Annex. Solvency II and accounting considerations for insurance companies when investing in the dollar credit market
Solvency Capital Requirements present a series of specific market risks at the asset-class level. Investments in dollar-denominated corporate bonds will involve currency risk and credit risk – depending on credit quality and on the bond’s modified spread duration, as well as interest-rate risk -- upward and downward movements interest-rate movements will apply to the valuation of both assets and liabilities valuation --and concentration risk.
The first market risk that investors will be facing when diversifying into dollar denominated bonds is currency risk. The Solvency II Directive (2009/138/EC) set a specific and deterrent (25%) solvency capital charge applicable in the event of currency mismatches between insurance companies’ assets and liabilities. Unless the insurance company already has liabilities in dollars, this may discourage it from profiting from this type of opportunity, and is why the forex-hedging strategies described in the previous section should be put in place and monitored through time.
Taking apart Solvency II considerations, from a financial point of view, when maintaining an un-hedged position, the company needs to be right on its directional view, as FX volatility can easily wipe away excess return earned. In practice, most insurers usually choose to fully hedge their currency exposure.
Credit spread risk
Forex is not the only component of the Solvency Capital Requirements involved in the Market Risk module. The Credit Spread risk sub-module doesn’t take into account the nationality of the issuer or bond currency. It is based on the Credit Spread Duration of the bond and on its Credit Quality Step (CQS), which is the second-best rating of External Credit Assessment Institutions (ECAI, as well as the main rating agencies). If only one rating is available, this rating should be used.
Consequently, one can argue that an arbitrage in the credit space, favouring dollar- to euro-denominated bonds with the same CQS and with the same spread duration, is neutral from a SCR Spread point of view. However, considering that we need to freeze some capital when buying a credit bond, it is of the utmost importance to optimise its spread, as the spread net of cost of capital, depending mainly on the return on equity assumption, can result in a much lower and sometimes negative spread. This is why widening the credit investment universe to dollar bonds is a positive move, with many opportunities potentially arising from this market.
Comparing dollar-denominated credit investments with euro-equivalent bonds is less straightforward from an interest-rate risk perspective.
First, the shocks to the dollar and euro risk-free curves aren’t the same. Even if a standard formula is subject to a material revision, since current methodology understates downward interest-rate risk, (see “A more restrictive capital requirement for insurers in 2019?” Amundi), the principal of proportional shocks applies. Consequently, as rates on the dollar are higher than rates on the euro, dollar-asset shocks can be more painful.
Second, it is not possible to hedge euro liabilities with dollar assets following the standard formula, as this model allows for no benefit from the correlation between interest curves in dollars and euros. All currency interest curves are shocked in the same direction at the same time, and a negative change in net asset value less best estimate liabilities in one currency may not be cleared with a positive change in another currency.
Bear in mind that, under the Solvency II regime, the interest-rate part of the Market SCR is calculated by applying a shock per currency to the difference between liabilities and assets. If assets are longer than liabilities, the shock will translate into a rate increase (S_up). If liabilities are longer than assets, the opposite applies.
Let us look at the generally standard situation of life insurance companies – where liability maturities exceed those of assets -- doing their business in euros, where the interest-rate portion of the Market SCR is calculated applying an interest-rate decline on both assets and liabilities in euros (‘S_down’). In this case, investing into a dollar-denominated bond would have the following effects:
- It would not contribute to reducing the euro interest-rate portion of the market SCR as the dollar bond would not contribute to the euro duration of the assets (S_down unchanged in euros).
- The dollar bond position would contribute to the dollar interest-rate portion of market SCR (S_up in dollar) as the insurance company does not have dollar denominated liabilities.
If the portfolio is too concentrated on some specific group issuers, an additional capital charge may arise, depending on issuer credit quality (i.e., BBB-rated names with a weight exceeding 1.5%). In this event, diversification into US market can be considered in order to reduce this risk and, consequently, the Solvency capital requirement.
Volatility and matching adjustments
On the liability side, the risk-free rate curve is generally used as the discount curve, regardless of the structure of the assets, though insurers can also use a slightly different curve (provided certain conditions are met) using either a volatility adjustment (VA) or matching adjustment (MA) optionality.
VA and MA are part of the ‘long-term guarantee’ package that aims to limit the short term market volatility impact on the own funds of long-term institutional investors when these are insurance companies. These approaches consist of applying an add-on spread to the risk free curve used to discount the liabilities. Both adjustments of the discount rate curve will have a positive and direct impact on available capital (improving the SCR ratio’s numerator).
The difference between the two options is that the add-on is provided by the EIOPA in the case of the VA, depending on country and currency, but is directly linked to the insurer’s portfolio structure for the MA. Thus, by increasing available capital as each yield pick-up in the dollar credit market lowers the valuation of liabilities, MA offers greater benefits than VA for insurers in terms of Solvency II ratio. Eligibility criteria are stricter for MA, and not all insurers have recourse to it.