European property associations moved quickly to challenge EIOPA's proposal to apply features of Solvency II to pension funds, says Jeff Rupp
Despite repeated public assurances from European Commission officials that the IORP Directive would not be a copy-and-paste exercise from Solvency II, when EIOPA released the Quantitative Impact Study (QIS) consultation in June it was immediately clear that it was nearly entirely that. INREV, EPRA, BPF, IPF, AREF, ZIA, the Swedish Property Federation and RICS agreed that there are strong arguments against such an approach and joined forces to prepare a submission challenging the extension of Solvency II rules to pension funds. Real estate is playing an increasingly prominent role in the portfolios of pension funds and property investment is consistent with the Commission's Europe 2020 strategy of encouraging more long-term investment in the European economy. But the IORP proposal is likely to decrease real estate investment, with negative knock-on effects for jobs and the economy.
One of the key points the industry needed to communicate to EIOPA was that the business models and liability profiles of pension funds differ significantly from insurance companies. Therefore, it would be inappropriate to transpose Solvency II rules onto pension funds, even if those rules were perfectly suited to insurance companies. Clearly, Solvency II is itself flawed and should not serve as a model, as many experts have noted.
Nevertheless, several mistakes and inconsistencies contained in the Solvency II QIS 5 are directly transposed into the EIOPA proposal. In fact, some of these oversights were included that have already been corrected in the Commission's most recent draft of Solvency II. For example, the provision that any financing in a real estate investment results in it being treated under the equity module appeared in the QIS 5, but it has been removed from the Commission's current Solvency II draft. However, this provision is included in the IORP consultation.
Other flaws that still remain in Solvency II are also incorporated into the QIS 5, even though they could have been easily avoided. For example, the importance of inflation risk is underestimated. In another example, the IPD review completed last year showed that the 25% standard solvency capital requirement (SCR) for property does not accurately reflect the true volatility of real estate markets across Europe. The review showed that a 15% capital charge for property is more appropriate. Nevertheless, the 25% SCR for real estate was imported without substantive analysis.
By imposing a high standard solvency capital charge on pension funds, EIOPA will reduce the ability of pension funds to meet their obligations to pensioners as a result of sidelining capital available for investment or requiring them to spend huge amounts of money in developing internal models that document the true volatility of their property portfolios. The costs of producing internal models will fall disproportionately on small pension funds, many of which are already struggling as a result of falling income from fixed return investments.
Reduced institutional investment in real estate will also have severe negative macroeconomic effects. A recent INREV/EPRA study shows that €715bn of investments in real estate are currently provided by IORPs and insurers. Considering that pension funds are some of Europe's largest investors in real estate, it can be expected that an inappropriately high SCR will sharply reduce this amount, just as European insurers have reported that high SCR under Solvency II have caused them to reduce their real estate investments, with a likely reduction in economic growth and jobs as a result.
In our submission to EIOPA we acknowledged that reducing volatility in financial markets would benefit investment in the real estate sector. But it is worth stressing the fact that real estate is a highly capital-intensive industry, which relies on readily available financing opportunities. The right balance needs to be struck when developing regulations between creating stable and transparent markets, and not undermining the ability of the real estate sector to continue to foster economic growth and employment in Europe. Achieving this balance is critical if real estate is to support the Europe 2020 strategy of encouraging greater long-term investment in the European economy.
We have been careful to not only focus on everything that we believe is wrong with EIOPA's proposal. We have also tried to be constructive and to offer possible solutions that the regulators could explore.
One thing we felt was really important to emphasise in respect of the 25% standard SCR for real estate, was the research carried out by IPD demonstrating that sufficient data is available to construct an index of property volatility across Europe. Not only would this data better reflect the true volatility of European property markets and therefore its real risk as an investment class, but it would also result in a solvency capital charge for real estate no higher than 15%.
Another significant point to highlight to EIOPA was that INREV is currently developing a matrix of available data sources for property valuations across Europe that, when completed, will be helpful if EIOPA decides to recalculate European property volatility using more representative data. We support EIOPA's objectives of stabilising financial markets and lowering systemic risk, and we hope to be able to meet with EIOPA or Commission officials to discuss the issues we raised and some of the ideas we have for improving the quality of the IORP Directive.
EIOPA will be going through the comments submitted in response to the QIS in the months ahead and will prepare advice to the Commission which is expected in the autumn. The Commission then hopes to be able to produce a proposal for the European Parliament and the European Council by the summer of 2013.
We can only hope that the consistent and robust evidence that we have presented to EIOPA will help them to appreciate the importance of avoiding a ‘one size fits all' approach to the IORP Directive.
Jeff Rupp is director for public affairs at INREV