However, in the course of this preparation, some insurers are finding out that they may not have the internal expertise to deal with such highly-sophisticated investment strategies and complicated asset classes.
Solvency II will be implemented in Asia beginning 2020-2021, with full implementation taking place two to three years after.
“Usually when you embrace a Solvency II-like regulatory framework, all of a sudden the role of liabilities becomes much more prominent. And you tend to have an investment decision-making process that is more liability driven. So, it forces organizations to be more disciplined,” says Michele Gaffo, managing director and global head of Insurance Coverage for DWS.
Similar trends that took place in Europe when Solvency II was implemented beginning January 2016 are expected to take place in Asia so it is useful for Asian insurers and regulators to pay attention to these trends. In Europe, the effect of the regulation on the insurance asset allocations started even before January 2016 because the framework was already well known by insurance companies.
“For example, what I have seen happening in Europe is when insurers needed to price their liabilities in a much more market-driven way, it usually emerges that they are running an interest rate mismatch. So, the asset duration is fairly different from the liability duration. I’ve seen it happen with insurance companies in Europe but I expect the same thing will be happening here as well,” Gaffo says during a recent visit to Hong Kong.
As part of their preparations for Solvency II, Gaffo recommends that Asian insurers start by being much more disciplined in looking for assets that better match their liability profile in order to reduce their interest rate risk.
In the second phase of their preparation, Asian insurers have to be ready to take on more credit risk when investing in fixed-income assets. Traditionally, insurers invested in Triple-A rated sovereign bonds that carry minimal risk. However, with the current low-interest rate environment such bonds no longer generate sufficient returns to meet the liabilities of the insurers.
By taking on more credit risk, the insurers will be investing in corporate bonds that offer higher returns but have a lower credit rating, such as Single-A or even Triple-B minus.
“In Europe, six to eight years ago insurance companies started taking more credit risks. In the beginning, they were the more liquid corporate bonds, for example, US long-term corporate bonds or going to lower than the average credit rating of their portfolio. For example, from a Single-A plus to Triple-B or even Triple-B minus in an attempt at sustaining the portfolio return,” Gaffo says.
In the third phase of their preparation, insurers are expected to take on more credit risk by investing in more illiquid assets. Such assets, such as private debt, real estate, private equity, or infrastructure financing, are generally more complex and demand more sophisticated investment management strategies.
“So, overall I wouldn’t say that the insurance companies have reduced the overall risk that they are taking. But they have transformed the way in which they do that, through a reduction of the interest rate risk but an increase of the credit risk part,” Gaffo says.
“When that happens, especially in the third phase of such a journey, the insurers often come to the conclusion that they do not have the internal capabilities that are needed. This is because the level sophistication of the asset classes that they need to invest in is on average much higher than before,” Gaffo says.
Because of these trends, Gaffo predicts that in the Asia-Pacific there will be a sustained growth towards outsourcing of investment mandates to third-party asset management firms, such as delegated CIO services.
Many companies and regulators in Asia are taking a keen interest in the developments in Europe with a view to either seeking regulatory equivalence or implementing various elements of Solvency II in their risk management initiatives. Asian subsidiaries of European insurers have been involved in previous quantitative impact studies (QIS) and some of the metrics under Pillar 1 have been discussed widely in Asia, according to a study by Ernest and Young.