find that Solvency II allows for a more diverse range of capital instruments and puts more emphasis on the matching of assets and liabilities. Furthermore, Solvency II is absent of any charge for liquidity risk. We also compare the specific capital charge calculation methods under Basel III and Solvency II and find that both frameworks have a very different approach in terms of diversification benefits, interest rate risk and loss absorbing capacity of liabilities.
The sixth chapter presents an overview of different asset classes and measures to which extent insurers can benefit from regulatory arbitrage opportunities compared to banks. To this end, we assess the Solvency II and Basel III capital charges for several asset classes. We find that the incentives provided by Basel III and Solvency II are largely consistent with the business model of banks and insurers, i.e. Solvency II directs insurers towards long-term fixed income investments, while Basel III favours investments with a shorter maturity.
The final chapter concludes and graphically represents the attractiveness of Basel III and Solvency II capital charges for different asset classes.

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1. BASEL III IMPLICATIONS FOR BANKS
This chapter provides an overview of different implications of Basel III on banks’ lending behaviour. This chapter is based on a theoretical review of Basel III implications and also provides outcomes of interviews with lending experts at 10 major European banks1. We start by giving a view on the influences of Basel III on loan pricing, followed by a discussion of reduced lending capacity, deleveraging and disintermediation. A detailed review of Basel III specifications can be found in Annex I.
Pricing
Basel III will considerably increase costs for a wide range of lending activities. The combined effect of capital requirements and liquidity ratios will highly influence banks’ cost of funding, which in turn will influence banks’ pricing behaviour.
Different elements in Basel III will increase the capital costs for banks’ lending activities:
- Higher capital ratios for common equity Tier 1 and Tier 1 capital
- The introduction of the capital conservation buffer, countercyclical buffer and a capital surcharge for systemically important financial institutions
- Stronger requirements for capital quality: phasing out of step-up hybrid capital previously included under Tier 1, elimination of Tier 3 capital and the deduction of several balance sheet items (e.g. goodwill, other intangibles and deferred tax assets) from CET1.
- Increased risk weights for interbank exposures and resecuritisations
Furthermore, liquidity requirements – notably the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) – influence costs through different channels:
- Increasing allocation to high quality liquid assets (e.g. government bonds or high rated corporate bonds) or increasing allocation to assets with a low required stable funding factor (i.e. high rated assets or assets with a residual maturity of less than one year). This will inevitably lower the yield of banks’ asset base.
- Increased funding from liabilities with low outflow assumptions (in order to optimise the LCR) or high available stable funding factors (in order to optimise the NSFR). Such liabilities include capital instruments, retail deposits, or generally liabilities with residual maturities of one year or more. Such liabilities are inevitably more expensive compared to e.g. short term wholesale funding.
1 Annex II presents a list of interviewees.

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Table 1 displays the funding cost increases due to Basel III for investing in a specific product, measured in basis points. This table distinguishes between the increase in capital costs (related to Basel III capital ratios, capital quality requirements and risk weights) and the increase in liquidity costs (related to the Basel III LCR and NSFR). Assumptions underlying these calculations can be found in Annex III. This table will be presented in more detail for each asset class in the next chapter.
Table 1 - Funding costs increase due to Basel III (basis points)
Asset – rating
Change capital cost
Change liquidity costs
Change total costs
Consumer loans
34.50
12.20
46.70
Residential mortgage loans
16.10
11.99
28.09
Corporate loans A
23.00
12.20
35.20
Government bonds AA or higher
0.00
0.11
0.11
Securitisations A 3 year maturity
28.75
12.20
40.95
Resecuritisations A
511.10
12.20
523.30
Table 1 indicates that the change in capital costs is the predominant component for most asset classes. Changes in liquidity costs are relatively low. This can be partly explained by the low interest rates at which banks can currently gather long-term stable funding, i.e. the cost of complying with the NSFR is relatively low.
Our interviews with 10 European banks also confirmed that pricing increased due to the combined effect of the LCR, NSFR and capital ratios introduced under Basel III. However, our interviewees noted that pricing is generally not conducted on a product basis (i.e. for individual loans) but on a relationship basis. All possible revenues (loans, payment services, bank accounts…) and all possible costs (including costs due to Basel III) are taken into account to determine the profitability of a relationship. Hence, the increased capital and liquidity costs introduced by Basel III do not necessarily have to reflect directly in higher margins for a particular loan. Our interviewees generally observe that most customers are capable of accepting higher margins, since reference rates are historically low: i.e. even though margins may increase, total (nominal) rates still remain very low.
Nevertheless, our interviews showed that, for certain lending segments, banks have become uncompetitive due to their increased funding costs. As an example, several banks also noted that large corporates can find cheaper funding through bond issuance compared to bank loans. Our interviews also revealed that the markets for long-term infrastructure loans and long-term loans to public sector entities are seeing increased competition from institutional investors. Indeed, institutional investors, such as insurers and pension funds, operate on a different cost basis compared to banks and can therefore provide a tighter pricing for certain niche lending segments.

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Basel III also introduced a non-risk based leverage ratio of 3%. Our interviews generally indicated that this leverage ratio does affect pricing behaviour since most banks have always maintained a leverage ratio above this strict minimum. The leverage ratio might nevertheless affect specific items which bear a low risk weighting but can take up a large part of a banks’ balance sheet. As such, our interviewees indicated that derivatives, securities lending and repos are highly affected by the leverage ratio.
Reduced lending capacity, deleveraging and disintermediation
Banks facing a shortfall in capital or stable funding will have to take significant mitigating steps in order to comply with Basel III requirements. Table 2 shows the evolution of CET1 shortfall and stable funding deficits as presented in the monitoring reports of the Basel Committee.
Table 2 – Capital and stable funding shortfall in Basel III monitoring reports (billions)
Monitoring exercise date
CET1 shortfall
Stable funding shortfall
30 June 2011
€518.00
€2,780.00
31 December 2011
€395.80
€2,500.00
30 June 2012
€224.20
€2,400.00
31 December 2012
€140.60
€2,000.00
30 June 2013
€85.20
(not disclosed)
Our interviews with 10 European banks have shown many possibilities of how to reduce a potential shortfall in capital or stable funding. Banks can e.g. choose to place non-core assets in bad banks, divest portfolios in non-strategic countries, reduce trading activities, increase longer term funding or issue shares. Another possible trend, advocated by many of our interviewees, is for banks to move towards an “originate and distribute” model. Indeed, many of the interviewed banks indicated that, due to funding constraints, activities such as corporate bond issuance, securitizations and co- financing agreements with institutional investors will play a more prominent role. Banks can thus leverage their knowledge in sourcing credits and can acquire RWA-free fee income instead of RWA- heavy net interest income. The next chapters will highlight for some particular asset classes and their potential of co-financing with institutional investors. Figure 1 illustrates the importance of disintermediation for credit to non-financial corporations in the Euro area. While the amount of bank loans has been declining since 2009, debt securities have continued to rise in recent years. Several interviewees noted that this trend towards bond issuance in Europe is likely to continue in the future: not only large corporates, but also mid-corp clients and in a later stage, larger SMEs might be pushed towards bonds issuance.

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This trend towards disintermediation is nevertheless highly dependent on the funding characteristics of banks. As an example, banks which have abundant access to retail deposits are generally better capable of answering all loan demands from their clients. Table 3 displays funding characteristics for banking sectors across countries.
Table 3 - Banks' funding characteristics
Source: ECB
Country
customer deposits
/ assets
Loan-to-deposit ratio
(capital + reserves)
/ assets
Belgium
60%
78%
5.74%
Germany
60%
98%
5.82%
France
48%
112%
6.39%
Netherlands
45%
121%
4.91%
United Kingdom
42%
107%
8.87%
This table, as well as our interviews with 10 European banks, show some interesting findings:
- Belgium and Germany have abundant access to cheap, long-term retail deposits. This funding base also entails that these banks can easily comply with the LCR and NSFR. Our interviews with Belgian banks even showed that, due to this access to retail deposits, banks have surplus liquidity on their balance sheet: Belgian banks do not see enough investment opportunities to put their liquidity to work. Hence, their need for disintermediation has disappeared. Our interviewees did note that, once the economy picks up again, banks may not have enough capital to absorb all the demand for loans: this could be a new pulse for disintermediation.
- In France, the UK and the Netherlands, bank cannot heavily rely on retail deposits and have to finance themselves more through e.g. short-term wholesale funding. For these banks, the LCR and NSFR can put constraints on lending activities. Disintermediation is therefore an
0
1
2
3
4
5
6
2007
2008
2009
2010
2011
2012
2013
2014
Bank loans
Securities other than shares
Figure 1 - Funding sources of Euro area non-financial corporations
Source: ECB. In trillion euros.

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important trend in these countries. The Netherlands faces additional problems due to their large amount of long-term mortgages, as depicted by the loan-to-deposit ratio of 121%.
Preliminary conclusion
Basel III is definitely not the only factor for the allocation or pricing decisions of banks seen over the past years. Other factors such as funding constraints experienced during the financial crisis, the low demand for loans in the current cycle of the economy, the strategy of certain banks to keep servicing certain customers, the potential for cross selling certain products etc. can also be important drivers of making certain allocation or pricing decisions for loans. Nevertheless, this chapter has indicated several important trends influenced by Basel III. The new regulatory framework influences pricing for a wide range of assets, even to an extent that bank may become uncompetitive for certain products. NSFR and capital requirements may put lending constraints on certain banks, which enhances the trends for deleveraging and disintermediation. The next chapters will provide details on the regulatory effects on specific asset classes.

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2. BASEL III IMPACT ON BANKS’ ASSET ALLOCATION
The previous chapter discussed banks’ higher funding costs introduced by Basel III. These higher funding costs may introduce a repricing for different lending segments, or when such a repricing is impossible, will lead to a divestment from banks of the businesses with an insufficient ROE. Banks facing a shortfall in capital or stable funding will be required to adapt their funding base, or reduce investments which consume the most capital and liquidity.
In this section, we discuss to which extent banks’ main asset classes will be affected by Basel III. Our focus is towards assets held in the banking book and not in the trading book. We consider securitisations, inter-bank loans, corporate loans, residential mortgages, long-term lending (e.g. infrastructure loans) and commercial real estate loans. This chapter is partly based on a theoretical review of Basel III. Our theoretical findings are compared with outcomes of interviews with lending experts of 10 major European banks and market data on banks’ asset allocation.
(Re)securitisations
Basel III risk weights for (re)securitisations have considerably risen compared to Basel II, as demonstrated in Annex I. Furthermore, higher capital ratios, capital quality requirements and liquidity ratios will considerably increase funding costs for holding (re)securitisations. In general, (re)securitisations require 85% of stable funding are not considered as high-quality liquid assets (HQLA). One exception are qualifying RMBS which only require 50% of stable funding and are considered to be HQLA for 75% of their value. Table 4 summarizes the increase in funding costs for (re)securitisations due to Basel III.
Table 4 - Funding costs increase for (re)securitisations due to Basel III (basis points)
Asset – rating – maturity
Risk weight
LCR factor
RSF Factor
Change capital cost
Change total costs
RMBS AAA 3 years
20%
75%
50%
9.20
9.07
18.27
RMBS AA 3 years
37.5%
75%
50%
17.25
9.07
26.32
Securitisations AAA 3 years
20%
0%
85%
9.20
12.20
21.40
Securitisations AA 3 years
37.5%
0%
85%
17.25
12.20
29.45
Securitisations A 3 years
62.5%
0%
85%
28.75
12.20
40.95
Securitisations BBB 3 years
110%
0%
85%
50.60
12.20
62.80
Securitisations BB 3 years
195%
0%
85%
89.70
12.20
101.90
Securitisations B 3 years
365%
0%
85%
167.90
12.20
180.10
Securitisations CCC 3 years
495%
0%
85%
227.70
12.20
239.90
Securitisations below CCC- 3 years
1250%
0%
85%
575.00
12.20
587.20

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Resecuritisations AAA
69%
0%
85%
31.69
12.20
43.88
Resecuritisations AA
693%
0%
85%
318.76
12.20
330.95
Resecuritisations A
1111%
0%
85%
511.10
12.20
523.30
Resecuritisations BBB or lower
1250%
0%
85%
575.00
12.20
587.20
The Basel III regulatory reforms, together with the general sub-prime considerations surrounding securitisations, have been an incentive for banks to divest such assets. This trend is likely to continue, particularly for the low rated or complex securitisation segments. On the other hand, the relative importance of plain vanilla or pass through securitisations might increase compared to the reduced attractiveness of securitisations in general. Our interviews with 10 European banks confirm these findings. All of the interviewed banks which previously invested in securitisations have considerably reduced such activities. These banks indeed confirmed that Basel III regulations are not favourable towards securitisations. Some banks still use ABS or MBS for liquidity purposes.
In line with the above reflections, a study by Fitch Ratings (2013) confirmed that securitisation exposures of European systemically important banks decreased by 29% during 2010-2012. Similarly, figure 2 shows a declining trend in the amount of outstanding securitisations in Europe.
Interbank lending
Inter-bank lending will be largely affected by the amended risk weights on financial institution exposures. Basel III introduces the so-called “asset value correlation multiplier”, which increases correlation assumptions for large financial institutions by 25%. Such correlation assumptions heavily impact risk-weighted asset calculations, and will therefore effectively discourage interbank lending. Having interbank loans on the liabilities side is also highly unattractive due the LCR calibration: interbank funding of less than 30 days bears a run-off factor of 100%.
Overall, European systemically important banks have decreased their exposures to the financial sector by 9% (see Fitch Ratings, 2013), and Basel III requirements are likely to have contributed to this reduction. Our interviews with 10 European banks largely confirm these findings: none of the banks see interbank lending as a strategic activity, and a majority of banks has materially reduced
1000
1500
2000
2500
2009
2010
2011
2012
2013
2014
Figure 2 - European outstanding securitisations
In billions. Source: AFME

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their interbank exposures. Our interviewees noted that interbank exposure of longer maturities (e.g. 6 months or more) are the most affected.
Even though repurchase agreements generally have lower risk weights compared to unsecured interbank lending, the leverage ratio introduced by Basel III might significantly reduce the potential of the repo market. After all, the leverage ratio effectively discourages lower risk exposures which take up a large part of the banks’ balance sheet. A report by Barclays (2013) indeed predicts a decline by 10 to 15% based on current leverage proposals.
Sovereign debt
High rated sovereign debt is given a beneficial treatment under Basel III. Risk weights, LCR factors as well as required stable funding (RSF) factors are inclined towards sovereign bonds. Furthermore, government bills and bonds form a substantial part of the high quality liquid assets (HQLA) required in the liquidity coverage ratio: at least 60% of HQLA needs to consist out of bank notes, central bank reserves or sovereign debt with a 0% risk weight. Table 5 provides the risk weights, LCR factors, RSF factors and funding cost increases for sovereign bonds under Basel III.
Table 5 - Funding costs increase for sovereign bonds due to Basel III (basis points)
Asset – rating
Risk weight
LCR factor
RSF Factor
Change capital cost
Change total costs
Government bonds – AA or higher
0%
100%
5%
0.00
0.11
0.11
Government bonds – A
20%
85%
15%
9.20
9.56
18.76
Government bonds – BBB
50%
0%
85%
23.00
12.20
35.20
Government bonds – BB or B
100%
0%
85%
46.00
12.20
58.20
Government bonds – below B-
150%
0%
85%
69.00
12.20
81.20
In order to comply with the stringent Basel III liquidity requirements, banks have been increasing their holdings of sovereign debt considerably over the past years. Indeed, a study by Fitch Ratings (2013) shows that European systemically important banks have increased their exposure to sovereigns by 26% over the period 2010-2012. Similarly, figure 3 shows a rising trend in government lending for euro area banks2 over the past years. Hence, these numbers clearly validate the beneficial capital and liquidity treatment of sovereign exposures under Basel III.
2 Figures 3, 4 and 7 provide aggregated investments of Monetary Financial Institutions (MFIs) excluding central banks as defined under the regulations ECB/2008/32 and ECB/2011/12.

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Our interviews with 10 major European Banks confirm the attractiveness of sovereign bonds due to their beneficial treatment under Basel III. A majority of interviewees confirmed they have increased their allocation towards sovereign exposures. One interviewee also noted that the ECB’s LTRO program provided an additional incentive to invest in sovereign debt. Nevertheless, most banks do not see sovereign debt as a strategic investment and only use such assets for their liquidity buffer.
Corporate exposures
Basel III will considerably increase the costs for holding corporate loans. Even though Basel III did not change the risk weights for corporate exposures, table 6 clearly shows that capital requirements, capital quality regulations and liquidity ratios will increase the funding costs for this asset class.
Table 6 - Funding costs increase due to Basel III/CRD IV for corporate exposures (basis points)
Asset – rating
Risk weight
LCR factor
NSFR factor
Change capital costs
Change total costs
Corporate loans – AA or higher
20%
0%
65%
9.20
11.99
21.19
Corporate loans – A
50%
0%
85%
23.00
12.20
35.20
Corporate loans – BBB or BB
100%
0%
85%
46.00
12.20
58.20
Corporate loans – below BB-
150%
0%
85%
69.00
12.20
81.20
Corporate loans – unrated
100%
0%
85%
46.00
12.20
58.20
SME loans – unrated3
57%
0%
85%
26.29
12.20
38.48
These higher funding costs can be an incentive towards disintermediation. Indeed, our interviews with 10 European banks have shown that large corporates may find cheaper funding in capital markets compared to ordinary bank loans.
Banks which are not able to secure enough capital and stable funding in order to comply with Basel III can also be pushed towards disintermediation. Our interviews with 10 European banks have
3 CRR/CRD IV Regulation (EU) No 575/2013 article 501 specifies a factor of 0.7619 (this is the so called SME "supporting factor") to be applied to capital requirements for SME loans. We assume SME loans to be weighted at 75% under the standard weight for retail exposures, not taking into account the supporting factor.
5,0%
5,5%
6,0%
6,5%
7,0%
2009
2010
2011
2012
2013
2014
Figure 3 - Government loans as a share of total lending
Source: ECB

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shown a great difference between Belgian and foreign banks in this respect. Whereas Belgian banks often have enough stable funding in order to satisfy loan demand, foreign banks often more inclined to issue bonds for their clients or to transfer loans to institutional investors. Several interviewees even see a potential for bond issues for larger SMEs.
This trend towards disintermediation is clearly reflected in the amount of corporate loans on banks’ balance sheets. A study by Fitch Ratings (2013) has indeed shown that European systemically important financial institutions reduced their corporate exposure by 9% over the years 2010-2012. Similarly, figure 4 shows a decline in loans to non-financial corporations since 2009.
Our interviews with 10 European banks generally show the strategic importance of corporate loans due to the potential of cross selling ancillary services. Interviewees generally indicate a constant or slight decrease in allocation to corporate and SME loans over the past years. Interviewees who admit a decreasing exposure point out that this is mainly due to the lower demand for loans from their clients. Indeed, ECB lending surveys show that demand for loans was particularly low over 2012-2014 (see figure 5), whereas supply credit standards (figure 6) have broadly remained at their historical average.
24,0%
24,5%
25,0%
25,5%
26,0%
26,5%
27,0%
27,5%
2009
2010
2011
2012
2013
2014
Figure 4 - Loans to non-financial corporations as a share of total bank lending
Source: ECB
-50
-40
-30
-20
-10
0
10
20
30
40
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Figure 5 - Loan demand
Measured as the difference between the share of banks reporting an increase in loan demand and the share of banks reporting a decline. Source: ECB bank lending survey
-20
0
20
40
60
80
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Figure 6 - Supply credit standards
Measurd as the difference between the share of banks reporting that credit standards have been tightened and the share of banks reporting that they have eased. Source: ECB bank lending survey

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Residential mortgages
Basel III reforms only have a minor impact on residential mortgage lending. The risk weight for mortgage loans under Basel II/Basel III is relatively low at 35%. Furthermore, under NSFR, residential mortgage loans are granted an RSF factor of only 65%. Table 7 shows that Basel III reforms do not heavily affect funding costs for residential mortgage loans. These funding costs can be further reduced through the use of covered bonds, which exist already for a long period in most jurisdictions and are allowed in Belgium under recent regulatory reforms.
Table 7 - Funding costs increase for residential mortgages due to Basel III (basis points)
Asset
Risk weight
LCR factor
RSF factor
Change capital cost
Change total costs
Residential mortgage loans
35%
0%
65%
16.10
11.99
28.09
It appears that mortgage loans are still an attractive asset class for banks: a report by Fitch Ratings (2013) has shown that exposures to residential mortgages have increased by 12% over the period 2010-2012. Similarly, figure 7 clearly shows that euro area banks have increased their holding of retail mortgage loans.
Our interviews with 10 European banks show that most banks have kept a stable or increasing allocation towards residential mortgage loans over the past years. The Belgian banks we interviewed, for example, have generally remained stable in their allocation towards residential mortgages, although they often have decreased the maturity and loan-to-value (LTV) of their portfolio. The interviewed Belgian banks note that loans with an exceptionally high maturity (30 years or more) or an LTV of 110% had an excessive credit risk and therefore are not issued anymore. The Dutch banks we interviewed have broadly decreased their allocation over the past years, often due to a lack of stable funding. Another interesting outcome of our interviews is that all banks viewed residential mortgage loans as a strategic activity, due to their potential of cross-selling other products and services.
18%
19%
20%
21%
22%
23%
24%
2009
2010
2011
2012
2013
2014
Figure 7 - Retail mortgage loans as a share of total bank lending
Source: ECB

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Long-term lending: infrastructure loans and export loans
Certain lending segments, such as infrastructure loans or long-term export loans, typically have very long maturities. Basel III particularly affects such long-term lending due to the introduction of the NSFR. This liquidity ratio asks to fund long-term lending with long-term liabilities, which are typically more expensive. Furthermore, the specific NSFR calibration is not specified yet: hence, banks who now grant long-term loans do not know exactly which liabilities will be allowed to cover such loans. This regulatory uncertainty is an additional burden for long-term lending.
Now that Basel III is being phased-in, banks rarely provide loans with a maturity longer than 10 years. Figure 8 indeed shows that the average maturity of European infrastructure loans has decreased significantly in the past decade: the maturity of loans in recent infrastructure projects is 7 years, whereas 15 year maturities were the norm in 2006-2008.
The funding costs for infrastructure loans and export financings are broadly similar to the costs presented in table 6. However, an important difference with general, shorter term corporate lending is that infrastructure loans and export loans are priced on a stand-alone basis. Indeed, our interviews with 10 European banks have shown that such loans are often one-off deals which do not provide any potential of cross-selling other products. Hence, the pricing for such loans is highly sensitive to new regulations, such as the NSFR. Our interviewees generally admit they are facing difficulties in competing with institutional investors for long-term lending, especially in the segment for long dated, fixed rated infrastructure projects with stable cash flows. Banks are on the other hand more competitive for floating rate financing, assets with construction risk, or assets with refinancing in the future.
Our interviews with 10 European banks show that a majority have reduced their allocation towards infrastructure loans. Banks also often admit that the infrastructure loans which they granted recently are of a relatively short maturity. Some Belgian banks however are facing an excess liquidity
0
5
10
15
2006
2007
2008
2009
2010
2011
2012
2013
Figure 8 - Average maturity of loans in infrastructure projects
Compiled from the Infrastructure Journal database. Average of greenfield and brownfield projects.

17
position, hence they cannot be selective in their loan policy: some interviewees therefore note that their excess liquidity forced them back into the long-term infrastructure market.
Commercial real estate loans
Commercial real estate loans are risk weighted at 100% under Basel II/Basel III. This relatively high risk weight, together with stringent liquidity requirements, induces substantially higher funding costs under Basel III, as shown in table 8.
Table 8 - Funding costs increase due to Basel III for commercial real estate (basis points)
Asset
Risk weight
LCR factor
RSF Factor
Change capital cost
Change total costs
Commercial real estate
100.0%
0%
85%
46.00
12.20
58.20
Our interviews with 10 European banks have shown that a minority of interviewees admit a lower allocation to CRE loans over the past years. However, such allocation decisions are often inspired by general risk considerations and are as such unrelated to Basel III. Indeed, our interviews have shown that market and credit factors are predominant when assessing CRE loans: the risk cost in this segment can be very important, and this often has a bigger impact than the capital and liquidity costs introduced by Basel III.
Basel III capital and liquidity requirements severely affect a wide range of lending segments. We show that securitisations, inter-bank loans, corporate loans, long-term lending and commercial real estate experience substantially higher funding costs as a consequence of Basel III. Our interviews demonstrate that banks have taken substantial mitigating actions to counter the effects of Basel III. Indeed, this report shows that banks have clearly reduced their allocation towards securitisations, inter-bank loans and infrastructure loans. Several banks have also taken steps to reduce the maturity of their portfolio of infrastructure debt. Our interviewees furthermore confirm a trend towards disintermediation for several lending segments.

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3. SOLVENCY I VS. SOLVENCY II
SOLVENCY I
The current framework on capital requirements for insurance companies, Solvency I, was introduced in 2002. The Solvency I framework amends the original insurance directives dating from 1973 and 1979. However, the overall structure of the original directives remained essentially unchanged. A summary of the capital requirements for life and non-life insurers under Solvency I can be found in table 9.
Table 9 - Solvency I capital requirements
Life insurance
Non-life insurance
The sum of:
 4% of technical provisions where the insurer runs investment risk
 1% of technical provisions of unit-linked products (i.e. technical provisions where the insurer does not run investment risk) where the management fee is settled for a period of more than 5 years
 25% of management fees for unit-linked products where the management fee is settled for a period of less than 5 years
 A charge for capital at risk (i.e. the amount payable on death less the technical provision of the life insurance policy)
o 0.1% of risk capital where the remaining term is less than 3 years
o 0.15% of risk capital where the remaining term is between 3 and 5 years
o 0.3% of risk capital where the remaining term is more than 5 years
The maximum of:
 18% of premiums under €50 million and 16% of premiums above €50 million
o Premiums for aircraft liability, liability for ships and general liability should be increased by 50 %
 26% of average claims under €35 million and 23% of average claims above €35 million
o Premiums for aircraft liability, liability for ships and general liability should be increased by 50 %
In order to obtain the Solvency I capital requirement for non-life insurers, this maximum should be multiplied by the ratio of net claims (i.e. claims after reinsurance) to gross claims (i.e. claims before reinsurance). The ratio should be at least be 50%.
Solvency I also asks insurers to set up a minimum guarantee fund as an absolute minimum level of capital. This minimum guarantee fund is set to be at a minimum of € 3 million, with some minor changes depending on the type of insurer. Given this low amount of the minimum guarantee fund, it is only relevant for the smallest European insurance companies.
Under Solvency I, investment risks are merely addressed by setting certain asset limits. These limits can apply either to the total investment portfolio or to exposures against a single counterparty. These limits are provided in table 10.

19
Table 10 - Asset limits under Solvency I
Asset class
Concentration limit
(% of gross technical provisions)
Any one piece of land or building
10
Total shares and negotiable instruments of one company
5
Total shares and debt securities not dealt in on a regulated market
10
Total unsecured loans
5
Any single unsecured loan, other than unsecured loans to financial institutions
1
Cash
3
Solvency I has been heavily criticised. The main disadvantages of Solvency I include:
 Solvency I capital requirements are essentially not risk based. There is no relationship between the riskiness of an insurer and its Solvency I capital requirements.
 The riskiness of the insurer’s investments are not taken into account for the Solvency I capital requirement. Indeed, the investment limits mentioned under table 10 are definitely not sufficient to account for market or credit risks.
 Solvency I includes some adverse incentives. Risk-reducing measures, such as increasing non-life premiums, or adding layers of prudence in the life technical provisions, result in rising capital requirements.
Solvency I is merely an update of directives dating back from the 1970s. The overall structure of the original directives remained essentially unchanged, which results in the fact that Solvency I is essentially not risk based. In the process of drafting the Solvency I requirements, it became clear that a more wide-ranging reform was required – hence Solvency II.

20
SOLVENCY II
The solvency II project has been launched in 2002 with the aim of making truly risk based solvency requirements. The current timeline specifies that the Solvency II regime will be applied as of 1 January 2016. Solvency II, just like Basel II and Basel III, is focussed around 3 pillars, as shown in table 11. The next paragraphs will focus on pillar 1 specifications.
Table 11 - Three pillar structure of Solvency II
Pillar 1: financial requirements
Pillar 2: supervisory review
Pillar 3: market discipline
 Valuation of technical provisions
 Solvency requirements: solvency capital requirement (SCR) and minimum capital requirement (MCR)
 Powers of supervisory authorities: supervisory review process (SRP)
 Governance guidelines
 Own risk and solvency assessment (ORSA)
 Disclosure requirements
Solvency capital requirement (SCR): different modules
The Solvency II capital requirement (SCR) is designed to meet all quantifiable risks on an existing portfolio plus one year’s expected new business. It is calibrated at a one year 99.5% VaR. The SCR aims for a comprehensive approach, including all relevant risks, taking into account diversification between the different risk classes. The different modules of the SCR are depicted under figure 9. Whereas Solvency I did not include capital charges for the insurers’ investment side, Solvency II now explicitly takes into account market risks. This explains the high importance of Solvency II for insurers’ investment activities.
Solvency Capital Requirement (SCR)
Adjustment for the risk absorbing effect of technical provisions and deferred taxes
Basic Solvency Capital Requirement (BSCR)
Health underwriting risk
cf. life
cf. non-life
Catastrophe
Life underwriting risk
Mortality
Longevity
Disability- morbidity
Lapse
Expense
Revision
Catastrophe
Non-life underwriting risk
Premium reserve
Lapse
Catastrophe
Counterparty default risk
Market risk
Interest rate
Equity
Property
Spread
Currency
Concentration
Intangible assets risk
Capital requirement for operational risk
Figure 9 - SCR modules and sub-modules

21
The specific stress calibrations and calculation methods used to determine the amount of the solvency capital requirement (SCR) are detailed under table 12.
Table 12 - SCR calculation methods
Risk module
Sub-module
Methodology for calculating SCR
Operational risk
Operational risk
Factor * premiums or factor * reserves. This amount is capped at 30% of the basic SCR. 25% of expenses related to unit-linked products are added.
Intangible asset risk
Intangible assets
80% of the value of intangible assets
Market risk
Interest rate
Maximum loss due to upward and downward interest rate shocks
Equity
39% decrease in value for equities listed in regulated markets of the EEA or the OECD. 22% decrease in strategic participations. 49% decrease in other equity exposures. Subject to a “symmetric adjustment”
Property
25% decrease in the value of land, buildings and immovable-property rights
Currency
Maximum loss due to a 25% upward and downward shock in foreign exchange rates
Spread
Market value * duration * shock factor, depending on the rating of the fixed income instrument
Concentration
Adjustment to address the risk regarding the accumulation of exposures with the same counterparty
Counterparty default risk
Counterparty default
This module covers risk-mitigating contracts, receivables from intermediaries, as well as any other credit exposures which are not covered in the spread risk sub-module. Different approach for rated and unrated counterparties. Calculations are based on shocks in LGD and PD.
Life risk
Mortality
Loss due to a 15% increase in mortality rates
Longevity
Loss due to a 20% decrease in mortality rates
Disability-morbidity
Loss due to a 35% increase in disability and morbidity rates in next year, 25% in the year afterwards; 20% for all years thereafter
Lapse
Maximum of 50% increase and decrease of lapse rates and a mass lapse shock of 40% (retail), 70% (non- retail)
Expense
Loss due to a 10% increase in expenses and a 1% increase in inflation rates used for the calculation of technical provisions
Revision
Loss due to a 3% increase in annual annuity payments
Catastrophe
Loss due to a 0.15 percentage point increase of mortality rates in next year
Non-life risk
Premium and reserve
Premium * factor plus reserves * factor, different factors per line of business
Lapse
Loss due to a 40% discontinuance of insurance policies and a 40 % decrease of future insurance contracts

22
Catastrophe
Losses due to natural catastrophes, man-made catastrophes and other non-life catastrophes
Health risk
Health similar to life techniques
Similar to life calculation methods, with different factors for disability-morbidity and lapse risk
Health non-similar to life techniques
Similar to non-life calculation methods, with different factors for premium and reserve risk
Catastrophe
Losses for mass accidents, accident concentrations and pandemic events, calculated by ratio of people affected * amounts insured
An insurance company can choose whether to calculate the SCR through the standard formula, i.e. using calculation methods detailed under table 12, or whether to develop its own internal model reflecting the specific risks the insurance company faces. If the insurer wishes to develop its own internal model, it needs to gain approval from the supervisor.
As an illustration, figures 10 and 11 provide insight into the relative importance of the risk modules and sub-modules of Solvency II. Figure 10 clearly shows that market risks are predominant in the calculation of the Basic Solvency Capital Requirement (BSCR). Figure 10 furthermore demonstrates the importance of diversification and the loss absorbing capacity of technical provisions and DTA in order to reduce the SCR. Figure 11 shows that the biggest components of market risk are spread risk, equity risk and interest rate risk. Figure 11 also demonstrates the importance of diversification benefits in order to reduce the market risk charge.
113%
149%
100%
8%
34%
10%
31%
46%
0%
10%
60%
3%
0%
50%
100%
150%
200%
250%
Figure 10 - BSCR structure
Group structure. Source: QIS 5. "Adj TP & DTA" stands for the loss absorbing capacity of technical provisions and deferred tax assets

23
Minimum capital requirement (MCR)
Besides the SCR, the Solvency II framework also specifies a Minimum Capital Requirement (MCR). The MCR indicates an absolute minimum level of capital. If the available capital drops below this threshold, supervisors are likely to intervene firmly. The MCR is calculated taking into account the following steps:
- Life risk: technical provisions or capital at risk times a certain factor, depending on the line of business
- Non-life risk: technical provisions or premium times a certain factor, depending on the line of business
- The MCR must be minimum 25% and maximum 45% of the SCR
- The MCR must be minimum €2.2 million for non-life insurers and €3.2 million for life insurers.
The reason why Solvency II has introduced the SCR as well as the MCR is to enable the so-called “supervisory ladder of intervention”. If an insurer’s own-funds fall below the SCR, then supervisors are required to take action in order to restore the insurer’s own-funds back to the SCR as soon as possible. If, however, the financial health of the insurer continues to deteriorate, then the level of supervisory intervention will be progressively intensified. The breach of the MCR triggers a very strict recovery plan, which, if not complied with, will result in the insurance company being closed down. Hence, the insurer's liabilities will be transferred to another insurance company and the license of the insurer will be withdrawn.
21%
100%
37%
15%
45%
14%
5%
37%
0%
20%
40%
60%
80%
100%
120%
140%
160%
Figure 11 - Market risk structure
Group structure. Source: QIS5.

24
Capital instruments and their importance
The Solvency II framework divides capital instruments into “basic own-funds” and “ancillary own- funds”. Basic own-funds are subdivided into Tier 1, Tier 2 and Tier 3 basic own-funds. Ancillary own- funds are subdivided into Tier 2 and Tier 3 ancillary own-funds.
The three basic own-fund tiers may include the following Items:
- ordinary share capital and the related share premium account
- initial funds and members' contributions
- subordinated mutual member accounts
- preference shares and the related share premium account
- subordinated liabilities
For a basic own-fund item to be included in a specific tier, it has to comply with the specific requirements of that tier in terms of subordination, duration, discretion over distributions and absence of encumbrances, among others. Other important differences between the basic own-fund tiers include the following:
- Tier 1 basic own-fund items need to be paid in
- Tier 2 basic own-fund items include called upon but unpaid items
- Tier 3 basic own-funds include any capital item which do not comply with the requirements for Tier 1 or Tier 2
- Tier 3 basic own-funds particularly include deferred tax assets
- Tier 1 basic own-funds particularly include a reconciliation reserve. This reconciliation reserve demonstrates the effect of moving from the accounting balance sheet to the Solvency II balance sheet. It ensures that the basic own-funds can be reconciled back to the excess of assets over liabilities. An important part of the reconciliation reserve are the expected profits included in future premiums (EPIFP). These EPIFP result from the inclusion in technical provisions of premiums on existing (in-force) business that will be received in the future, but that have not yet been received.
Tier 1 basic own-funds are further subdivided into:
- Tier 1 unrestricted basic own-funds, including ordinary share capital and the related share premium account, initial funds and members' contributions and the reconciliation reserve
- Tier 1 restricted basic own-funds, including subordinated mutual member accounts, preference shares and the related share premium account and subordinated liabilities
Table 13 details the composition of basic own-funds of European insurers:

25
Table 13 - Composition of basic own-funds
Solo undertakings. Source: QIS 5.
Basic own-fund instrument
%
Ordinary share capital (net of own shares)
14.07%
The initial fund (less item of the same type held)
1.26%
Share premium account
13.14%
Retained earnings including profits from the year net of foreseeable dividends
25.53%
Other reserves from accounting balance sheet
12.06%
Reconciliation reserve
11.62%
Surplus funds
7.26%
Expected profit in future premiums
8.87%
Preference shares
0.10%
Subordinated liabilities
5.05%
Subordinated mutual member accounts
0.03%
Other items not specified above
1.01%
Besides basic own-funds, Solvency II also allows insurers to include capital instruments called “ancillary own-funds”. These ancillary own-funds are subdivided into Tier 2 and Tier 3 ancillary own- funds. Definitions of these own-fund tranches are given under table 14.
Table 14 - Ancillary own-funds
Tier 2 ancillary own-funds
Items of capital other than basic own-funds which can be called up to absorb losses. Includes items such as unpaid share capital that has not been called up, letters of credit or guarantees, or any other legally binding commitments received by insurance and reinsurance undertakings. These items are subject to prior supervisory approval.
Items or arrangements which currently exist but which do not count towards the available solvency margin, subject to supervisory approval.
Table 15 details the composition of ancillary own-funds of European insurers:
Table 15 - Composition of ancillary own-funds
Ancillary own-fund instruments
Tier 2
Tier 3
Unpaid share capital or initial fund that has not been paid up
8.56%
0.63%
Letters of credit and guarantees held in trust
70.32%
0.00%
of which letters of credit
65.98%
0.00%
of which guarantees held in trust
4.34%
0.00%
Mutual calls for supplementary contributions
9.34%
0.53%
Mutual calls for supplementary contributions
8.61%
0.07%
Other items currently eligible to meet requirements under Solvency I
0.01%
1.95%
Total ancillary own-funds
96.83%
3.17%

26
In order to ensure a sufficient quality of capital, Solvency II sets limits to the different own-fund tiers, as detailed under table 16:
Table 16 - Solvency II weights of capital tiers
Own-funds item
Limit
Tier 1 basic own-funds
≥ 50% of the SCR
Tier 1 restricted own-funds
< 20% of all Tier 1 items
Tier 2 & 3 basic own-funds
+ Tier 2 &3 ancillary own-funds
< 50% of the SCR
+ Tier 3 ancillary own-funds
< 15% of the SCR
Table 17 shows the relative shares of the different own-fund tiers for European insurers:
Table 17 - Structure of available own-funds
Own-fund tier
%
Tier 1 unrestricted
91.94%
Tier 1 restricted
0.72%
4.22%
1.25%
1.85%
0.02%
Total Tier 1
92.66%
Total Tier 2
5.48%
Total Tier 3
1.86%
Capital requirements for assets
The following elements of Solvency II have to be taken into account when calculating capital requirements for insurers’ investment activities:
- Stress calibrations: the calculation of the SCR for a particular investment starts from the spread shock, property shock or equity shock detailed in the Solvency II technical specifications. We also denote these shocks as the “stand-alone” capital requirement. Some examples of these stand-alone SCR calibrations for different asset classes can be found in the second column of table 20.
- Interest rate risk: Solvency II asks insurance companies to hold capital against interest rate risks. The interest rate risk sub-module of Solvency II is designed to account for changes in both assets and liabilities when an interest rate shock occurs. As such, the interest rate risk sub-module demands to hold more capital when assets and liabilities are not properly matched, i.e. when the duration of assets is different from the duration of liabilities. As life

27
insurers face long-term liabilities, the interest rate risk sub-module of Solvency II will impose higher capital charges for life insurers when they invest in assets with a shorter duration.
- Diversification: Solvency II explicitly takes into account different types of diversification benefits when aggregating capital charges: (1) diversification within the same risk class and business line; (2) diversification within a risk class and across business lines; (3) diversification across risk classes; and (4) diversification at a group level. As an example, table 18 provides the correlation coefficients across risk classes under Solvency II.
Table 18 - Solvency II correlation factors across risk classes
Correlation coefficients
Market risk
Life underwriting
Health underwriting
Non-life underwriting
Market risk
1
0.25
1
Life underwriting
0.25
0.25
1
Health underwriting
0.25
0.25
0.25
1
Non-life underwriting
0.25
0.5
0
0
1
The table 19 shows correlation coefficients across risk classes for the market risk module under Solvency II.
Table 19 - Solvency II correlation coefficients across market risk sub-classes
Correlation coefficients
Interest
Equity
Property
Spread
Currency
Concentration
Interest rate risk
1
Equity risk
0 – 0.5
1
Property risk
0 – 0.5
0.75
1
Spread risk
0 – 0.5
0.75
0.5
1
Currency risk
0.25
0.25
0.25
0.25
1
Concentration risk
0
0
0
0
0
1
- Loss absorbing capacity: Solvency II accounts for the loss absorbing capacity of technical provisions (TP) and deferred tax assets (DTA). This means that under Solvency II, overall capital requirements are reduced because the insurer can reduce payments of discretionary benefits (loss absorbing capacity of technical provisions) or because the insurer has to pay less tax than initially expected (loss absorbing capacity of deferred taxes) after an adverse event. The fifth quantitative impact study (QIS5) has shown that the loss absorbing capacity of technical provisions and deferred taxes results in an average reduction of 40% in solvency capital requirements (see figure 10).

28
By taking into account all the above considerations (stress calibrations, interest rate risk, diversification benefits, the loss absorbing capacity of TP and DTA) we obtain the so-called “all-in capital charge”. The full range of assumptions behind our calculation of this all-in capital charge is largely based on a recent report by EIOPA (2013). EIOPA modelled the investment portfolio and balance sheet of an average European life insurance company, for which the incremental change in SCR is calculated resulting from a small shift from cash into other assets. As such, EIOPA’s model takes into account diversification, loss absorbing capacity and the matching of assets and liabilities (i.e. interest rate risk). We use this model as a basis for our own calculations, and we try to improve this model by adapting EIOPA’s method of calculating capital charges for interest rate risk. The full range of assumptions behind our calculations can be found in Annex IV.
Table 20 provides an overview of solvency capital requirements for different asset classes. The column “Solvency II all-in capital charge” provides the capital requirement for making a certain investment, taking into account diversification benefits, loss absorbing capacity, and the matching of assets and liabilities (i.e. interest rate risk). These capital charges can be compared to the “stand- alone” Solvency II capital charge. The latter is merely based on the spread risk, equity risk, property risk or counterparty default modules of Solvency II.
Table 20 - The solvency II capital requirement (SCR) for different assets
Asset class – rating – duration
Solvency II stand- alone capital charge
Solvency II all- in capital charge
Corporate debt A 3 years
4.2%
3.73%
7.0%
4.25%
10.5%
3.86%
13.0%
3.00%
Corporate debt BB 3 years
13.5%
8.27%
22.5%
11.84%
35.0%
15.90%
EU Government debt A 10 years
0.0%
-2.10%
Non-EU Government debt A 10 years
8.4%
2.84%
Residential mortgage loan
10 years, 80% LTV
0%
-2.10%
15 years, 80% LTV
0%
-5.58%
10 years, 100% LTV
3%
-0.95%
15 years, 100% LTV
3%
-4.44%
Covered bond AAA 5 years
3.5%
2.55%

29
Covered bonds AA 5 years
4.50%
3.03%
Type 1 securitisation AA 3 years
12.6%
7.83%
Type 1 securitisation A 3 years
22.2%
12.53%
Type 2 securitisation AA 3 years
40.2%
21.40%
Type 2 securitisation A 3 years
49.8%
26.16%
Resecuritisation AA 2 years
80.0%
41.64%
Real estate
25%
13.90%
Type 1 equity (i.e. equity listed in regulated markets of EEA or OECD member states)
39.0%
23.37%
Type 2 equity (i.e. equities other than type 1 such as private equity, hedge funds, commodities)
49.0%
28.64%
Table 20 shows how the stand-alone capital charges for fixed income investments rise considerably for longer durations. The all-in capital charges, however, are not necessarily higher for long-dated fixed income compared to short-dated exposures: the beneficial effects of asset-liability matching induce a lower interest rate risk charge, which also leads to a relatively low all-in capital charge. Table 20 also shows a remarkably low 0% stand-alone capital charge for EU government bonds. Due to diversification benefits and a reduced interest rate risk, the all-in capital charge for EU government bonds can even become negative. Table 20 also illustrates the generally very low capital charges for residential mortgage loans.
Table 20 furthermore demonstrates the generally very high capital charges for securitisations. Solvency II has recently introduced a different approach for “Type 1” and Type 2” securitisations, where the former have to comply with stringent requirements based on the quality of the underlying assets, underwriting processes, structural features, rating, seniority, listing and transparency for investors, among others. This higher quality of type 1 securitisations also leads to lower capital requirements under Solvency II.
Some limitations with respect to our calculations in table 20 have to be noted:
- Our calculations are based on the standard models of Solvency II, while larger insurers are likely to use an internal model. The use of internal models can have beneficial effects on solvency capital requirements: QIS5 has shown that the median (mean) SCR calculated via internal models is 91% (99%) of the equivalent SCR derived from the standard formula.
- Our calculations assume a 100% SCR for insurers. However, insurers are likely to target a higher capital than this minimum imposed by Solvency II.
- Solvency II requires significant amounts of capital for underwriting activities in addition to capital for asset risks. One could argue that a charge for underwriting risks needs to be taken into account when assessing the overall capital requirement for insurers’ investments. However, we have decided to only take into account market risk and counterparty default

30
risk when calculating the capital requirement for insurers’ investments. We advocate an imaginary separation of the investment side and underwriting side of an insurer: the investment side bears the capital charges for market risk and counterparty default risk, and is allocated all investment profits above the risk-free rate. The underwriting side bears the capital charge for all other risk modules (life, non-life, and health underwriting risk) and is allocated the underwriting income, added to the risk-free rate as an investment return for remunerating its policyholders. This approach is similar to the case study of Doff (2006).
Valuation of assets and liabilities
The valuation methods for assets and liabilities under Solvency II are based on fair value and are largely in line with IFRS Phase II. Figure 12 illustrates the most important valuation practices under Solvency II.
The risk-free rate used to calculate the best estimate of technical provisions is the swap rate, corrected for credit risk. This adjustment for credit risk is subject to a floor of 10 bps and a cap of 35 bps.
It is widely recognised in academic literature that asset prices are more volatile than implied by their default rates. Multiple publications4 furthermore demonstrate that interest rates do not only remunerate for credit risk, but also include an (often considerable) remuneration for illiquidity: the so-called “illiquidity premium”. As insurers are typically long-term investors, they are not affected by
4 A good overview is given by Moody’s Analytics (2014), Illiquid Assets and Capital-Driven Investment Strategies.
Best
estimate
of
technical
provisions
Risk margin
SCR
Fair value
of assets
Available
own-funds
Surplus
Assets
Liabilities
Capital
requirements
Figure 12 - Valuation under Solvency II
Assets are assigned their market value or, when market values are unavailable, are "marked to model"
Present value of expected liability cash flows, including the value of embedded options and guarantees, discounted using the relevant risk-free rate.
A risk margin, or market value margin is added for non-hedgeable technical provisions. This risk margin is calculated by cost of capital method. Hence, current and future capital requirements are calculated for the run-off of non-hedgeable technical provisions. The present value of these capital requirements is then calculated. The "risk margin" is then calculated by multiplying this present value by the cost- of-capital rate (6%).

31
the artificial volatility or illiquidity premiums inherent in market prices. These considerations are recognised under Solvency II: in order to correct for this excess volatility and/or illiquidity premium inherent in market prices, liabilities are discounted with an additional factor. As such, the risk-free rate, used to value liabilities, is corrected with either a “volatility adjustment” or a “matching adjustment”. Both are detailed in the paragraphs below.
Volatility adjustment
The volatility adjustment allows insurers to increase the risk-free interest rate used to value liabilities. The volatility adjustment is calculated by EIOPA based on a notional portfolio representing an insurer’s typical portfolio of assets. It is calibrated to 65% of the portion of the spread of this reference portfolio that is not attributable to "a realistic assessment of expected losses or unexpected credit or other risk of the assets".
The volatility adjustment, calculated by EIOPA for year-end 2013, equals 22 bps for a euro portfolio. A historical overview of volatility adjustments is given under table 21.
Table 21 - Volatility adjustment (bps) under the LTGA specifications
Note: this table is based on LTGA calibrations, i.e. calculated using a 20% risk-corrected spread, not the 65% risk-corrected spread as specified in the Omnibus II directive.
Year
Volatility adjustment (bps)
2004
1
2009
6
2011
25
2012
13
The volatility adjustment may be increased for certain euro zone countries when this country faces a significantly higher risk-corrected spread. At year-end 2013, EIOPA specified a higher volatility adjustment for five euro zone countries:
Table 22 - Volatility adjustments (bps) at year-end 2013
Eurozone standard volatility adjustment:
22
National adjustments:
Cyprus
Greece
Italy
Latvia
Slovenia
137
72
47
64
51
Insurers are not required to hold any specific assets in order to be allowed to apply the volatility adjustment. However, the effectiveness of the volatility adjustment may diminish when the assets actually held by the insurer differ from the assets in the reference portfolio calculated by EIOPA. In addition, the insurance industry has raised questions about the relatively low volatility adjustments calculated by EIOPA for year-end 2013. A joint letter by Insurance Europe, the CFO Forum and CRO

32
Forum5 states: “The volatility adjustment at the end of 2013 would be around 15 bps lower than industry estimations based on the latest draft for Delegated Acts. Additionally, against our expectations, national adjustments in a period of time where sovereign debt is still under stress were only to be applied in Italy and Greece and even in those cases, to a very limited degree.”
Matching adjustment
The matching adjustment is an adjustment to the risk-free rate used to value predictable liabilities. The matching adjustment is equal to the spread over the risk-free rate on assets admissible to back these predictable liabilities, less an estimate of the costs of default and downgrade of these backing assets. Contrary to the volatility adjustment, the matching adjustment is company specific and is calculated by the insurance undertaking itself. The matching adjustment cannot be used together with the volatility adjustment. The size of the matching adjustment depends on:
- the type of insurance obligations
- the assets held against these insurance obligations
- the degree of matching.
The size of the matching adjustment is capped at 70% of the spread on EEA sovereign debt and 65% of the spread on other debt. The portfolio of backing assets must comply with various requirements in order for an insurance company to be allowed to apply the matching adjustment:
- the portfolio consists of bonds and other assets with similar cash-flow characteristics
- the expected cash-flows of the assigned portfolio replicate the expected cash-flows of the portfolio of insurance or reinsurance obligations
- the cash-flows of the portfolio of assets are fixed and cannot be changed by the issuers of the assets or any third parties.
In addition, the underlying insurance obligations also have to comply with a series of stringent requirements in order to be eligible for the matching adjustment. This however makes the matching adjustment impractical for most insurance undertakings. Figure 13 shows that the matching adjustment can only be applied for specific annuity products in some specific countries. Even though the matching adjustment, from a theoretical viewpoint, could incentivise long-term investing by life insurers, figure 13 shows that, due to the limited applicability of the matching adjustment, it is unlikely to influence insurers’ investment decisions.
5 See Joint Insurance Europe, CFO and CRO Forum letter on Solvency II –Volatility adjustment,
http://www.insuranceeurope.eu/uploads/Modules/Publications/joint-letter-on-volatility-adjustement.pdf

33
Solvency II has introduced major changes in the regulation of the European insurance sector. The main innovations of Solvency II include among others the three-pillar structure, risk-based supervision, the possibility for insurers to choose between standard approaches and internal models, and an increasing reliance on fair value. Solvency II also includes two adjustments to the risk-free rate used to value liabilities: the volatility adjustment and the matching adjustment. These two measures recognise that insurers are less exposed to short-term market volatility and illiquidity discounts related to asset pricing. Whereas Solvency I did not require any capital for insurers’ investment activities, Solvency II now imposes specific capital charges for a wide range of asset classes. This makes Solvency II a highly relevant topic for insurers’ asset management. The next chapter discusses the asset allocation implications of Solvency II.
0%
5%
10%
15%
20%
25%
30%
35%
UK
Spain
Netherlands
Denmark
Portugal
Belgium
Figure 13 - Percentage of technical provisions eligible for the matching adjustment at year-end 2011
Source: QIS 5

34
4. SOLVENCY II IMPACT ON INSURER’S ASSET ALLOCATION
This chapter aims to test the impact of Solvency II on an insurance company’s asset allocation. We first attempt to build a set of portfolios with optimal risk-return characteristics, the so-called “efficient frontier”. This chapter then describes the capital charges for these efficient portfolios under the Solvency II standard formula. We furthermore compare and analyse these capital charges with respect to a likely budget for market risk. We thus can determine whether the Solvency II standard formula impedes or enhances an efficient asset allocation. This chapter ends with a discussion of the asset allocation of an average European life insurer. We calculate the solvency capital requirement for the portfolio of this average life insurer and determine whether it complies with a conventional budget for market risk. We also compare the portfolio of an average life insurer to the efficient portfolios calculated in this chapter.
Inputs for constructing the efficient frontier
We choose the indices included in our efficient frontier to be similar to the indices described in the Solvency II calibration paper of CEIOPS (2010). We gather monthly return data for the period January 1996 – July 2014 from Bloomberg. All indices are total return indices. We calculated the geometric mean of monthly returns and the corresponding standard deviations. The different indices and their risk-return characteristics are depicted in table 23. All indices are denominated in Euro. In order to proxy for money market fund returns, we use the Euribor, or, prior the the introduction of the Euro, the German Fibor. We do not include an equity index corresponding to the “type 1 equity” Solvency II calibration, since the most relevant equity index (MSCI total return) appears to be dominated, under the period considered, by the MSCI EM BRIC Local index and fixed income indices. We have chosen not to include illiquid assets such as infrastructure loans, export loans or residential mortgage loans due to a lack of sufficient data on risk-return characteristics.
A caveat with respect to the IPD total return index is that it is based on appraised values rather than actual sales transactions. This leads to a degree of smoothing within the index data, as appraisal values tend to be backward-looking, depending on previous valuation prices as part of the current reported price. Therefore, in order to obtain a correct standard deviation of the IPD returns, we “de- smooth” the return data, using the same approach as described in the QIS 3 calibration paper of CEIOPS (2007).

35
Table 23 - Descriptive statistics of asset classes
Asset – rating - maturity
Full name (code)
Monthly return
Standard deviation of monthly returns
Money market (Euribor)
FIBOR DEM 1 Month (FD0001M Index)
0.2055%
0.1212%
Corporate bonds AA 1-5 years
The BofA Merrill Lynch 1-5 Year AA Euro Corporate Index ( ER2V)
0.3642%
0.5468%
Corporate bonds A 1-5 years
The BofA Merrill Lynch 1-5 Year Single-A Euro Corporate Index ( ER3V)
0.3673%
0.7074%
Corporate bonds BBB 1-5 years
The BofA Merrill Lynch 1-5 Year BBB Euro Corporate Index ( ER4V)
0.4124%
0.8722%
Government bonds 1-5 years
The BofA Merrill Lynch 1-5 Year Euro Government Index ( EG0V)
0.3696%
0.5752%
The BofA Merrill Lynch 5-10 Year Euro Government Index ( EG06)
0.5254%
1.2566%
Government bonds 10+ years
The BofA Merrill Lynch 10+ Year Euro Government Index ( EG09)
0.6407%
2.0792%
The BofA Merrill Lynch 15+ Year Euro Government Index ( EG08)
0.6467%
2.2986%
The BofA Merrill Lynch 20+ Year Euro Government Index ( EG0Y)
0.6504%
2.4415%
Securitised/collateralized assets
The BofA Merrill Lynch Euro Non-Periphery Securitized / Collateralized Index ( ELAX)
0.4089%
0.7109%
Covered bonds 1-5 years
The BofA Merrill Lynch 1-5 Year AAA Euro Covered Bond Index ( EC1V)
0.3480%
0.5267%
The BofA Merrill Lynch 5-10 Year Euro Pfandbrief Index ( EP06)
0.5015%
1.0606%
Covered bonds 10+ years
The BofA Merrill Lynch 10+ Year Euro Covered Bond Index ( ECVH)
0.5967%
1.9283%
Property
UK IPD Total Return All Proper (IPDMPROP Index)
0.6833%
3.6811%
Equity emerging markets
MSCI EM BRIC Local (MSELBRIC Index)
0.8410%
7.3241%

36
The efficient frontier
In order to calculate the efficient portfolios composing the efficient frontier, we solve the following, well-known optimization problem:
(Minimise the portfolio variance. w is the vector of portfolio weights and Σ is the variance-covariance matrix)
Subject to
(The portfolio return must equal the target return, μ. M is a vector of average asset returns)
(The portfolio weights must sum up to 1)
(No short-selling)
(The weights of corporate bonds, covered bonds, government bonds, securitisations and property investments must remain under 20% in order to avoid asset concentrations)
55 efficient portfolios were constructed. Figure 14 displays the efficient frontier and the individual asset indices which compose the efficient frontier. Figure 15 provides a breakdown of the efficient portfolios. Figure 15 shows that less risky portfolios load more on money market instruments and short term fixed income investments. Riskier portfolios, i.e. portfolios with a higher expected return, allocate more towards equity investments, property and long-term fixed income. The index of A rated corporate bonds is not used in the efficient frontier since, in this setting, the index is dominated by government bond portfolios with better risk-return characteristics.

37
0,00%
0,10%
0,20%
0,30%
0,40%
0,50%
0,60%
0,70%
0,80%
0,90%
0,00%
1,00%
2,00%
3,00%
4,00%
5,00%
6,00%
7,00%
Monthly return
Standard deviation (monthly)
Figure 14 - Efficient frontier
Efficient frontier
Property
Euribor

38
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0
5
10
15
20
25
30
35
40
45
50
Allocation (% of total portfolio)
Portfolio number
Figure 15 - Allocation of efficient portfolios
Property
Euribor

39
Calculation of a budget for market risk and market risk capital charges
In order to assess the eligibility of efficient portfolios under Solvency II, a budget for market risk is needed. The calculation details of our budget for market risk are detailed under table 24. All statistics are based on QIS 5. It remains an open question to which extent insurers will target a ratio of own-funds above the solvency capital requirement. We therefore calculate two market risk budgets: the first is based on a simple 100% SCR target ratio (€ 107.21 million). The second market risk budget (€64.98 million) assumes a 165% SCR target ratio, based on the QIS 5 statistic that insurers on average have 165% of own-funds compared to the SCR.
Table 24 - Calculation of a budget for market risk
Own-funds (% of balance sheet total)
12.8%
(1)
Basic solvency capital requirement (% of solvency capital requirement)
148%
(2)
Diversified market risk (% of basic solvency capital requirement)
56.5%
(3)
Budget for diversified market risk if the insurer targets a 100% SCR € 107.21 mio
= (1)*(2)*(3)
(based on a hypothetical balance sheet total of €1000 million)
Average own-funds as a % of SCR
165%
(4)
Budget for diversified market risk if the insurer targets a 165% SCR € 64.98 mio
= (1)*(2)*(3)/(4)
(based on a hypothetical balance sheet total of €1000 million)
We calculated capital charges for the market portfolios conform the method explained chapter 3. SCR stand-alone capital charges are based on the duration of the asset portfolios and their average rating, as displayed under table 25. These stand-alone capital charges are aggregated into an overall capital charge for the total market portfolio taking into account interest rate risk, diversification benefits and the loss absorbing capacity of technical provisions and deferred tax assets. We assume that the market portfolio constitutes 90% of the asset total of the hypothetical life insurer. We assume that another 5% of the asset total is allocated to cash with a 0 year duration and another 5% to mortgage loans with a 10 year duration. These assumptions on the balance sheet total of an average life insurer are based on balance sheet statistics of QIS 5. We assume a balance sheet total of €1000 million.
We have assumed that the portfolio of securitised/collateralized assets follows the “type 2” SCR calibration, leading to a significant stand-alone capital charge of 53.75%. Our choice for the type 2 calibration is justified since a major part of the securitised/collateralized portfolio includes assets issued some years ago and are therefore unlikely to be structured in a way that they comply to the numerous “type 1” requirements set out by EIOPA.

40
Table 25 - SCR stand-alone capital charges under the standard formula
Asset – rating - maturity
Modified duration
(years)
Average Rating
SCR stand- alone capital charge
1.0
AAA
0.90%
2.7
AA
2.97%
2.8
A
3.92%
2.9
BBB
7.25%
2.8
AA-
0.00%
6.5
AA-
0.00%
13.1
AA-
0.00%
15.4
AA-
0.00%
16.9
AA
0.00%
4.3
AAA
53.75%
2.8
AAA
1.96%
6.4
AAA
4.20%
10.3
A+
10.35%
Property
25.00%
49.00%
Analysis of capital charges for efficient frontier portfolios
Figure 16 displays the market risk charge for the 55 portfolios on the efficient frontier. A breakdown into interest rate risk, spread risk, property risk and equity risk capital charges is provided. 39 out of 55 portfolios comply with the market risk budget if the life insurer targets a 100% SCR (black line in figure 16). 23 out of 55 portfolios comply with the market risk budget if the life insurer targets a 165% SCR (red line in figure 16). Portfolios complying with the 100% SCR market risk budget are characterised by a an average total asset duration of 4.6 years and a low allocation to equity and property investments. Portfolios complying with the 165% SCR market risk budget are in addition characterised by a low allocation to securitised/collateralised assets.
Figure 17 displays the link between interest rate risk charge, total market risk charge and the duration of total assets. It is very clear that asset portfolios with a higher duration bear a lower interest rate risk charge, therefore also inducing a lower total market risk charge. For portfolios 39 until 44, the duration of assets becomes higher than the duration of liabilities, leading to a local peak for interest rate risk capital charges.

41
00%
20%
40%
60%
80%
100%
120%
140%
160%
180%
200%
0
5
10
15
20
25
30
35
40
45
50
% of market risk budget
Portfolio number
Figure 16 - Market risk charge for efficient frontier portfolios
Expressed as a share (%) of market risk budget for a 100% SCR target
% equity charge
% property charge
% spread charge
% interest rate risk
Market risk budget for a 165% SCR target
Market risk budget for a 100% SCR target

42
Figure 16 displays how the spread charge increases sharply from portfolio 17 to 19. This is entirely due to a higher allocation towards securitised/collateralized assets. Similarly, the spread charge decreases sharply from portfolio 27 to 33, for which the exposure to securitisations decline. Portfolios which have a high allocation towards securitisations do not comply with the 100% SCR budget for market risk and are therefore unlikely to be selected by the life insurer. The high market risk charge for portfolios containing securitisations contradicts with the relatively low standard deviation of these portfolios. Even though the Solvency II standard formula aims not to drive insurers’ investment decisions6, it is clear that the current SCR calibrations effectively incentivise insurers not to allocate towards securitised exposures.
The efficient frontier portfolio which entails the lowest market risk capital charge is given by portfolio 13. Details of this portfolio composition are given under table 26.
6 Carlos Montalvo, Executive Director of EIOPA, recently claimed in an interview with Blackrock that “Capital charges cannot be the same because risks are not the same, but if there were incentives to allocate assets in a given way, it would not be right”. See Blackrock, 2013, Global insurance investment strategy at an inflection point, p. 21.
0
2
4
6
8
10
0
20
40
60
80
100
120
140
160
180
200
0
5
10
15
20
25
30
35
40
45
50
Modified duration (years)
Capital charge (€million)
Portfolio number
Figure 17 - Market risk charge, interest rate risk charge & asset duration
interest rate risk capital charge (left scale)
market risk capital charge (left scale)
average duration of assets (right scale)

43
Table 26 - Characteristics of the minimum market risk charge portfolio
Asset
Allocation
Return (monthly)
0.3900%
19.68%
Standard deviation (monthly)
0.4918%
15.39%
Duration fixed income investments (years)
3.08
14.06%
20.00%
Average duration of total assets (years)
3.06
6.09%
17.02%
Market risk capital charge (€ million)
46.43
Property
6.46%
1.29%
% of market risk budget
43.30%
Portfolio 13 bears the lowest capital charge but is unlikely to be selected by the life insurer. Indeed, if the life insurer chooses to optimise the ratio of monthly return/market risk charge, depicted in figure 18, portfolio 36 should be preferred above portfolio 13. Portfolio 36 has a comparatively lower allocation to money market instruments, and a higher allocation towards long-term fixed income, property and equity.
We can conclude from the above paragraphs that the Solvency II standard formula is indeed risk- based. Solvency II charges a higher market risk capital when assets are not properly matched to liabilities and when the insurer allocates heavily towards risky exposures (e.g. property or equity). As an example, portfolios 44 until 54 have a relatively low duration and allocate heavily to property and emerging market equity, which induces high market risk capital charges and makes the portfolios inadmissible under the market risk budget. As Solvency II has an excessive stress calibration for type 2 securitisations, insurers are incentivised not to include these securitisations in their portfolio, even though such securitisations may enhance the portfolio’s risk-return characteristics.
0,00000
0,00002
0,00004
0,00006
0,00008
0,00010
0,00012
0
5
10
15
20
25
30
35
40
45
50
Portolio number
Figure 18 - Monthly return/market risk charge

44
Does an average life insurer’s market portfolio comply with the market risk budget?
This section assesses whether an average European life insurer’s asset portfolio complies with the market risk budget used in the previous sections. Data on the asset allocation of an average European life insurer are provided in recent publication of Höring (2013). This study based its data on a sample7 of individual insurance companies’ annual reports and investor presentations from 2009 and 2010. The average allocation, rating and duration of the asset portfolio is described under tables 27 and 28.
Table 27 - Asset allocation of an average life insurer
Asset
Allocation (%)
Capital charge (%)
Type 1 equity
4.50%
39.00%
Type 2 equity
2.50%
49.00%
Property
11.00%
25.00%
Sovereign debt EEA
31.98%
0.00%
Sovereign debt non-EEA
8.04%
2.18%
Corporate debt
29.52%
8.67%
Covered bonds
12.46%
4.45%
Average duration of asset portfolio (years)
5.1
The stand-alone Solvency II capital charges for each asset are also given in tables 27 and 28. The method for calculating the overall market risk capital charge is similar to the method used in the previous paragraphs. Again, we take into account interest rate risk, diversification benefits and the loss absorbing capacity of technical provisions and deferred tax assets. Similar to the calculations under the previous paragraphs, we assume that the market portfolio constitutes 90% of the asset total of the life insurer. Furthermore, we assume that another 5% of the asset total is allocated to cash with a 0 year duration and another 5% to mortgage loans with a 10 year duration. Our final results of the market risk capital charge calculations are given under table 29.
7 The sample consists of Allianz, AXA, Ageas, Aviva, Baloise, CNP Assurances, Fondaria SAI, Fortis, Generali, Helvetia, Legal & General, Swiss Life, Vienna Insurance and Zurich.

45
Table 28 - Rating and duration breakdown of fixed income portfolio
sovereign debt EEA
sovereign debt non-EEA
corporate debt
covered bonds
Allocation (%)
Capital charge (%)
Allocation (%)
Capital charge (%)
Allocation (%)
Capital charge (%)
Allocation (%)
Capital charge (%)
AAA
58.8%
0.00%
65.0%
0.00%
17.5%
4.70%
92.0%
4.10%
AA
20.6%
0.00%
17.5%
0.00%
15.0%
5.74%
4.0%
5.10%
A
18.1%
0.00%
2.5%
6.64%
40.0%
7.28%
2.0%
7.84%
BBB
0.6%
0.00%
10.0%
8.33%
20.0%
13.10%
1.0%
14.30%
BB
1.9%
0.00%
0.0%
15.35%
2.0%
23.50%
0.0%
25.50%
B or lower
0.0%
0.00%
3.0%
27.25%
0.5%
39.18%
0.0%
42.54%
Unrated
0.0%
0.00%
2.0%
18.23%
5.0%
15.68%
1.0%
17.04%
Average duration (years)
6.9
6.9
5.4
6.2
Table 29 - Market risk capital charges for an average life insurer's portfolio (in million EUR)
interest rate risk
Spread charge
Equity charge
Property charge
Diversified market risk charge
Budget for diversified market risk charge under a 165% SCR target
Budget for diversified market risk charge under a 100% SCR target
27.31
29.59
25.14
24.75
57.51
64.98
107.22

46
Table 29 shows that the market portfolio of an average European life insurer induces a market risk capital charge of €57.51 million. This is below the 165% SCR market risk budget of €64.98 million. Hence, we can conclude that the Solvency II standard formula for market risk should not lead to significant reallocations of the market portfolio for the average life insurer.
In order to test the relevance of the efficient frontier calculated under the previous paragraphs, it would be interesting to check whether a portfolio of this efficient frontier corresponds to the average European life insurer’s portfolio. Annex V indeed shows that portfolio 38 on the efficient frontier is very similar to the average European life insurer’s portfolio. This points out that 1) the average European life insurer is likely to hold a portfolio with optimal risk-return characteristics and/or 2) the efficient frontier calculated in the previous paragraphs is relevant in the real world as it is able to broadly capture the average life insurer’s asset portfolio.
This chapter assessed the implications of Solvency II on the asset allocation of insurance companies. We built an efficient frontier based on 15 asset indices and calculated the market risk capital charges for the portfolios of this efficient frontier. We furthermore calculated the market risk capital for the portfolio of an average European life insurer and compared this portfolio to our efficient frontier. Our results showed that:
- A considerable share of efficient portfolios (23 out of 55) comply with a stringent budget for market risk;
- Portfolios with a higher duration will, on average, bear lower market risk capital requirements;
- Portfolios which allocate heavily towards securitisations are likely to be inadmissible under a budget for market risk, even though the true spread risk of these portfolios remains reasonable;
- Portfolios which allocate heavily towards equities and property investments are likely to be inadmissible under a budget for market risk;
- A life insurer which chooses to optimize the return/market risk charge ratio, would select a market portfolio composed of 71.4% fixed income (average duration 10.1 years, 40% AAA, 31% AA, 2% A and 27% BBB) and 28.6% property and equity investments (i.e. portfolio 36 of the efficient frontier);
- The market portfolio of an average European life insurer is likely to comply with a stringent budget for market risk.

47
5. BASEL III VS. SOLVENCY II
Several similarities exist between the Basel III and Solvency II regulations. As an example, both frameworks are structured in three pillars, both frameworks allow for standardised as well as internal models, and both frameworks structure eligible capital items in different tiers. A detailed comparison of Solvency II and Basel III nevertheless shows important differences, and this for all three pillars of the regulatory frameworks. In this section, we will focus mainly on the differences between Solvency II and Basel III that could have an influence on investment decisions.
This chapter compares Solvency II and Basel III with respect to requirements for the quality of capital, risk types included in both frameworks and the calibration of these risk types. We will focus on the banking book, and not on the trading book when comparing different regulations. The paragraphs below are based on the most recent technical specifications published by EIOPA.
Quality of capital
Basel III as well as Solvency II define various tiers of capital, but these tiers are not consistent with one another in terms of definition of the allowed capital instruments, nor in terms of the relative proportions of the different tiers. The most significant differences in capital tier characteristics are presented in table 30.
Table 30 - Differences in capital instrument characteristics under Basel III and Solvency II
Basel III capital
Solvency II basic own-funds (BOF)
Tier 1
Broadly similar characteristics under Basel III and Solvency II
Tier 2
Items need to be paid in
Includes called upon but unpaid items
Original maturity of at least 5 years
Original maturity of at least 10 years
No mandatory suspension of repayment in the event of non- compliance with capital ratios
Suspension of repayment in the event of non-compliance with the SCR
Tier 3
Phased out
Includes e.g. deferred tax assets
Ancillary own- funds
Not included
Includes items such as unpaid share capital that has not been called up, letters of credit or guarantees, or any other legally binding commitments received by insurance and reinsurance undertakings. These items are subject to prior supervisory approval.
These differences in definitions of capital instruments seem to be in favour of insurers. Indeed, Solvency II seems to put less emphasis on quality of capital, as e.g. deferred tax assets (DTA) are allowed to be considered as basic own-funds (BOF) under Solvency II, while DTA are deducted from

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