We often talk of the danger of making assumptions and the regulator's approach is a case in point. Considerable work is still required, as Michael Englisch and Markus Königstein report
The European insurance industry is facing revision and standardisation of its regulatory guidelines similar to that already experienced by the banking sector under Basel ll. After years of preparation, the new regulatory framework, Solvency II, has now reached its final stages of consultation and is set to have an enormous impact on the insurance and European real estate industries.
The area of regulation concerning the requirements for capital resources is of particular interest. Under Solvency II an insurance company must hold a specific amount of its own equity called Solvency Capital Requirement against each individual investment in order to be able to meet its own liabilities even in instances of unforeseeable capital losses. This sum will be set by the majority of insurance companies according to a standard scheme that not only is too simplistic, but also fails to adequately represent reality. "Solvency II ignores the basic empirical evidence relating to the risks presented by different real estate markets. Additionally, it ignores the methodology of property valuation. A global risk for all kind of properties all over the world simply does not exist," says Bernhard Berg, head of IVG fund business and property veteran of the German insurance industry.
Shortcoming 1: Model assumes all property carries the same risk - for real estate financed entirely with equity Solvency II assumes in a stress scenario a 25% reduction in value. Surprisingly, the draft legislation holds this capital requirement to be appropriate for all kinds of property. Thus a new office property in the centre of Brussels which holds a long-term rental contract with an EU administrative department is equated with a 25-year-old logistics facility on Finland's northern border with Russia that is let to only 60% of its capacity. In both cases the insurance company has to back the investment with 25% capital requirement.
Shortcoming 2: Model assumes that real estate returns are closely correlated with stock returns - most European insurance companies regard real estate as a portfolio stabilizer and invest in it for diversification benefits, reducing the overall risk. This should allow for a noticeable reduction of the Total Solvency Capital Requirement. Not so with Solvency II as the model strangely assumes an almost perfect correlation between stock and real estate, denying all empirical evidence and the parameters that have an impact on the value (rental income, tenant, lease length and maybe the location, etc).
Shortcoming 3: Model carries total loss assumption for real estate - the possibility of total loss is an assumption inherent to the value at risk model used by Solvency II. Whereas this assumption might be plausible in the case of shares and bonds, it overstates the risk for real estate by denying the intrinsic value for land.
Shortcoming 4: Model assumes that different gearing levels have the same impact on volatility - Solvency II denies that insurance companies actually use gearing for other reasons than leverage: it mitigates tax disadvantages in cross-border transactions and diminishes the exposure to currency fluctuations. For geared property investments an equity capital backing of 39% is required, as for global equity, regardless of the level of loan capital involved. The effect is bizarre: the property in Brussels as described above, financed by loan capital of 20%, will be classified in exactly the same way as the investment in the Finnish logistics facility which is 80% geared. Since only the equity financed proportion has to be backed, the Brussels property actually requires four times more equity backing than the Finnish property.
Unless there are changes to the present regulatory framework, some of the far-reaching implications for the sector might be that:
• Property will lose its importance as an investment: government bonds, already forming a high proportion of insurance company portfolios, could further increase their share as they do not require any capital requirement.
Hence the net returns after cost of capital from a Greek bond will in future be more attractive than the net returns from a core property. Thinking of current state deficit levels this actually is in the interests of the EU...
While in today's low interest rate environment property may still compete with bonds in spite of the regulatory disadvantage, real estate departments of insurance companies will find it increasingly difficult to make a case for property investments in a world of higher interest rates. Rather we may expect large-scale disinvestments from those institutions that currently have higher property allocations.
• The demand for core property will decline but risk appetite will increase: investment will be redirected within the property sector itself. An opportunistic highly geared property investment ties up less capital in absolute terms than a core property financed only minimally through loan capital. This has a preposterous effect: if an insurance company needs to reduce its Solvency Capital Requirement it just increases the gearing of its property investments. There are incentives under Solvency ll to concentrate investment into the higher-risk segment;
• The investment management market will consolidate: Insurance businesses have increasingly grown their property exposure through indirect investments by granting a mandate to external investment managers. However, because of the necessary 39% equity requirement, core property with low loan capital gearing will become comparatively uninteresting, as it does not earn an adequate return on the capital costs. For the reasons stated before business for the core investment manager will shrink and so will the property fund management industry as a whole.
With the quantitative impact study (QIS 6) still ahead there should be enough time to implement a better standard model. Rating models for property exist. A simple model that assesses risk for property under the four aspects of ‘asset' (sector risk), ‘location' (country property market risk), ‘letting' (tenant and contractual risk) and ‘financing'" (high and low gearing risk, currency risk) may still be susceptible to criticism but is clearly superior to the proposal currently under discussion.
Michael Englisch (far left) is director, value scouts and Markus Königstein is director, head of real estate investment, R+V Insurance Group