A new EDHEC study shows that LTGA calibration continues to favour short-duration bonds and could undermine the financial stability and financing of both sovereigns and corporates

Written on 12 November 2013.

EDHEC Publication

Discussions on the Omnibus II Directive have been in deadlock since July 2012. The main points of contention relate to the integration of ALM mechanisms into the standard formula. Their omission from the QIS5 impact study led to increased artificial volatility of prudential balance sheets and consequently to regulatory capital requirements that are sometimes overestimated. The aim of the Long-Term Guarantees Assessment (LTGA), conducted in the first semester of 2013, was to test a variety of measures which aim to integrate ALM mechanisms into long-term insurance activities, (life insurance, pensions, liability insurance, etc.). These measures relate to the valuation of insurance liabilities (extrapolation of long-term rates, implementation of a counter-cyclical premium and a matching adjustment) as well as to new risk calibrations, particularly that of spread risk.

In a study entitled, “LTGA Impact Assessment and Bond Management: Has Solvency II reached a Deadlock?”, the EDHEC Financial Analysis and Accounting Research Centre analyses the effect of the new LTGA spread risk calibration on bond management. This analysis is conducted comparatively to the QIS5 calibration in order to evaluate the potential contributions of the LTGA study, particularly with respect to the quality of the bond SCR risk measure and its impact on bond investment choices. The paper is produced as part of the research chair on “Solvency II” at EDHEC-Risk Institute, supported by Russell Investments, the purpose of which is to design new benchmarks for European insurance companies that are representative of a dynamic allocation strategy to equities.

The study shows that the application of the LTGA spread risk calibration theoretically leads to a reduction in the SCR spread for a number of rating-maturity pairs. However, in practice, this effect is significantly reduced because bond issuances, hence insurance company bond portfolios, do not include bonds that would benefit from this significant reduction in regulatory capital requirements.

Our research shows that the sophistication of the spread risk measure introduced in the LTGA impact study hardly impacts the quality of the bond risk measure. Bond SCR remains a measure of risk that is generally relevant for fixed-rate bonds. However, as SCR does not always reflect the overall risk level, it could provide room for improvement by integrating the effects of economic cycles (via a bond Dampener), incorporating the specificities of ALM for long-term commitments (flat-rate treatment for long-maturity investment grade bonds as is applied to equities), as well as those of high-yield bonds (substitution using a default model).

Additionally, the LTGA calibration maintains the strong correlation of bond SCR to VaR and volatility. There is therefore no need for Solvency II to add a fourth dimension to bond management, which is currently based on the return-volatility-VaR triple factor. It would in fact be possible to manage fixed-rate debt instruments using only the bond return-SCR pair.

Lastly, an analysis of the impact on bond choices shows that the LTGA calibration continues to favour short-duration bonds. Solvency II therefore naturally encourages insurers to reduce their levels of investment in long-term bonds, especially those rated BBB or lower. Given that the insurance sector plays a leading role in financing the European economy, with €3.5 trillion invested in bonds, this bond risk calibration could undermine the financial stability and financing of both sovereigns and corporates.

A copy of “LTGA Impact Assessment and Bond Management: Has Solvency II reached a Deadlock?” can be downloaded via the following link:

EDHEC Publication LTGA Impact Assessment DEF

This research was supported by Russell Investments as part of the research chair at EDHEC-Risk Institute on “Solvency II.”

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