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Fitch Ratings : Solvency II poised to transform asset allocation and impact capital markets

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Fitch Ratings believes that Solvency II, the new regulatory regime for European insurers from 1 January 2013, is set to transform how insurers invest their assets and could lead to asset reallocations impacting pricing or demand in several asset classes. European insurers are the largest investors in the European financial markets, holding EUR6.7trn of assets including more than EUR3trn of government and corporate debt.

The new rules will force insurers to value asset and liabilities at market value in determining their solvency position and to hold explicit capital to reflect short-term volatility in the market value of assets. This means that insurers’ asset allocations will be heavily influenced by Solvency II capital charges reflecting the price volatility of each asset class – a fundamental change from current asset allocations, which are driven by expected long-term investment returns.

“If the current Solvency II proposals were fully implemented on 1 January 2013, insurers would be expected to carry out significant changes to asset portfolios to optimise their capital position under the new rules,” says Clara Hughes, Director in Fitch’s Insurance team. “This would have ramifications for certain segments of the European debt markets. The main impacts would be a shift from long-term to shorter-term debt; an increase in the attractiveness of higher-rated corporate debt and government bonds; diversification of large asset holdings; an increase in the attractiveness of covered bonds; a preference for assets based on the long-term swap rate and a shift from short-dated paper to deposits.”

“Fitch expects to see better duration matching with derivatives such as swaps and floors and an increase in downside protection to mitigate the impact of the new capital charges,” says Aymeric Poizot, Senior Director in Fitch’s Fund and Asset Management team. “Fitch also anticipates an increase in financial engineering to create Solvency II-friendly assets such as reverse repos and structured notes, which can optimise return on capital.”

However, Fitch considers it unlikely that large-scale reallocations will happen in the short term as transitional arrangements are likely to phase in implementation of Solvency II over several years.

“Transitional arrangement may give insurers up to ten years to adapt their business and investment strategies to the new regime,” says Hughes. “The calibration of Solvency II is still under discussion, so the capital charges for asset risk and price volatility may not be as onerous as the current draft, mitigating the impact on investment markets.”

Insurers will also have the option to calculate their capital position using an internal model rather than the proposed standard formula. This could offset the impact of any capital requirements in the standard formula that do not accurately reflect the risk in insurers’ portfolios.

Fitch will issue a full report on this topic later this month, and will hold conferences in Frankfurt (16 June 2011), London (24 June 2011) and Paris (27 June 2011) to discuss the subject.

Source : Fitch Press Release