Summary and implications
The response to the financial crisis is producing a continual stream of proposals to monitor. In many cases, they don’t hit the mark, or hit the wrong one. Solvency II does not sound as if it has a real estate angle. However, once its capital requirements are read, it clearly does.
UK focus is bound to be dominated at the moment by the Independent Commission on Banking's consultation on reform options for UK banking. However, the world of European insurance also has its own proposals to tackle: namely, Solvency II. In particular, it raises concerns for the real estate sector:
- The modelling applied by the draft Solvency II Directive perceives real estate as far riskier than industry observers believe or market data supports;
- The solvency capital requirements in the proposals create different results when applied to direct and indirect real estate and geared and ungeared investments; and
- The proposals do not reflect the diversification attributes of real estate and have been proposed as a reaction to the financial crisis rather than to real estate as an investment class.
The potential consequences are fundamental. Will insurers continue to invest in the real estate sector? If so, will they invest directly or indirectly (e.g. in funds or companies)? If they invest in funds, what level of debt is suitable?
The impact of Solvency II remains uncertain and will probably vary from member state to member state. The European Commission continues its technical work on implementing measures in light of the results of the fifth (and final) Quantitative Impact Study, published in March. Implementation is expected to be January 2013.
What it is
Solvency II seeks to impose a harmonised risk-based capital adequacy regime for insurers and reinsurers across Europe. The main objective of the Directive is better protection of policy holders, so that the probability of insurers meeting their obligations to policyholders over a one year horizon is 99.5 per cent. Insurers in the EU will have to review their regulatory capital structures (for property, equity, bonds and derivatives) to establish whether they will have adequate solvency capital to satisfy the new requirements and minimise investment risks.
How it works
Insurers have to hold sufficient financial resources to meet obligations to their policyholders (expected), absorb any losses (unexpected) and meet risks. The Directive uses statistical theory and analysis to apply ‘shock testing’ to different asset classes to determine the necessary capital requirements. The higher the perceived risk of an asset class, the more capital the insurer needs to set aside to ensure that, if its value falls, the insurer’s ability to cover all its notional liabilities to policyholders is not affected.
The Directive, in harmonising capital adequacy requirements from current varying frameworks and practices in play across Europe, could mean that the allocations that an insurance company makes to different asset classes will change. In turn, this could effect the amount of capital that the insurance company is required to hold. In general, this means that insurance companies that are looking to reduce or minimise their solvency capital requirement are likely to consider using products with lower capital requirements (such as unit-linked funds rather than own balance sheet products) or restrict investment to more capital efficient assets such as secured property lending and away from equities and property itself.
The table opposite sets out proposed standard solvency capital requirements for some example assets, by applying the standard formula calculation in the draft Directive. Insurers can also tailor their own models, to be first approved by the insurer’s regulator, to determine solvency capital requirements applicable to them. Although these may better match an insurer’s own risk profile, delays in regulator approval of Directive-compliant internal models are expected, and in the meantime insurers will have to comply with the standard models adopted.
Areas of concern in the real estate sector
The table over the page sets out some areas of concern in the real estate sector in respect of Solvency II.
Professional bodies, including INREV, EPRA, IPF and the British Property Federation continue to monitor and review Solvency II. A group of industry bodies (led by INREV and including EPRA, BPF, IPF, ABI, BVI and ZIA) jointly commissioned research by IPD to more accurately determine the true risk profile of a number of real estate markets throughout Europe. The results are due to be released shortly.
Other challenges to Solvency II
Solvency II is being challenged generally by the insurance industry for its conservative nature, drafting and potential dire consequences. Various representatives from the European insurance industry recently wrote to Michal Barnier, European commissioner for internal markets and services, with the aim of ensuring that (in their view) the overly prescriptive and conservative approach in the draft implementing measures for Solvency II would be urgently addressed.
In January 2011 Phillip Neyt, Chairman of the Belgian Association of Pension Institutions, warned in the FT that if Solvency II rules applied to European pension funds, €1,200bn of equity holdings would have to be sold off.
Potential application to pension schemes
Whilst insurance companies represent a significant chunk of real estate ownership (about 10–15 per cent in Europe), there have also been suggestions (in an EU green paper on the future of pensions, published in July 2010) that a Solvency II-style regime could be applied to pension schemes. The European Insurance and Occupational Pensions Authority (EIOPA) will be considering Solvency II’s application to defined contribution schemes this year.
Click here to view table detailing areas of concern in the real estate sector.
Work in progress
EIOPA was established on 1 January 2011 as one of the three European Supervisory Authorities. EIOPA replaces the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) in the insurance and occupational pensions sector. Delivery on Solvency II is one of the four key priorities for EIOPA in 2011.
EIOPA published the results of its fifth and final Solvency II Quantitative Impact Study in March 2011, and the Financial Services Authority also published a UK country specific report. EIOPA’s report stated that the financial position of the European insurance and reinsurance sector solvency capital requirements calculated in accordance with the standard formula or internal models remains ‘comfortable’, with eligible own funds in excess of the regulatory requirements by €395bn. However, it acknowledged that further technical work is required, for instance in relation to the design and calibration of standard capital requirements.
The Solvency II system is expected to apply to financial years commencing on or after 1 January 2013. It first needs to be adopted in Europe and then implemented in member states.
The new regime represents a significant change in the regulation of European insurance businesses and real estate is not immune from the impact of the proposed new requirements.