The precise nature of Solvency II is still unclear, but views on the potential impact on the property market vary widely, from exciting new opportunities to the apocalyptic. Allocations will come under scrutiny, as Christine Senior reports

An impending change to the regulatory landscape in Europe is casting a shadow of uncertainty over the real estate industry. Solvency II, the EU directive that will change the regime governing insurance companies, comes into force on 1 January 2013, and it could have profound implications for insurance companies' investments in real estate.

But just how that will pan out is something of a mystery at the moment - and something which, by and large, insurance companies and the real estate industry are reluctant to discuss, at least for the time being. Some feel it is too early to say exactly what will happen, but the change is barely more than two years away.

What is clear is that Solvency II will set out a risk-based procedure requiring insurance companies to adopt a prudent-person approach to the assets they invest in.

The rules set out under Solvency II focus on short-term risk. Insurers must have a 99.5% confidence they are solvent by calculating the effects of shocks that might affect their assets over a one-year period.

As far as their investment strategy goes, those that are invested in risky assets - and real estate counts as more risky than bonds, but less risky than equities - will be required to hold more capital on their balance sheets. This could in theory deter insurers from investing in real estate, and there is a real possibility that insurers will sell off their real estate portfolios or parts of them to retreat to the safety of bonds.

While insurers have relatively small allocations to real estate, on aggregate their holdings do form a significant figure. In the UK, for example, in December 2009, insurance companies held 6% of their assets in property, but their total assets weighed in at a massive £1.6tn (€1.8tn).

The finer details of the directive are still being worked out. A series of quantitative impact studies (QIS) have been run by the European supervisory organisation CEIOPS, where insurers have been testing their internal regimes against a matrix of calculations proposed under the rules. The most recent exercise, QIS5, is still underway, running from August to November this year, and its results are due to be published next April. This is stress testing companies against the proposed rules, where real estate is subject to a 25% shock, compared with 30% to 40% for equities.

But an extra complication is that the metrics being tested by QIS5 are for a standard model. Larger insurers are permitted to use their own internal models if they have long enough records of data to provide an illustration of solvency using less stringent criteria, for example they might use 20% for property rather than the standard model's 25%.

Individual insurers might argue that their own property portfolios do not contain the level of risk assigned to property that Solvency II provides for. Kiran Patel, global head of strategy & business development at AXA REIM, says AXA's real estate portfolio spreads risk because of its diversification. "When you look at AXA's real estate portfolio it's spread over seven countries with a mixture of risk profiles: some that has leverage, some that hasn't. In any one year we don't see a 25% shock. We might in the UK but that's counterbalanced by what we hold in, say, Switzerland, which has different dynamics."

Until the outcome of QIS5 is known it's difficult to speculate what kind of changes insurers might make to their investment portfolios, says John Hale, investment affairs manager at the ABI. "At one level for each firm it's a competitive issue. They don't want to broadcast to competitors what sort of regulatory capital they are estimating." This might account for their reluctance to speak to the press.

How much difference the new regulation will make to insurers depends to a degree on where they are based, as UK companies already follow a regime that goes some of the way toward Solvency II requirements.

The UK rules are partially risk sensitive, says Bruce Porteous, head of UK risk capital development at Standard Life Group. "We have the individual capital assessment or ICA. It's something close to Solvency II but it's not a public measure; it's a private thing between the industry and the supervisor. In continental Europe their regimes are a long way from Solvency II, they are generally not risk sensitive. I think they are massively underestimating the risk in property investment."

This doesn't apply to the biggest insurers in Continental Europe though, says Porteous: "In Europe the really big companies have their own internal metrics which should already be quite risk sensitive. They shouldn't have a problem getting to Solvency II and when they make a property investment they should already be reflecting the risk of that investment in their internal metrics."

A white paper produced jointly by Edhec Risk Institute and Ortec Finance has looked in more depth at the allocation between non-risky and risky assets, and at how the determination of what is optimal under Solvency II depends on the time frame.

Ortec's managing director, Andrew Slater, says: "Solvency II is very much short-term and our paper is looking at long-term considerations, which boils down to if you optimise in a Solvency II world you end up with a low-risk portfolio, and low risk means low return. That comes back to bite you in the long term. The bigger dynamic is change of duration in your assets to be more in line with liabilities."

It seems that most insurance companies are still establishing their response to Solvency II and the outcome of the latest QIS will obviously have an influence on how they decide to proceed. In any case it's unlikely there would be a sudden and total reversal of their real estate investment policy. Any changes are likely to be adopted progressively, but assessments are likely to be taking place from now on.

"There may be some companies that will struggle to make the new capital requirements on 1 January 2013," says Paul Clarke, chairman of PwC's Solvency II team. "They won't wait till that date to find a solution. One of the solutions they may choose to follow is to adjust the asset mix before we get to 2013. It wouldn't surprise me if we saw changes in the asset mix begin to happen from now on. It doesn't follow that all insurance companies will sell off all their property."

The response is most likely to be a reappraisal of their total asset mix. "Solvency II will require insurers to reappraise the risk-adjusted return on capital and as part of that reappraisal, property, equities, bonds, derivatives will all be reconsidered as part of the journey to an end. People won't consider individual asset classes on a completely isolated standalone basis," says Clarke.

But within real estate the type of assets that have traditionally been the focus of insurance company portfolios should continue to be attractive, he says.

"Historically, because of the way liabilities get discounted, based on the yield of the underlying assets, a strong rental yield has been attractive. That's why insurance companies invest in grade A commercial property, be that flagship office developments or large retail complexes, all of which tend to provide strong rental yields. I don't see anything that would shift that particularly."

One possible route insurers might decide to take is to hedge property portfolios with the use of derivatives. This in turn would create demand for products that currently don't exist in sufficient quantities.

"Insurance companies are going to look at risk on their balance sheet and if they decide there is too much risk there are two possible solutions. They might hedge that risk using property derivatives to try to eliminate some of the risk or they may switch out of property-type investments to lower-risk asset categories like government bonds," says Porteous. "There might be increased demand for property derivatives from insurance companies and presumably investment banks will step in and come up with new products and offerings."

Patel, while relatively relaxed about the changes that might happen to real estate portfolios as a result of Solvency II, feels real estate bonds could fare rather well. "One winner you might see is real estate bonds because in general terms they are more in the bond camp than the real estate camp. If you are buying mortgages you are buying debt, that might have a favourable treatment in terms of the capital charge. The insurance companies I think will find real estate debt quite interesting."

INREV is in the process of working out how the directive affect the unlisted sector, and is working with insurers and the real estate industry to formulate a response. A study currently being made should be completed over the next few weeks.

At the moment the precise influence of the directive on the non-listed sector is still unclear, according to Lonneke Löwik, director of research and market information. "It's still a bit tricky to understand the impact of Solvency II because indirect investments are not covered in detail. There is only one line on the non-listed sector."

AXA REIM's head of fund management, Laurent Lavergne, has done presentations for INREV, and is part of the campaign to raise awareness.

The next few months will be crucial in thrashing out a response to the proposed changes.

Some feel the changes could verge on the apocalyptic for real estate. A real estate investment manager who wanted to remain anonymous says: "This could be hugely significant. But it's clear there is no consistent understanding in the real estate arms of the insurance community on what this will mean. For the insurance industry real estate could almost become a non-sector."

In Germany and other countries where pensions and insurance products are obliged to produce guaranteed rates of return to policy holders, there are particular difficulties that arise out of the proposed rules. In an environment of low interest and low bond yields, insurers need to increase their investment in risky assets to meet their return targets. But the requirements of Solvency II mean they will have to reduce their allocation to these or set more capital aside on their balance sheets.

Markus Königstein, head of investment strategy and portfolio management for real estate at R+V Lebensversicherung, comments: "In Germany and elsewhere, we guarantee policy holders on average between 3 and 3.5% so it is easy to see in an environment where German bonds pay you 2.4%, or 2.5% and you also have internal costs, in the long run as long as you are not fully hedged it's impossible to grant policy holders 3%. From a timing perspective it would be a perfect time to invest in real estate because you are able to achieve higher coupons but now Solvency II says the real estate return is not stable, it has quite a risk. This will definitely affect allocations."

Another controversial aspect of Solvency II is that all real estate is treated equally, whether it's a prestige office block in the City of London or a run-down shopping centre in a provincial town in eastern Europe, and regardless of the degree of leverage. Even own-use properties used by the insurance companies themselves are treated in the same way under the directive.

"It's absurd," says Königstein. "Logistics property in northern Scotland is treated the same as retail units in Munich. And it's quite clear if the pricing is correct a different return would be achievable for a retail unit in Munich where there is less risk than for logistics in northern Scotland. Also leverage has no effect - if you have 1% leverage or 99% it's all the same."

A great deal can happen in two years. But judging by reaction so far, Solvency II could raise just as much of a rumpus as the Alternative Investment Fund Managers directive.