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Principal-protected products could benefit from Solvency II

Published online only Source: Risk magazine Author: Mark Pengelly Source: Risk magazine | 22 Mar 2011 Categories: Solvency II Topics: Deutsche Bank, Morgan Stanley, Solvency II, Socit Gnrale (SG), Capital guaranteed, Principal protected note, Insurance, Structured products

A boon for structuring desks? New risk-based capital rules for insurers could help demand for products with principal protection, say bankers The European market for principal-protected structured products could benefit from Solvency II, say bankers, as insurance companies adapt their portfolios to cater for the new risk-based capital rules.

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Related articles Basel 2.5 prompts flurry of asset sales and risk transfer deals Corporates fear CVA charge will make hedging too expensive Developing structured solutions for Solvency II The encroachment of Solvency II Solvency II is occupying the minds of insurers and bankers alike, but market participants warn the rules are a work in progress. In January, the European Commission adopted a proposal that would allow for a transition period of up to 10 years for some of the most onerous aspects of the legislation. Meanwhile, the results of a quantitative impact study published on March 14 are expected to lead to further tweaks to the rules. Despite the possibility of further changes, the rules are expected to have an impact on the investment portfolios of European insurance companies. Youve changed the capital framework for insurers, so youve also changed the risk-reward framework of every asset class and its attractiveness on an absolute and relative basis, says Jeff Sayer, managing director of institutional solutions at Morgan Stanley in London. If you can provide any kind of principal protection there could be a benefit compared with an unprotected asset While asset classes including asset-backed securities are expected to suffer under the new regime, bankers believe products that incorporate some form of principal protection or capital guarantee could benefit. The inclusion of these guarantees, they note, could help pare down the capital charge for investing in a range of risky asset classes. If you can provide any kind of principal protection not necessarily 100% protection there could be a benefit compared with an unprotected asset. Were spending a lot of time internally looking at the cost and benefit of protection and whether it makes sense for insurance companies, says Andrew Berman, co-head of European insurance and pensions sales at Deutsche Bank in London. For a passive equity portfolio tracking an index, this might involve buying a put (financed by the sale of a call) to protect against downside risk. In addition to equities, bankers say insurers might try to cheapen regulatory capital requirements in other asset classes using some form of protection, including hedge finds and commodities. One product being actively touted towards insurers is Titanium by Socit Gnrale Corporate and Investment Banking. The bank looked at a range of strategies in an attempt to determine which performed best from a return and capital perspective. We did a big study on the best way to invest in equities under Solvency II and we compared the different equity options strategies insurers would be implementing. We ran a lot of simulations to determine the average internal rate of return of the various investments, net of the average cost of Solvency II capital, says Ludovic Antony, director of global solutions for financial institutions at the bank in Paris. The analysis compared various ways of investing in equities, including constant proportion portfolio insurance products and direct investments with collars where the purchase of a put is partly or wholly financed by the sale of a call. The bank simulated returns on the strategies over an eight-year period, trying to find the best return compared with the cost of capital under the new rules. We found that investing in medium- to long-term capital-guaranteed products with indexation to equity performance was the most efficient method. The long-term guarantee provided significant capital relief, while

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enabling the companies to benefit significantly from positive equity performances, says Antony. The study served as a starting point for the banks efforts to tailor Solvency II-efficient structured products. One of these is Titanium a product that offers an equity investment with a capital guarantee that pays out like a bond, with annual coupons exposed to yearly equity performance through a volatility adjustment. The structure is intended to provide better long-term performance than traditional long equity exposure with hedges (collars), but is subject to a reduced capital requirement under Solvency II. As it is structured as a bond, it can also benefit from friendly accounting treatment under International Financial Reporting Standards, the bank claims. Topics: Deutsche Bank, Morgan Stanley, Solvency II, Socit Gnrale (SG), Capital guaranteed, Principal protected note, Insurance, Structured products

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