The potential implications for real estate markets of Solvency II are significant but the regulators still have work to do to ensure appropriate treatment for the asset class, as David Skinner reports
There has been much speculation about the potential impact of Solvency II (SII) on insurance company investment portfolios and asset allocation, most of it focused on the implications for equities and fixed income.
However, little thought has been given to how much less capital efficient it will be to hold real estate under the new regime and whether insurance companies will have the same appetite for the asset class as a result. Although the impact is still unknown and will vary between countries and insurers, the fact that real estate accounts for a relatively small share of portfolios (circa 5%) means insurance companies may be willing to hold it and accept a higher capital charge.
Direct real estate: The stand-alone capital charge for direct real estate is 25%. However, the amount of capital that insurers will actually need to hold depends on the assumed correlation of direct real estate performance with other risk assets and with other risks more generally. As a result, the actual capital that will need to be held against real estate will vary from company to company. The 25% stand alone charge has been based on the UK market experience where there is a reasonably long time series of data on performance of the asset class available from IPD.
This has given rise to a number of criticisms:
• The UK market is one of the more volatile markets in Europe (if not the most volatile). Insurance companies that do not have 100% of their real estate portfolios held in UK real estate could argue that the capital charge is too penal;
• The composition of the UK market is quite different to that of most markets in Europe. For example, there is virtually no residential element in the UK IPD indices unlike in the Netherlands, France and Germany, for example, where residential forms a significant proportion of insurance company holdings. Again, to the extent that the performance of residential property tends to exhibit lower volatility, many non-UK insurers could argue the current proposed capital charge is too high;
• Implicitly, property sector and geographic diversification is ignored. The same charge would be applied irrespective of whether the portfolio was comprised entirely of central London offices or entirely of Munich residential.
The diversification benefit of direct real estate is lower than expected in the standard model. The correlation between property and equities is over-stated (75%) reducing the benefit of property exposure in a diversified portfolio.
Indirect real estate: The treatment of collective investment vehicles in SII still needs to be clarified. The use of leverage appears to reclassify real estate into private equity, which carries a higher capital charge and is assumed to be more highly correlated with other risk assets (reducing the diversification benefits of holding it).
If the regulation was enacted in its current form, the outcome for collective investment vehicles would likely be perverse. The regulation appears to encourage investing into highly leveraged funds to the extent that the capital charge is applied to NAV rather than GAV. While private equity carries a higher charge than property (49%), a fund with leverage of 90% would be much more capital efficient than one with 10% leverage (and than direct property for that matter). This would be a surprising outcome for a new regulatory framework intended to encourage more rigorous risk assessment and management.
Furthermore, listed real estate securities are to be treated in the same way as general equities and carry an equity charge of 39% for companies listed on regulated markets in EEA/OECD countries and 49% otherwise.
Domestic vs foreign real estate holdings: Under current SII proposals, all other things being equal, foreign real estate has a higher capital requirement than domestic real estate. This is a result of the fact that under current proposals insurance companies are required to hold capital to cover currency risk associated with foreign ownership in addition to that required to cover the property risk.
Mortgages: It looks likely that investment in property through mortgages will be capital efficient. Both residential and commercial mortgages carry a capital requirement of less than 10%.
Implications for European property valuations: One of the key principles of SII is that the value of both assets and liabilities are marked to market. In many European countries, insurance company assets are held at book cost. Mainland European property valuations are generally considered to be marked to market less aggressively than they are in the UK. In markets where insurance companies comprise a large share of the IPD universe, greater volatility in performance may be a consequence.
Implications for returns-enhancing and liability-matching (REALM) assets: The SII stress tests are applied to the difference between assets and liabilities. As a result there is likely to be much greater focus on asset-liability matching. For assets that match liabilities very well capital requirements are likely to be less burdensome. By implication, in internal models where liability matching credentials can be demonstrated, REALM assets will likely be attractive relative to traditional real estate.
Do pension funds need to worry about SII? The short answer is yes. There will be changes to the investment behaviour of insurance companies and they represent a significant chunk of real estate ownership. Furthermore, an EU green paper on the future of pensions published in July and focused on adequate, sustainable and safe European pension systems, suggested that a SII-type regime could be applied to pension schemes.
Whatever the final form of the regulation, the impact on the general investment landscape is likely to be significant. While it is too soon to say how significant it is for real estate markets, it is clear that pension funds, as well as insurers, should engage with their asset managers now to start considering the potential implications for their investment portfolios.
David Skinner is investment strategy and research director - real estate at Aviva Investors