As the latest review of Solvency II approaches, research yet again confirms that the capital charge for real estate should be lowered, writes Jeff Rupp

In 2010, as the Solvency II directive was being developed, the European Insurance and Occupational Pension Authority (EIOPA) determined that the standard model Solvency Capital Requirement (SCR) for real estate, and real estate funds following the look-though principle, should be 25%. This figure is designed to reflect the volatility of real estate investments across Europe. However, due to a lack of good data in other markets, the index EIOPA used reflects only relatively volatile UK office and retail assets, consisting of properties located primarily in London. 

As the Solvency II Directive was being debated in the European Commission, Parliament and Council in 2011-13, policymakers knew that the proposed 25% standard model SCR for real estate was not based on data reflecting market volatility across all of Europe. Many privately acknowledged that the UK data used as the basis for determining the real estate SCR significantly overstates the volatility of real estate investment in Europe as a whole.

IPD (now MSCI) released a research report in 2011 that documented this fact. It went on to conclude that a more broadly based and therefore more representative measure of real estate volatility across Europe and, as a result, the solvency capital necessary to meet the worst-case downside market scenario, would be no greater that 15%. 

Nevertheless, in late 2013, policymakers, anxious to establish a single market for insurance services across Europe, agreed to enact the directive with the 25% SCR for real estate, but with the explicit requirement built into the directive that they revisit the SCRs within five years. With the review of Solvency II SCRs set to begin soon, the question arises: do regulators have the data necessary to properly assess the volatility of real estate investments in Europe?

Update provides important new data

The outcome of the SCR review and the establishment of solvency capital requirements for insurers across Europe is important for both large and small insurers, as well as the fund management industry that helps them access the returns real estate offers. Large insurers can develop internal models that result in solvency capital requirements that reflect the volatility of their individual real estate portfolios; however, many have found it difficult to convince their national supervisory authorities that the outcomes of their internal models are accurate, even though they are often nearly half of the standard model requirements. 

Smaller insurers, unable or unwilling to dedicate the immense time and expense required to develop an internal model, are left to comply with the 25% SCR. This effectively sidelines capital that could otherwise be put to use generating the returns needed to meet obligations to policyholders. 

Potentially worse, the 25% SCRe distorts investment decisions away from asset-liability-matching model outcomes or optimal risk-return solutions, to a solution that incorporates the effects of having to sideline capital, regardless of insurers’ real estate investments’ actual downside risk.

“The appropriate shock factor to use for determining the real estate solvency capital requirement should not exceed 15% for all of Europe. Perhaps even more interestingly, MSCI concluded that it should not exceed 12% for European composites that exclude the UK”

In an effort to prepare for the upcoming review and provide fresh evidence to support an SCR for real estate that more accurately reflects the volatility of real estate investment across Europe, INREV – along with five other prominent real estate associations, AREF, BPF, BVI, IPF and ZIA – asked MSCI to update its 2011 research. 

The update, which was published in March, adds six years of European investment market data and five new countries to the data that was available at the time of the original study, bringing the capital risk analysis up to December 2015. 

MSCI updated the original study by first constructing full 15-year quarterly valuation-based indexes for each of the 17 European markets fully covered by MSCI. It went on to estimate additional trading volatility, if any, using transaction-linked indicator methods for key national markets and all relevant pan-European composites. Finally, it used these new series to establish better grounded value at risk (VaR) estimates, using EIOPA-defined methodologies to identify worst-case 12-month negative return sequences. 

This comprehensive search for current evidence of the most extreme European tail VaR indicates that any downside disruptions since 2009 essentially confirm the 2011 conclusions – the appropriate shock factor to use for determining the real estate SCR should not exceed 15% for all of Europe. Perhaps even more interestingly, MSCI concluded that it should not exceed 12% for European composites that exclude the UK. 

Matthias Thomas, CEO of European real estate association INREV, says: “The current 25% SCR for real estate fundamentally misrepresents the picture of volatility across Europe – it’s not based on data representative of the entire market.” 

Stephan Rabe, managing director of ZIA, the German Property Federation, says: “If the capital requirements are not reduced, the equity costs for property investments will increase to an extent that insurers will likely reduce their property investments. This is especially true for properties with a low risk/return structure.

“Instead, insurance companies will have to invest in property markets with higher risk-return profiles in order to achieve returns that not only cover the cost of capital but are sufficient to cover insurance obligations. This is a misdirected incentive not only from the point of view of the property market players but also from the point of view of insurers.”

Industry efforts to support review

The real estate industry is working to encourage regulators to use the updated research from MSCI in the review of the Solvency II SCRs. Almost immediately after the release of the new study, the results were forwarded to the Commission as part of many associations’ responses to the Capital Markets Union (CMU) mid-term review.

Ion Fletcher, director of policy at the British Property Federation, says: “The CMU is designed to eliminate barriers to long-term investment and to avoid distortion caused by regulations, among others. Adopting a more appropriate SCR for real estate would be a good start.”

John Cartwright, CEO of AREF, another UK body, adds: “Regulators don’t have this depth and quality of data at hand, so we hope to help them understand that better and richer data exists that can support them in their review of the SCRs, which, of course, is ultimately better for both insurers and the real estate industry.”

Beyond the SCR review, though, historical data on real estate volatility in 17 European markets updated through the end of 2015 is extremely helpful for the industry.

Sue Forster, CEO of Investment Property Forum, says: “We are not a lobbying organisation. Our principal reason for supporting this study was the facilitation of important new data on real estate volatility that the industry can use for other purposes, such as ALM modelling and risk management.”

Jeff Rupp is director of public affairs at INREV