Insurance companies are holding back on real estate investing because of concerns over Solvency II. Jochen Schenk sets out an alternative approach to risk/return assessment

R ecent surveys and studies suggest that the real estate allocation of Ger man insurance companies currently stands at between 6% and 7%. This means that insurance companies are holding real estate assets of no less than €65-75bn. At first glance, this looks quite impressive. Relatively speaking, though, the ratio is actually quite low. The portfolios of high-net-worth individuals, for instance, who tend to pursue a conservative approach similar to that of insurance companies, show a substantially higher real estate allocation. A recent survey by Citbank/Knight Frank came to the conclusion that high-net-worth Europeans invest nearly 50% of their assets in real estate.

While there is no plausible explanation as to why German insurance companies have a much lower real estate allocation than high-net-worth individuals, it is the professed intention of Germany's insurers to expand it. At least that is what polls and surveys have reported for years, most notably the trend barometer for real estate investments of insurance companies compiled by Ernst & Young Real Estate.

According to this survey, 69% of the insurance companies polled stated their intention to raise their real estate allocation before the end of 2010; the remaining 31% intend to keep their allocation stable. Yet these glad tidings are not reflected in the statistics. So far, there is little evidence to suggest that the real estate allocation is being raised along the lines suggested by the surveys.

One reason that could explain this slow expansion of real estate allocation is the planned regulation of the insurance industry by Solvency II. The existing solvency model, Solvency I, was introduced in the early 1970s, and defines lump-sum capital requirements in a relatively straightforward manner. Under this regulation, the required capital share depends solely on the business volume of a given insurance company. This model used to give rise to criticism because the actual risks of the insurance business were in no way adequately reflected.

By contrast, Solvency II will oblige insurance companies to keep considerably more capital on hand to satisfy the stipulations of insurance contracts. The directive includes, among other things, specific capital and supervision rules for European insurance companies, the objective being to achieve a risk-adequate definition of their capital requirements. According to the new model, the equity a given insurance company will need to provide depends on its investments. Real estate investments will be subject to a flat-rate capital requirement of no less than 25%. For private equity and hedge fund investments, insurance companies will actually have to set aside 55% of committed capital.

The Solvency II capital requirements could pose challenges for insurance companies of smaller size and lower net worth. To be sure, even these will favour real estate over stock, which requires an equity stake of 40%. But government bonds issued within the euro-zone are exempt from mandatory equity commitments altogether. Only short-term bonds will be subject to a capital requirement of 4%.

It is interesting to note that the capital requirements of Solvency II fail to distinguish between the bonds issued by euro-zone governments of varying credit worthiness. This means that the required capital holdings for Greek and Portuguese bonds would be the same under Solvency II as those for German bonds. So bonds from euro-zone countries will most likely benefit from the new regulatory catalogue.

These bonds are bound to be particularly interesting for insurance companies with a low net worth. Assuming that all the capital of a given insurance company has already been committed to other investments, such bonds would actually represent the only investment option that remains open to them. The capital requirements may relegate real estate to a secondary role for such insurance companies - even if a real estate portfolio is a rather sensible way to optimise total returns, speaking from an asset allocation perspective.

One way to avoid the 25% rule for real estate might present itself by assessing the risk/reward profiles of individual real estate portfolios, taking into account both the different types of use and regional location, right down to individual cities. For German real estate portfolios, for example, the synthetic real estate index Realix presents the findings as an annual time series starting in 1990 that maps the entire asset development along with the corresponding annual performance. Similar to the approach used with other asset classes, these statistics may be used to derive forward-looking assumptions. If the supervisory authority accepts the customised risk calculation model of a given insurance company, the capital deposit ratio tends to remain well below 25%.

For the time being, it remains impossible to make a detailed assessment of the ramifications that Solvency II will have for capital requirements. Some German insurance companies, particularly the medium-sized ones, are therefore uneasy, which in turn explains why the planned increase in real estate allocations has been a long time coming.

It is far from true that German insurance companies have refrained from investing in real estate altogether. Wherever the opportunity presents itself, they invest millions. Moreover, it needs to be remembered that even a minor expansion of the real estate allocation would involve vast capital commitments.

For instance, raising real estate allocations by just one percentage point equates to more than €10bn. So the investment behaviour of insurance companies plays a key role in the real estate and capital markets, notwithstanding the fact that the real estate ratio increase appears to have been marginal so far.

Jochen Schenk is member of the board of management, Real I.S.