The Impact of Solvency II on Bond Management

Liliana Arias, Philippe Foulquier, Alexandre Le Maistre: This study conducted by the EDHEC Financial Analysis and Accounting Research Centre analyses the impact of the new prudential regulation on bond management.

Author(s):

Liliana Arias

Research Engineer at EDHEC Business School Financial Analysis and Accounting Research Centre.

Philippe Foulquier

Professor of Finance and Accounting and Director of EDHEC Financial Analysis and Accounting Research Centre.

Alexandre Le Maistre

Associate Research Engineer at EDHEC Business School Financial Analysis and Accounting Research Centre.

The insurance industry’s new prudential regulation will come into effect in 2014. By considering the majority of risks faced by insurance companies, Solvency II seeks to encourage insurers to better manage and control all risks they might face (underwriting risk, market risk, counterparty risk, operational risk). One of the major changes with Solvency II is the treatment of market risks. In exchange for complete liberty when choosing and allocating their assets, an intrinsic cost of capital is allocated to each asset (referred to as the Solvency Capital Requirement or SCR). This is likely to structurally change the way in which insurers’ assets are managed. In a new study entitled "The Impact of Solvency II on Bond Management", the authors consider the appropriateness of bond SCR as a risk measure, the effects of this risk measure on bond management using the three dimensions of return, volatility and VaR, and whether Solvency II will give rise to a new bond hierarchy and arbitrage opportunities. This study demonstrates that an investor is able to evaluate bond SCR by using only two variables, residual maturity and rating, rather than the nine initially tested. Moreover, the correlation between real credit spread and SCR is not high. This is due to the flat-rate treatment of spread risk under Solvency II (which assigns a single risk factor to each rating and does not account for internal variances in ratings). Given the additional marginal cost that could be considered excessive in proportion to the return generated, bonds rated BBB or lower could end up being neglected by investors. SCR – as defined by the standard formula – is, overall, an appropriate measure of risk. However, given their specificities, SCR does not fully reflect the risk associated with long-maturity investment grade bonds, high yield and unrated bonds. Due to the features of bond SCR (high correlation with volatility and historical VaR), bond management currently based on the return-VaR-volatility triple factor should evolve under Solvency II, more towards a management approach based solely on the bond return-SCR pair. Finally, an analysis of the efficiency of risk-taking measured by the bond return/SCR ratio shows that the standard formula favours low duration bonds, particularly high yield bonds. This management, within the constraints of SCR, could lead to a shortening of durations, given the calibration and current term structure of interest rates.

Type: EDHEC Publication
Date: le 16/07/2012
Research Cluster : Financial Analysis and Accounting

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