1

REGULATORY IMPACT

ON BANKS’ AND INSURERS’ INVESTMENTS

VLERICK CENTRE FOR FINANCIAL SERVICES

PART OF THE AGEAS CHAIR:

“THE ROLE OF INSURERS FINANCING THE ECONOMY”

PROF. DR. ANDRE THIBEAULT

MATHIAS WAMBEKE

SEPTEMBER 2014

We would like to extend particular thanks

to our research chair partner, Ageas, for their support.

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TABLE OF CONTENTS

Executive summary ................................................................................................................................. 2

Introduction ............................................................................................................................................ 3

1. Basel III implications for banks........................................................................................................ 5

2. Basel III impact on banks’ asset allocation.................................................................................... 10

3. Solvency I vs. Solvency II ............................................................................................................... 18

4. Solvency II impact on insurer’s asset allocation ........................................................................... 34

5. Basel III vs. Solvency II ................................................................................................................... 47

6. Differences in capital requirements for banks and insurers ......................................................... 53

Conclusion ............................................................................................................................................. 70

Annex I - Basel II vs. Basel III ................................................................................................................. 72

Annex II – List of interviewees .............................................................................................................. 79

Annex III – Product cost increase due to Basel III ................................................................................. 80

Annex IV – Solvency II capital charge calculations ................................................................................ 82

Annex V – Comparison between efficient frontier and the average life insurers’ portfolio ................ 84

Sources .................................................................................................................................................. 86

Corresponding author:

mathias.wambeke@vlerick.com or mathias.wambeke@assuralia.be, Tel: 0032498134744

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EXECUTIVE SUMMARY

This report identifies how two major regulatory changes in the financial industry, Basel III and

Solvency II, will impact asset allocation decisions of banks and insurers. We study the Basel III

implications for banks’ asset management through interviews with lending experts, calculations of

funding costs and market data on banks’ asset allocation. We furthermore construct an efficient

frontier based on 15 asset indices and discuss to which extend Solvency II calibrations influence

portfolio selection.

We also compare Basel III and Solvency II capital charges and measure to which extent insurers can

benefit from regulatory arbitrage opportunities compared to banks for different asset classes. We

find that the incentives provided by Basel III and Solvency II are largely consistent with the business

model of banks and insurers. As such, Solvency II directs insurers towards long-term fixed income

investments, which match the long-term liabilities of insurance companies. Basel III, on the other

hand, favours investments with a shorter maturity.

As an example, we find that insurers, from a regulatory capital viewpoint, have a very clear

advantage over banks for residential mortgage loans. This is especially the case for mortgages with a

long maturity and mortgages with a low loan-to-value ratio.

We also find that Solvency II calibrations are advantageous compared to Basel III for other long-term

loan segments, such as infrastructure loans, long-term export loans and long-term loans to public

sector entities. These are granted a beneficial treatment under Solvency II, since insurers are better

able to cover their interest rate risk with such long-term loans. This reduced interest rate risk leads

to lower regulatory capital requirements for insurers.

We find that sovereign debt is treated favourably under both Basel III and Solvency II. Indeed,

sovereign debt rated AA or higher requires no capital under Basel III. Solvency II takes this even a

step further, requiring no capital for any sovereign debt exposure from the entire European Union.

The treatment of other, shorter term asset classes is often similar under both regulatory

frameworks. As such, we find that capital charges for short- and medium-term corporate exposures

are largely comparable under both Basel III and Solvency II. Securitised assets are an exception to

this rule: capital charges for securitisations are highly unattractive for insurers compared to banks.

The transactions and partnerships between banks and insurers observed recently in financial

markets often corroborate our findings on regulatory incentives provided by Basel III and Solvency II.

Furthermore, we see additional potential for insurers to become active in the market for residential

mortgage loans.

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INTRODUCTION

The regulatory landscape is changing for the European financial sector. On the banks’ side, the

capital requirements regulation (CRR) and capital requirements directive (CRD IV) are being

introduced. CRR and CRD IV implement the global Basel III framework, imposing stronger capital and

liquidity requirements for banks. Insurers, on the other hand, also face changing capital

requirements with the introduction of Solvency II.

These changing regulations can influence how banks and insurers compete or cooperate in certain

markets. More specifically, this report studies the influence of Basel III and Solvency II on the

investment behaviour of banks and insurers, respectively. We provide an overview of the Basel III

framework and assess the implications for banks’ asset management decisions through interviews

with lending experts, calculations of funding costs and market data on banks’ asset allocation. We

also provide an overview of Solvency II regulations and verify to which extent Solvency II may affect

insurers’ asset allocation. We furthermore ask whether Basel III capital requirements for certain

asset classes are similar to capital requirements under Solvency II. As such, we check whether

insurers may have regulatory arbitrage opportunities over banks for certain asset classes.

The first chapter analyses how Basel III affects banks’ lending activities. We find that the pricing of

loans will be highly influenced by capital and liquidity requirements, even to an extent that bank may

become uncompetitive for certain products. Certain banks may also face constraints in their lending

capacity due to Basel III, which reinforces the trends for deleveraging and disintermediation.

The second chapter of this report identifies how specific assets classes are impacted by new Basel III

requirements. We find that banks have clearly reduced their allocation towards securitisations,

inter-bank loans and infrastructure loans. We show that several banks have taken steps to reduce

the maturity of their portfolio of infrastructure debt. We also find evidence for disintermediation in

a wide range of lending segments.

The third chapter assesses the new regulatory framework for the European insurance sector:

Solvency II. We present an overview of Solvency II regulations and compare these to the previous

Solvency I regime. We show that Solvency II takes into account all relevant risks related to the

insurer’s investments, whereas Solvency I did not provide any risk measure for the insurer’s asset

side. We also provide an overview of capital charges under the Solvency II standard formula for a

range of asset classes.

The fourth chapter assesses the implications of Solvency II on the asset allocation of insurance

companies. We build an efficient frontier based on 15 asset indices and calculate the market risk

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capital charges for the portfolios of this efficient frontier. We furthermore calculate the market risk

capital for the portfolio of an average European life insurer and assess whether this portfolio

complies with a likely budget for market risk capital.

The fifth chapter compares the Basel III and Solvency II framework, focussing on regulations for the

investment side of banks and insurers. We find that Solvency II allows for a more diverse range of

capital instruments and puts more emphasis on the matching of assets and liabilities. Furthermore,

Solvency II is absent of any charge for liquidity risk. We also compare the specific capital charge

calculation methods under Basel III and Solvency II and find that both frameworks have a very

different approach in terms of diversification benefits, interest rate risk and loss absorbing capacity

of liabilities.

The sixth chapter presents an overview of different asset classes and measures to which extent

insurers can benefit from regulatory arbitrage opportunities compared to banks. To this end, we

assess the Solvency II and Basel III capital charges for several asset classes. We find that the

incentives provided by Basel III and Solvency II are largely consistent with the business model of

banks and insurers, i.e. Solvency II directs insurers towards long-term fixed income investments,

while Basel III favours investments with a shorter maturity.

The final chapter concludes and graphically represents the attractiveness of Basel III and Solvency II

capital charges for different asset classes.

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1. BASEL III IMPLICATIONS FOR BANKS

This chapter provides an overview of different implications of Basel III on banks’ lending behaviour.

This chapter is based on a theoretical review of Basel III implications and also provides outcomes of

interviews with lending experts at 10 major European banks1. We start by giving a view on the

influences of Basel III on loan pricing, followed by a discussion of reduced lending capacity,

deleveraging and disintermediation. A detailed review of Basel III specifications can be found in

Annex I.

Pricing

Basel III will considerably increase costs for a wide range of lending activities. The combined effect of

capital requirements and liquidity ratios will highly influence banks’ cost of funding, which in turn

will influence banks’ pricing behaviour.

Different elements in Basel III will increase the capital costs for banks’ lending activities:

- Higher capital ratios for common equity Tier 1 and Tier 1 capital

- The introduction of the capital conservation buffer, countercyclical buffer and a capital

surcharge for systemically important financial institutions

- Stronger requirements for capital quality: phasing out of step-up hybrid capital previously

included under Tier 1, elimination of Tier 3 capital and the deduction of several balance

sheet items (e.g. goodwill, other intangibles and deferred tax assets) from CET1.

- Increased risk weights for interbank exposures and resecuritisations

Furthermore, liquidity requirements – notably the liquidity coverage ratio (LCR) and net stable

funding ratio (NSFR) – influence costs through different channels:

- Increasing allocation to high quality liquid assets (e.g. government bonds or high rated

corporate bonds) or increasing allocation to assets with a low required stable funding factor

(i.e. high rated assets or assets with a residual maturity of less than one year). This will

inevitably lower the yield of banks’ asset base.

- Increased funding from liabilities with low outflow assumptions (in order to optimise the

LCR) or high available stable funding factors (in order to optimise the NSFR). Such liabilities

include capital instruments, retail deposits, or generally liabilities with residual maturities of

one year or more. Such liabilities are inevitably more expensive compared to e.g. short term

wholesale funding.

1 Annex II presents a list of interviewees.

6

Table 1 displays the funding cost increases due to Basel III for investing in a specific product,

measured in basis points. This table distinguishes between the increase in capital costs (related to

Basel III capital ratios, capital quality requirements and risk weights) and the increase in liquidity

costs (related to the Basel III LCR and NSFR). Assumptions underlying these calculations can be found

in Annex III. This table will be presented in more detail for each asset class in the next chapter.

Table 1 - Funding costs increase due to Basel III (basis points)

Asset – rating Change capital

cost

Change liquidity

costs

Change total

costs

Consumer loans 34.50 12.20 46.70

Residential mortgage loans 16.10 11.99 28.09

Corporate loans A 23.00 12.20 35.20

Government bonds AA or higher 0.00 0.11 0.11

Securitisations A 3 year maturity 28.75 12.20 40.95

Resecuritisations A 511.10 12.20 523.30

Table 1 indicates that the change in capital costs is the predominant component for most asset

classes. Changes in liquidity costs are relatively low. This can be partly explained by the low interest

rates at which banks can currently gather long-term stable funding, i.e. the cost of complying with

the NSFR is relatively low.

Our interviews with 10 European banks also confirmed that pricing increased due to the combined

effect of the LCR, NSFR and capital ratios introduced under Basel III. However, our interviewees

noted that pricing is generally not conducted on a product basis (i.e. for individual loans) but on a

relationship basis. All possible revenues (loans, payment services, bank accounts…) and all possible

costs (including costs due to Basel III) are taken into account to determine the profitability of a

relationship. Hence, the increased capital and liquidity costs introduced by Basel III do not

necessarily have to reflect directly in higher margins for a particular loan. Our interviewees generally

observe that most customers are capable of accepting higher margins, since reference rates are

historically low: i.e. even though margins may increase, total (nominal) rates still remain very low.

Nevertheless, our interviews showed that, for certain lending segments, banks have become

uncompetitive due to their increased funding costs. As an example, several banks also noted that

large corporates can find cheaper funding through bond issuance compared to bank loans. Our

interviews also revealed that the markets for long-term infrastructure loans and long-term loans to

public sector entities are seeing increased competition from institutional investors. Indeed,

institutional investors, such as insurers and pension funds, operate on a different cost basis

compared to banks and can therefore provide a tighter pricing for certain niche lending segments.

7

Basel III also introduced a non-risk based leverage ratio of 3%. Our interviews generally indicated

that this leverage ratio does affect pricing behaviour since most banks have always maintained a

leverage ratio above this strict minimum. The leverage ratio might nevertheless affect specific items

which bear a low risk weighting but can take up a large part of a banks’ balance sheet. As such, our

interviewees indicated that derivatives, securities lending and repos are highly affected by the

leverage ratio.

Reduced lending capacity, deleveraging and disintermediation

Banks facing a shortfall in capital or stable funding will have to take significant mitigating steps in

order to comply with Basel III requirements. Table 2 shows the evolution of CET1 shortfall and stable

funding deficits as presented in the monitoring reports of the Basel Committee.

Table 2 – Capital and stable funding shortfall in Basel III monitoring reports (billions)

Monitoring exercise date CET1 shortfall Stable funding shortfall

30 June 2011 €518.00 €2,780.00

31 December 2011 €395.80 €2,500.00

30 June 2012 €224.20 €2,400.00

31 December 2012 €140.60 €2,000.00

30 June 2013 €85.20 (not disclosed)

Our interviews with 10 European banks have shown many possibilities of how to reduce a potential

shortfall in capital or stable funding. Banks can e.g. choose to place non-core assets in bad banks,

divest portfolios in non-strategic countries, reduce trading activities, increase longer term funding or

issue shares. Another possible trend, advocated by many of our interviewees, is for banks to move

towards an “originate and distribute” model. Indeed, many of the interviewed banks indicated that,

due to funding constraints, activities such as corporate bond issuance, securitizations and co-

financing agreements with institutional investors will play a more prominent role. Banks can thus

leverage their knowledge in sourcing credits and can acquire RWA-free fee income instead of RWA-

heavy net interest income. The next chapters will highlight for some particular asset classes and their

potential of co-financing with institutional investors. Figure 1 illustrates the importance of

disintermediation for credit to non-financial corporations in the Euro area. While the amount of

bank loans has been declining since 2009, debt securities have continued to rise in recent years.

Several interviewees noted that this trend towards bond issuance in Europe is likely to continue in

the future: not only large corporates, but also mid-corp clients and in a later stage, larger SMEs

might be pushed towards bonds issuance.

8

This trend towards disintermediation is nevertheless highly dependent on the funding characteristics

of banks. As an example, banks which have abundant access to retail deposits are generally better

capable of answering all loan demands from their clients. Table 3 displays funding characteristics for

banking sectors across countries.

Table 3 - Banks' funding characteristics Source: ECB

Country

customer deposits

/ assets

Loan-to-deposit

ratio

(capital + reserves)

/ assets

Belgium 60% 78% 5.74%

Germany 60% 98% 5.82%

France 48% 112% 6.39%

Netherlands 45% 121% 4.91%

United Kingdom 42% 107% 8.87%

This table, as well as our interviews with 10 European banks, show some interesting findings:

- Belgium and Germany have abundant access to cheap, long-term retail deposits. This

funding base also entails that these banks can easily comply with the LCR and NSFR. Our

interviews with Belgian banks even showed that, due to this access to retail deposits, banks

have surplus liquidity on their balance sheet: Belgian banks do not see enough investment

opportunities to put their liquidity to work. Hence, their need for disintermediation has

disappeared. Our interviewees did note that, once the economy picks up again, banks may

not have enough capital to absorb all the demand for loans: this could be a new pulse for

disintermediation.

- In France, the UK and the Netherlands, bank cannot heavily rely on retail deposits and have

to finance themselves more through e.g. short-term wholesale funding. For these banks, the

LCR and NSFR can put constraints on lending activities. Disintermediation is therefore an

0

1

2

3

4

5

6

2007 2008 2009 2010 2011 2012 2013 2014

Bank loans Securities other than shares

Figure 1 - Funding sources of Euro area non-financial corporations Source: ECB. In trillion euros.

9

important trend in these countries. The Netherlands faces additional problems due to their

large amount of long-term mortgages, as depicted by the loan-to-deposit ratio of 121%.

Preliminary conclusion

Basel III is definitely not the only factor for the allocation or pricing decisions of banks seen over the

past years. Other factors such as funding constraints experienced during the financial crisis, the low

demand for loans in the current cycle of the economy, the strategy of certain banks to keep servicing

certain customers, the potential for cross selling certain products etc. can also be important drivers

of making certain allocation or pricing decisions for loans. Nevertheless, this chapter has indicated

several important trends influenced by Basel III. The new regulatory framework influences pricing for

a wide range of assets, even to an extent that bank may become uncompetitive for certain products.

NSFR and capital requirements may put lending constraints on certain banks, which enhances the

trends for deleveraging and disintermediation. The next chapters will provide details on the

regulatory effects on specific asset classes.

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2. BASEL III IMPACT ON BANKS’ ASSET

ALLOCATION

The previous chapter discussed banks’ higher funding costs introduced by Basel III. These higher

funding costs may introduce a repricing for different lending segments, or when such a repricing is

impossible, will lead to a divestment from banks of the businesses with an insufficient ROE. Banks

facing a shortfall in capital or stable funding will be required to adapt their funding base, or reduce

investments which consume the most capital and liquidity.

In this section, we discuss to which extent banks’ main asset classes will be affected by Basel III. Our

focus is towards assets held in the banking book and not in the trading book. We consider

securitisations, inter-bank loans, corporate loans, residential mortgages, long-term lending (e.g.

infrastructure loans) and commercial real estate loans. This chapter is partly based on a theoretical

review of Basel III. Our theoretical findings are compared with outcomes of interviews with lending

experts of 10 major European banks and market data on banks’ asset allocation.

(Re)securitisations

Basel III risk weights for (re)securitisations have considerably risen compared to Basel II, as

demonstrated in Annex I. Furthermore, higher capital ratios, capital quality requirements and

liquidity ratios will considerably increase funding costs for holding (re)securitisations. In general,

(re)securitisations require 85% of stable funding are not considered as high-quality liquid assets

(HQLA). One exception are qualifying RMBS which only require 50% of stable funding and are

considered to be HQLA for 75% of their value. Table 4 summarizes the increase in funding costs for

(re)securitisations due to Basel III.

Table 4 - Funding costs increase for (re)securitisations due to Basel III (basis points)

Asset – rating – maturity Risk

weight

LCR

factor

RSF

Factor

Change

capital

cost

Change

liquidity

costs

Change

total

costs

RMBS AAA 3 years 20% 75% 50% 9.20 9.07 18.27

RMBS AA 3 years 37.5% 75% 50% 17.25 9.07 26.32

Securitisations AAA 3 years 20% 0% 85% 9.20 12.20 21.40

Securitisations AA 3 years 37.5% 0% 85% 17.25 12.20 29.45

Securitisations A 3 years 62.5% 0% 85% 28.75 12.20 40.95

Securitisations BBB 3 years 110% 0% 85% 50.60 12.20 62.80

Securitisations BB 3 years 195% 0% 85% 89.70 12.20 101.90

Securitisations B 3 years 365% 0% 85% 167.90 12.20 180.10

Securitisations CCC 3 years 495% 0% 85% 227.70 12.20 239.90

Securitisations below CCC- 3 years 1250% 0% 85% 575.00 12.20 587.20

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Resecuritisations AAA 69% 0% 85% 31.69 12.20 43.88

Resecuritisations AA 693% 0% 85% 318.76 12.20 330.95

Resecuritisations A 1111% 0% 85% 511.10 12.20 523.30

Resecuritisations BBB or lower 1250% 0% 85% 575.00 12.20 587.20

The Basel III regulatory reforms, together with the general sub-prime considerations surrounding

securitisations, have been an incentive for banks to divest such assets. This trend is likely to

continue, particularly for the low rated or complex securitisation segments. On the other hand, the

relative importance of plain vanilla or pass through securitisations might increase compared to the

reduced attractiveness of securitisations in general. Our interviews with 10 European banks confirm

these findings. All of the interviewed banks which previously invested in securitisations have

considerably reduced such activities. These banks indeed confirmed that Basel III regulations are not

favourable towards securitisations. Some banks still use ABS or MBS for liquidity purposes.

In line with the above reflections, a study by Fitch Ratings (2013) confirmed that securitisation

exposures of European systemically important banks decreased by 29% during 2010-2012. Similarly,

figure 2 shows a declining trend in the amount of outstanding securitisations in Europe.

Interbank lending

Inter-bank lending will be largely affected by the amended risk weights on financial institution

exposures. Basel III introduces the so-called “asset value correlation multiplier”, which increases

correlation assumptions for large financial institutions by 25%. Such correlation assumptions heavily

impact risk-weighted asset calculations, and will therefore effectively discourage interbank lending.

Having interbank loans on the liabilities side is also highly unattractive due the LCR calibration:

interbank funding of less than 30 days bears a run-off factor of 100%.

Overall, European systemically important banks have decreased their exposures to the financial

sector by 9% (see Fitch Ratings, 2013), and Basel III requirements are likely to have contributed to

this reduction. Our interviews with 10 European banks largely confirm these findings: none of the

banks see interbank lending as a strategic activity, and a majority of banks has materially reduced

1000

1500

2000

2500

2009 2010 2011 2012 2013 2014

Figure 2 - European outstanding securitisations In billions. Source: AFME

12

their interbank exposures. Our interviewees noted that interbank exposure of longer maturities (e.g.

6 months or more) are the most affected.

Even though repurchase agreements generally have lower risk weights compared to unsecured

interbank lending, the leverage ratio introduced by Basel III might significantly reduce the potential

of the repo market. After all, the leverage ratio effectively discourages lower risk exposures which

take up a large part of the banks’ balance sheet. A report by Barclays (2013) indeed predicts a

decline by 10 to 15% based on current leverage proposals.

Sovereign debt

High rated sovereign debt is given a beneficial treatment under Basel III. Risk weights, LCR factors as

well as required stable funding (RSF) factors are inclined towards sovereign bonds. Furthermore,

government bills and bonds form a substantial part of the high quality liquid assets (HQLA) required

in the liquidity coverage ratio: at least 60% of HQLA needs to consist out of bank notes, central bank

reserves or sovereign debt with a 0% risk weight. Table 5 provides the risk weights, LCR factors, RSF

factors and funding cost increases for sovereign bonds under Basel III.

Table 5 - Funding costs increase for sovereign bonds due to Basel III (basis points)

Asset – rating Risk

weight

LCR

factor

RSF

Factor

Change

capital

cost

Change

liquidity

costs

Change

total

costs

Government bonds – AA or higher 0% 100% 5% 0.00 0.11 0.11

Government bonds – A 20% 85% 15% 9.20 9.56 18.76

Government bonds – BBB 50% 0% 85% 23.00 12.20 35.20

Government bonds – BB or B 100% 0% 85% 46.00 12.20 58.20

Government bonds – below B- 150% 0% 85% 69.00 12.20 81.20

In order to comply with the stringent Basel III liquidity requirements, banks have been increasing

their holdings of sovereign debt considerably over the past years. Indeed, a study by Fitch Ratings

(2013) shows that European systemically important banks have increased their exposure to

sovereigns by 26% over the period 2010-2012. Similarly, figure 3 shows a rising trend in government

lending for euro area banks2 over the past years. Hence, these numbers clearly validate the

beneficial capital and liquidity treatment of sovereign exposures under Basel III.

2 Figures 3, 4 and 7 provide aggregated investments of Monetary Financial Institutions (MFIs) excluding central

banks as defined under the regulations ECB/2008/32 and ECB/2011/12.

13

Our interviews with 10 major European Banks confirm the attractiveness of sovereign bonds due to

their beneficial treatment under Basel III. A majority of interviewees confirmed they have increased

their allocation towards sovereign exposures. One interviewee also noted that the ECB’s LTRO

program provided an additional incentive to invest in sovereign debt. Nevertheless, most banks do

not see sovereign debt as a strategic investment and only use such assets for their liquidity buffer.

Corporate exposures

Basel III will considerably increase the costs for holding corporate loans. Even though Basel III did not

change the risk weights for corporate exposures, table 6 clearly shows that capital requirements,

capital quality regulations and liquidity ratios will increase the funding costs for this asset class.

Table 6 - Funding costs increase due to Basel III/CRD IV for corporate exposures (basis points)

Asset – rating Risk

weight

LCR

factor

NSFR

factor

Change

capital

costs

Change

liquidity

costs

Change

total

costs

Corporate loans – AA or higher 20% 0% 65% 9.20 11.99 21.19

Corporate loans – A 50% 0% 85% 23.00 12.20 35.20

Corporate loans – BBB or BB 100% 0% 85% 46.00 12.20 58.20

Corporate loans – below BB- 150% 0% 85% 69.00 12.20 81.20

Corporate loans – unrated 100% 0% 85% 46.00 12.20 58.20

SME loans – unrated3 57% 0% 85% 26.29 12.20 38.48

These higher funding costs can be an incentive towards disintermediation. Indeed, our interviews

with 10 European banks have shown that large corporates may find cheaper funding in capital

markets compared to ordinary bank loans.

Banks which are not able to secure enough capital and stable funding in order to comply with Basel

III can also be pushed towards disintermediation. Our interviews with 10 European banks have

3 CRR/CRD IV Regulation (EU) No 575/2013 article 501 specifies a factor of 0.7619 (this is the so called SME

"supporting factor") to be applied to capital requirements for SME loans. We assume SME loans to be weighted at 75% under the standard weight for retail exposures, not taking into account the supporting factor.

5,0%

5,5%

6,0%

6,5%

7,0%

2009 2010 2011 2012 2013 2014

Figure 3 - Government loans as a share of total lending Source: ECB

14

shown a great difference between Belgian and foreign banks in this respect. Whereas Belgian banks

often have enough stable funding in order to satisfy loan demand, foreign banks often more inclined

to issue bonds for their clients or to transfer loans to institutional investors. Several interviewees

even see a potential for bond issues for larger SMEs.

This trend towards disintermediation is clearly reflected in the amount of corporate loans on banks’

balance sheets. A study by Fitch Ratings (2013) has indeed shown that European systemically

important financial institutions reduced their corporate exposure by 9% over the years 2010-2012.

Similarly, figure 4 shows a decline in loans to non-financial corporations since 2009.

Our interviews with 10 European banks generally show the strategic importance of corporate loans

due to the potential of cross selling ancillary services. Interviewees generally indicate a constant or

slight decrease in allocation to corporate and SME loans over the past years. Interviewees who

admit a decreasing exposure point out that this is mainly due to the lower demand for loans from

their clients. Indeed, ECB lending surveys show that demand for loans was particularly low over

2012-2014 (see figure 5), whereas supply credit standards (figure 6) have broadly remained at their

historical average.

24,0%

24,5%

25,0%

25,5%

26,0%

26,5%

27,0%

27,5%

2009 2010 2011 2012 2013 2014

Figure 4 - Loans to non-financial corporations as a share of total bank lending Source: ECB

-50

-40

-30

-20

-10

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20

30

40

20

03

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04

20

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20

06

20

07

20

08

20

09

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10

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13

20

14

Figure 5 - Loan demand Measured as the difference between the share of banks

reporting an increase in loan demand and the share of banks reporting a decline. Source: ECB bank lending survey

-20

0

20

40

60

80

20

03

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04

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Figure 6 - Supply credit standards Measurd as the difference between the share of banks

reporting that credit standards have been tightened and the share of banks reporting that they have eased. Source: ECB

bank lending survey

15

Residential mortgages

Basel III reforms only have a minor impact on residential mortgage lending. The risk weight for

mortgage loans under Basel II/Basel III is relatively low at 35%. Furthermore, under NSFR, residential

mortgage loans are granted an RSF factor of only 65%. Table 7 shows that Basel III reforms do not

heavily affect funding costs for residential mortgage loans. These funding costs can be further

reduced through the use of covered bonds, which exist already for a long period in most jurisdictions

and are allowed in Belgium under recent regulatory reforms.

Table 7 - Funding costs increase for residential mortgages due to Basel III (basis points)

Asset Risk weight

LCR factor

RSF factor

Change

capital

cost

Change

liquidity

costs

Change

total

costs

Residential mortgage loans 35% 0% 65% 16.10 11.99 28.09

It appears that mortgage loans are still an attractive asset class for banks: a report by Fitch Ratings

(2013) has shown that exposures to residential mortgages have increased by 12% over the period

2010-2012. Similarly, figure 7 clearly shows that euro area banks have increased their holding of

retail mortgage loans.

Our interviews with 10 European banks show that most banks have kept a stable or increasing

allocation towards residential mortgage loans over the past years. The Belgian banks we

interviewed, for example, have generally remained stable in their allocation towards residential

mortgages, although they often have decreased the maturity and loan-to-value (LTV) of their

portfolio. The interviewed Belgian banks note that loans with an exceptionally high maturity (30

years or more) or an LTV of 110% had an excessive credit risk and therefore are not issued anymore.

The Dutch banks we interviewed have broadly decreased their allocation over the past years, often

due to a lack of stable funding. Another interesting outcome of our interviews is that all banks

viewed residential mortgage loans as a strategic activity, due to their potential of cross-selling other

products and services.

18%

19%

20%

21%

22%

23%

24%

2009 2010 2011 2012 2013 2014

Figure 7 - Retail mortgage loans as a share of total bank lending Source: ECB

16

Long-term lending: infrastructure loans and export loans

Certain lending segments, such as infrastructure loans or long-term export loans, typically have very

long maturities. Basel III particularly affects such long-term lending due to the introduction of the

NSFR. This liquidity ratio asks to fund long-term lending with long-term liabilities, which are typically

more expensive. Furthermore, the specific NSFR calibration is not specified yet: hence, banks who

now grant long-term loans do not know exactly which liabilities will be allowed to cover such loans.

This regulatory uncertainty is an additional burden for long-term lending.

Now that Basel III is being phased-in, banks rarely provide loans with a maturity longer than 10

years. Figure 8 indeed shows that the average maturity of European infrastructure loans has

decreased significantly in the past decade: the maturity of loans in recent infrastructure projects is 7

years, whereas 15 year maturities were the norm in 2006-2008.

The funding costs for infrastructure loans and export financings are broadly similar to the costs

presented in table 6. However, an important difference with general, shorter term corporate lending

is that infrastructure loans and export loans are priced on a stand-alone basis. Indeed, our interviews

with 10 European banks have shown that such loans are often one-off deals which do not provide

any potential of cross-selling other products. Hence, the pricing for such loans is highly sensitive to

new regulations, such as the NSFR. Our interviewees generally admit they are facing difficulties in

competing with institutional investors for long-term lending, especially in the segment for long

dated, fixed rated infrastructure projects with stable cash flows. Banks are on the other hand more

competitive for floating rate financing, assets with construction risk, or assets with refinancing in the

future.

Our interviews with 10 European banks show that a majority have reduced their allocation towards

infrastructure loans. Banks also often admit that the infrastructure loans which they granted

recently are of a relatively short maturity. Some Belgian banks however are facing an excess liquidity

0

5

10

15

2006 2007 2008 2009 2010 2011 2012 2013

Figure 8 - Average maturity of loans in infrastructure projects Compiled from the Infrastructure Journal database. Average of greenfield and brownfield projects.

17

position, hence they cannot be selective in their loan policy: some interviewees therefore note that

their excess liquidity forced them back into the long-term infrastructure market.

Commercial real estate loans

Commercial real estate loans are risk weighted at 100% under Basel II/Basel III. This relatively high

risk weight, together with stringent liquidity requirements, induces substantially higher funding costs

under Basel III, as shown in table 8.

Table 8 - Funding costs increase due to Basel III for commercial real estate (basis points)

Asset Risk weight

LCR factor

RSF Factor

Change capital cost

Change liquidity costs

Change total costs

Commercial real estate 100.0% 0% 85% 46.00 12.20 58.20

Our interviews with 10 European banks have shown that a minority of interviewees admit a lower

allocation to CRE loans over the past years. However, such allocation decisions are often inspired by

general risk considerations and are as such unrelated to Basel III. Indeed, our interviews have shown

that market and credit factors are predominant when assessing CRE loans: the risk cost in this

segment can be very important, and this often has a bigger impact than the capital and liquidity

costs introduced by Basel III.

Preliminary conclusion

Basel III capital and liquidity requirements severely affect a wide range of lending segments. We

show that securitisations, inter-bank loans, corporate loans, long-term lending and commercial real

estate experience substantially higher funding costs as a consequence of Basel III. Our interviews

demonstrate that banks have taken substantial mitigating actions to counter the effects of Basel III.

Indeed, this report shows that banks have clearly reduced their allocation towards securitisations,

inter-bank loans and infrastructure loans. Several banks have also taken steps to reduce the maturity

of their portfolio of infrastructure debt. Our interviewees furthermore confirm a trend towards

disintermediation for several lending segments.

18

3. SOLVENCY I VS. SOLVENCY II

SOLVENCY I

The current framework on capital requirements for insurance companies, Solvency I, was introduced

in 2002. The Solvency I framework amends the original insurance directives dating from 1973 and

1979. However, the overall structure of the original directives remained essentially unchanged. A

summary of the capital requirements for life and non-life insurers under Solvency I can be found in

table 9.

Table 9 - Solvency I capital requirements

Life insurance Non-life insurance

The sum of:

4% of technical provisions where the insurer

runs investment risk

1% of technical provisions of unit-linked

products (i.e. technical provisions where the

insurer does not run investment risk) where

the management fee is settled for a period of

more than 5 years

25% of management fees for unit-linked

products where the management fee is

settled for a period of less than 5 years

A charge for capital at risk (i.e. the amount

payable on death less the technical provision

of the life insurance policy)

o 0.1% of risk capital where the remaining

term is less than 3 years

o 0.15% of risk capital where the remaining

term is between 3 and 5 years

o 0.3% of risk capital where the remaining

term is more than 5 years

The maximum of:

18% of premiums under €50 million and

16% of premiums above €50 million

o Premiums for aircraft liability, liability

for ships and general liability should

be increased by 50 %

26% of average claims under €35 million

and 23% of average claims above €35

million

o Premiums for aircraft liability, liability

for ships and general liability should

be increased by 50 %

In order to obtain the Solvency I capital

requirement for non-life insurers, this

maximum should be multiplied by the ratio of

net claims (i.e. claims after reinsurance) to

gross claims (i.e. claims before reinsurance).

The ratio should be at least be 50%.

Solvency I also asks insurers to set up a minimum guarantee fund as an absolute minimum level of

capital. This minimum guarantee fund is set to be at a minimum of € 3 million, with some minor

changes depending on the type of insurer. Given this low amount of the minimum guarantee fund, it

is only relevant for the smallest European insurance companies.

Under Solvency I, investment risks are merely addressed by setting certain asset limits. These limits

can apply either to the total investment portfolio or to exposures against a single counterparty.

These limits are provided in table 10.

19

Table 10 - Asset limits under Solvency I

Asset class Concentration limit

(% of gross technical provisions)

Any one piece of land or building 10

Total shares and negotiable instruments of

one company

5

Total shares and debt securities not dealt in

on a regulated market

10

Total unsecured loans 5

Any single unsecured loan, other than

unsecured loans to financial institutions

1

Cash 3

Solvency I has been heavily criticised. The main disadvantages of Solvency I include:

Solvency I capital requirements are essentially not risk based. There is no relationship

between the riskiness of an insurer and its Solvency I capital requirements.

The riskiness of the insurer’s investments are not taken into account for the Solvency I

capital requirement. Indeed, the investment limits mentioned under table 10 are

definitely not sufficient to account for market or credit risks.

Solvency I includes some adverse incentives. Risk-reducing measures, such as increasing

non-life premiums, or adding layers of prudence in the life technical provisions, result in

rising capital requirements.

Solvency I is merely an update of directives dating back from the 1970s. The overall structure of the

original directives remained essentially unchanged, which results in the fact that Solvency I is

essentially not risk based. In the process of drafting the Solvency I requirements, it became clear

that a more wide-ranging reform was required – hence Solvency II.

20

SOLVENCY II

The solvency II project has been launched in 2002 with the aim of making truly risk based solvency

requirements. The current timeline specifies that the Solvency II regime will be applied as of 1

January 2016. Solvency II, just like Basel II and Basel III, is focussed around 3 pillars, as shown in table

11. The next paragraphs will focus on pillar 1 specifications.

Table 11 - Three pillar structure of Solvency II

Pillar 1: financial requirements Pillar 2: supervisory review Pillar 3: market discipline

Valuation of technical

provisions

Solvency requirements:

solvency capital requirement

(SCR) and minimum capital

requirement (MCR)

Powers of supervisory

authorities: supervisory

review process (SRP)

Governance guidelines

Own risk and solvency

assessment (ORSA)

Disclosure requirements

Solvency capital requirement (SCR): different modules

The Solvency II capital requirement (SCR) is designed to meet all quantifiable risks on an existing

portfolio plus one year’s expected new business. It is calibrated at a one year 99.5% VaR. The SCR

aims for a comprehensive approach, including all relevant risks, taking into account diversification

between the different risk classes. The different modules of the SCR are depicted under figure 9.

Whereas Solvency I did not include capital charges for the insurers’ investment side, Solvency II now

explicitly takes into account market risks. This explains the high importance of Solvency II for

insurers’ investment activities.

Solvency Capital Requirement (SCR)

Adjustment for the risk absorbing effect of technical provisions and deferred

taxes

Basic Solvency Capital Requirement (BSCR)

Health underwriting

risk

cf. life

cf. non-life

Catastrophe

Life underwriting

risk

Mortality

Longevity

Disability-morbidity

Lapse

Expense

Revision

Catastrophe

Non-life underwriting

risk

Premium reserve

Lapse

Catastrophe

Counterparty default risk

Market risk

Interest rate

Equity

Property

Spread

Currency

Concentration

Intangible assets risk

Capital requirement for operational risk

Figure 9 - SCR modules and sub-modules

21

The specific stress calibrations and calculation methods used to determine the amount of the

solvency capital requirement (SCR) are detailed under table 12.

Table 12 - SCR calculation methods

Risk module Sub-module Methodology for calculating SCR

Operational risk Operational risk Factor * premiums or factor * reserves. This amount is capped at 30% of the basic SCR. 25% of expenses related to unit-linked products are added.

Intangible asset risk Intangible assets 80% of the value of intangible assets

Market risk Interest rate Maximum loss due to upward and downward interest

rate shocks

Equity 39% decrease in value for equities listed in regulated markets of the EEA or the OECD. 22% decrease in strategic participations. 49% decrease in other equity exposures. Subject to a “symmetric adjustment”

Property 25% decrease in the value of land, buildings and

immovable-property rights

Currency Maximum loss due to a 25% upward and downward

shock in foreign exchange rates

Spread Market value * duration * shock factor, depending on

the rating of the fixed income instrument

Concentration Adjustment to address the risk regarding the

accumulation of exposures with the same

counterparty

Counterparty default risk

Counterparty default

This module covers risk-mitigating contracts, receivables from intermediaries, as well as any other credit exposures which are not covered in the spread risk sub-module. Different approach for rated and unrated counterparties. Calculations are based on shocks in LGD and PD.

Life risk Mortality Loss due to a 15% increase in mortality rates

Longevity Loss due to a 20% decrease in mortality rates

Disability-morbidity Loss due to a 35% increase in disability and morbidity rates in next year, 25% in the year afterwards; 20% for all years thereafter

Lapse Maximum of 50% increase and decrease of lapse rates and a mass lapse shock of 40% (retail), 70% (non-retail)

Expense Loss due to a 10% increase in expenses and a 1% increase in inflation rates used for the calculation of technical provisions

Revision Loss due to a 3% increase in annual annuity payments

Catastrophe Loss due to a 0.15 percentage point increase of mortality rates in next year

Non-life risk Premium and reserve

Premium * factor plus reserves * factor, different factors per line of business

Lapse Loss due to a 40% discontinuance of insurance policies and a 40 % decrease of future insurance contracts

22

Catastrophe Losses due to natural catastrophes, man-made catastrophes and other non-life catastrophes

Health risk Health similar to life techniques

Similar to life calculation methods, with different factors for disability-morbidity and lapse risk

Health non-similar to life techniques

Similar to non-life calculation methods, with different factors for premium and reserve risk

Catastrophe Losses for mass accidents, accident concentrations and pandemic events, calculated by ratio of people affected * amounts insured

An insurance company can choose whether to calculate the SCR through the standard formula, i.e.

using calculation methods detailed under table 12, or whether to develop its own internal model

reflecting the specific risks the insurance company faces. If the insurer wishes to develop its own

internal model, it needs to gain approval from the supervisor.

As an illustration, figures 10 and 11 provide insight into the relative importance of the risk modules

and sub-modules of Solvency II. Figure 10 clearly shows that market risks are predominant in the

calculation of the Basic Solvency Capital Requirement (BSCR). Figure 10 furthermore demonstrates

the importance of diversification and the loss absorbing capacity of technical provisions and DTA in

order to reduce the SCR. Figure 11 shows that the biggest components of market risk are spread risk,

equity risk and interest rate risk. Figure 11 also demonstrates the importance of diversification

benefits in order to reduce the market risk charge.

113% 149%

100%

8% 34%

10%

31% 46%

0% 10%

60%

3%

0%

50%

100%

150%

200%

250%

Figure 10 - BSCR structure Group structure. Source: QIS 5. "Adj TP & DTA" stands for the loss absorbing capacity of technical provisions and deferred tax assets

23

Minimum capital requirement (MCR)

Besides the SCR, the Solvency II framework also specifies a Minimum Capital Requirement (MCR).

The MCR indicates an absolute minimum level of capital. If the available capital drops below this

threshold, supervisors are likely to intervene firmly. The MCR is calculated taking into account the

following steps:

- Life risk: technical provisions or capital at risk times a certain factor, depending on the line of

business

- Non-life risk: technical provisions or premium times a certain factor, depending on the line

of business

- The MCR must be minimum 25% and maximum 45% of the SCR

- The MCR must be minimum €2.2 million for non-life insurers and €3.2 million for life

insurers.

The reason why Solvency II has introduced the SCR as well as the MCR is to enable the so-called

“supervisory ladder of intervention”. If an insurer’s own-funds fall below the SCR, then supervisors

are required to take action in order to restore the insurer’s own-funds back to the SCR as soon as

possible. If, however, the financial health of the insurer continues to deteriorate, then the level of

supervisory intervention will be progressively intensified. The breach of the MCR triggers a very strict

recovery plan, which, if not complied with, will result in the insurance company being closed down.

Hence, the insurer's liabilities will be transferred to another insurance company and the license of

the insurer will be withdrawn.

21%

100% 37%

15%

45%

14%

5%

37%

0%

20%

40%

60%

80%

100%

120%

140%

160%

Figure 11 - Market risk structure Group structure. Source: QIS5.

24

Capital instruments and their importance

The Solvency II framework divides capital instruments into “basic own-funds” and “ancillary own-

funds”. Basic own-funds are subdivided into Tier 1, Tier 2 and Tier 3 basic own-funds. Ancillary own-

funds are subdivided into Tier 2 and Tier 3 ancillary own-funds.

The three basic own-fund tiers may include the following Items:

- ordinary share capital and the related share premium account

- initial funds and members' contributions

- subordinated mutual member accounts

- preference shares and the related share premium account

- subordinated liabilities

For a basic own-fund item to be included in a specific tier, it has to comply with the specific

requirements of that tier in terms of subordination, duration, discretion over distributions and

absence of encumbrances, among others. Other important differences between the basic own-fund

tiers include the following:

- Tier 1 basic own-fund items need to be paid in

- Tier 2 basic own-fund items include called upon but unpaid items

- Tier 3 basic own-funds include any capital item which do not comply with the requirements

for Tier 1 or Tier 2

- Tier 3 basic own-funds particularly include deferred tax assets

- Tier 1 basic own-funds particularly include a reconciliation reserve. This reconciliation

reserve demonstrates the effect of moving from the accounting balance sheet to the

Solvency II balance sheet. It ensures that the basic own-funds can be reconciled back to the

excess of assets over liabilities. An important part of the reconciliation reserve are the

expected profits included in future premiums (EPIFP). These EPIFP result from the inclusion

in technical provisions of premiums on existing (in-force) business that will be received in

the future, but that have not yet been received.

Tier 1 basic own-funds are further subdivided into:

- Tier 1 unrestricted basic own-funds, including ordinary share capital and the related share

premium account, initial funds and members' contributions and the reconciliation reserve

- Tier 1 restricted basic own-funds, including subordinated mutual member accounts,

preference shares and the related share premium account and subordinated liabilities

Table 13 details the composition of basic own-funds of European insurers:

25

Table 13 - Composition of basic own-funds Solo undertakings. Source: QIS 5.

Basic own-fund instrument %

Ordinary share capital (net of own shares) 14.07%

The initial fund (less item of the same type held) 1.26%

Share premium account 13.14%

Retained earnings including profits from the year net of foreseeable dividends 25.53%

Other reserves from accounting balance sheet 12.06%

Reconciliation reserve 11.62%

Surplus funds 7.26%

Expected profit in future premiums 8.87%

Preference shares 0.10%

Subordinated liabilities 5.05%

Subordinated mutual member accounts 0.03%

Other items not specified above 1.01%

Besides basic own-funds, Solvency II also allows insurers to include capital instruments called

“ancillary own-funds”. These ancillary own-funds are subdivided into Tier 2 and Tier 3 ancillary own-

funds. Definitions of these own-fund tranches are given under table 14.

Table 14 - Ancillary own-funds

Tier 2 ancillary own-funds Items of capital other than basic own-funds which can be called up to absorb losses. Includes items such as unpaid share capital that has not been called up, letters of credit or guarantees, or any other legally binding commitments received by insurance and reinsurance undertakings. These items are subject to prior supervisory approval.

Tier 3 ancillary own-funds Items or arrangements which currently exist but which do not count towards the available solvency margin, subject to supervisory approval.

Table 15 details the composition of ancillary own-funds of European insurers:

Table 15 - Composition of ancillary own-funds Solo undertakings. Source: QIS 5.

Ancillary own-fund instruments Tier 2 Tier 3

Unpaid share capital or initial fund that has not been paid up 8.56% 0.63%

Letters of credit and guarantees held in trust 70.32% 0.00%

of which letters of credit 65.98% 0.00%

of which guarantees held in trust 4.34% 0.00%

Mutual calls for supplementary contributions 9.34% 0.53%

Mutual calls for supplementary contributions 8.61% 0.07%

Other items currently eligible to meet requirements under Solvency I 0.01% 1.95%

Total ancillary own-funds 96.83% 3.17%

26

In order to ensure a sufficient quality of capital, Solvency II sets limits to the different own-fund tiers,

as detailed under table 16:

Table 16 - Solvency II weights of capital tiers

Own-funds item Limit

Tier 1 basic own-funds ≥ 50% of the SCR

Tier 1 restricted own-funds < 20% of all Tier 1 items

Tier 2 & 3 basic own-funds + Tier 2 &3 ancillary own-funds

< 50% of the SCR

Tier 3 basic own-funds + Tier 3 ancillary own-funds

< 15% of the SCR

Table 17 shows the relative shares of the different own-fund tiers for European insurers:

Table 17 - Structure of available own-funds Solo undertakings. Source: QIS 5.

Own-fund tier %

Tier 1 unrestricted 91.94%

Tier 1 restricted 0.72%

Tier 2 basic own-funds 4.22%

Tier 2 ancillary own-funds 1.25%

Tier 3 basic own-funds 1.85%

Tier 3 ancillary own-funds 0.02%

Total Tier 1 92.66%

Total Tier 2 5.48%

Total Tier 3 1.86%

Capital requirements for assets

The following elements of Solvency II have to be taken into account when calculating capital

requirements for insurers’ investment activities:

- Stress calibrations: the calculation of the SCR for a particular investment starts from the

spread shock, property shock or equity shock detailed in the Solvency II technical

specifications. We also denote these shocks as the “stand-alone” capital requirement. Some

examples of these stand-alone SCR calibrations for different asset classes can be found in

the second column of table 20.

- Interest rate risk: Solvency II asks insurance companies to hold capital against interest rate

risks. The interest rate risk sub-module of Solvency II is designed to account for changes in

both assets and liabilities when an interest rate shock occurs. As such, the interest rate risk

sub-module demands to hold more capital when assets and liabilities are not properly

matched, i.e. when the duration of assets is different from the duration of liabilities. As life

27

insurers face long-term liabilities, the interest rate risk sub-module of Solvency II will impose

higher capital charges for life insurers when they invest in assets with a shorter duration.

- Diversification: Solvency II explicitly takes into account different types of diversification

benefits when aggregating capital charges: (1) diversification within the same risk class and

business line; (2) diversification within a risk class and across business lines; (3)

diversification across risk classes; and (4) diversification at a group level. As an example,

table 18 provides the correlation coefficients across risk classes under Solvency II.

Table 18 - Solvency II correlation factors across risk classes

Correlation coefficients Market risk

Counterparty default

Life underwriting

Health underwriting

Non-life underwriting

Market risk 1

Counterparty default 0.25 1

Life underwriting 0.25 0.25 1

Health underwriting 0.25 0.25 0.25 1

Non-life underwriting 0.25 0.5 0 0 1

The table 19 shows correlation coefficients across risk classes for the market risk module

under Solvency II.

Table 19 - Solvency II correlation coefficients across market risk sub-classes

Correlation coefficients Interest Equity Property Spread Currency Concentration

Interest rate risk 1

Equity risk 0 – 0.5 1

Property risk 0 – 0.5 0.75 1

Spread risk 0 – 0.5 0.75 0.5 1

Currency risk 0.25 0.25 0.25 0.25 1

Concentration risk 0 0 0 0 0 1

- Loss absorbing capacity: Solvency II accounts for the loss absorbing capacity of technical

provisions (TP) and deferred tax assets (DTA). This means that under Solvency II, overall

capital requirements are reduced because the insurer can reduce payments of discretionary

benefits (loss absorbing capacity of technical provisions) or because the insurer has to pay

less tax than initially expected (loss absorbing capacity of deferred taxes) after an adverse

event. The fifth quantitative impact study (QIS5) has shown that the loss absorbing capacity

of technical provisions and deferred taxes results in an average reduction of 40% in solvency

capital requirements (see figure 10).

28

By taking into account all the above considerations (stress calibrations, interest rate risk,

diversification benefits, the loss absorbing capacity of TP and DTA) we obtain the so-called “all-in

capital charge”. The full range of assumptions behind our calculation of this all-in capital charge is

largely based on a recent report by EIOPA (2013). EIOPA modelled the investment portfolio and

balance sheet of an average European life insurance company, for which the incremental change in

SCR is calculated resulting from a small shift from cash into other assets. As such, EIOPA’s model

takes into account diversification, loss absorbing capacity and the matching of assets and liabilities

(i.e. interest rate risk). We use this model as a basis for our own calculations, and we try to improve

this model by adapting EIOPA’s method of calculating capital charges for interest rate risk. The full

range of assumptions behind our calculations can be found in Annex IV.

Table 20 provides an overview of solvency capital requirements for different asset classes. The

column “Solvency II all-in capital charge” provides the capital requirement for making a certain

investment, taking into account diversification benefits, loss absorbing capacity, and the matching of

assets and liabilities (i.e. interest rate risk). These capital charges can be compared to the “stand-

alone” Solvency II capital charge. The latter is merely based on the spread risk, equity risk, property

risk or counterparty default modules of Solvency II.

Table 20 - The solvency II capital requirement (SCR) for different assets

Asset class – rating – duration Solvency II stand-

alone capital

charge

Solvency II all-

in capital

charge

Corporate debt A 3 years 4.2% 3.73%

Corporate debt A 5 years 7.0% 4.25%

Corporate debt A 10 years 10.5% 3.86%

Corporate debt A 15 years 13.0% 3.00%

Corporate debt BB 3 years 13.5% 8.27%

Corporate debt BB 5 years 22.5% 11.84%

Corporate debt BB 10 years 35.0% 15.90%

EU Government debt A 10 years 0.0% -2.10%

Non-EU Government debt A 10 years 8.4% 2.84%

Residential mortgage loan

10 years, 80% LTV

0% -2.10%

Residential mortgage loan

15 years, 80% LTV

0% -5.58%

Residential mortgage loan

10 years, 100% LTV

3% -0.95%

Residential mortgage loan

15 years, 100% LTV

3% -4.44%

Covered bond AAA 5 years 3.5% 2.55%

29

Covered bonds AA 5 years 4.50% 3.03%

Type 1 securitisation AA 3 years 12.6% 7.83%

Type 1 securitisation A 3 years 22.2% 12.53%

Type 2 securitisation AA 3 years 40.2% 21.40%

Type 2 securitisation A 3 years 49.8% 26.16%

Resecuritisation AA 2 years 80.0% 41.64%

Real estate 25% 13.90%

Type 1 equity (i.e. equity listed in regulated

markets of EEA or OECD member states) 39.0% 23.37%

Type 2 equity (i.e. equities other than type 1

such as private equity, hedge funds, commodities) 49.0% 28.64%

Table 20 shows how the stand-alone capital charges for fixed income investments rise considerably

for longer durations. The all-in capital charges, however, are not necessarily higher for long-dated

fixed income compared to short-dated exposures: the beneficial effects of asset-liability matching

induce a lower interest rate risk charge, which also leads to a relatively low all-in capital charge.

Table 20 also shows a remarkably low 0% stand-alone capital charge for EU government bonds. Due

to diversification benefits and a reduced interest rate risk, the all-in capital charge for EU

government bonds can even become negative. Table 20 also illustrates the generally very low capital

charges for residential mortgage loans.

Table 20 furthermore demonstrates the generally very high capital charges for securitisations.

Solvency II has recently introduced a different approach for “Type 1” and Type 2” securitisations,

where the former have to comply with stringent requirements based on the quality of the

underlying assets, underwriting processes, structural features, rating, seniority, listing and

transparency for investors, among others. This higher quality of type 1 securitisations also leads to

lower capital requirements under Solvency II.

Some limitations with respect to our calculations in table 20 have to be noted:

- Our calculations are based on the standard models of Solvency II, while larger insurers are

likely to use an internal model. The use of internal models can have beneficial effects on

solvency capital requirements: QIS5 has shown that the median (mean) SCR calculated via

internal models is 91% (99%) of the equivalent SCR derived from the standard formula.

- Our calculations assume a 100% SCR for insurers. However, insurers are likely to target a

higher capital than this minimum imposed by Solvency II.

- Solvency II requires significant amounts of capital for underwriting activities in addition to

capital for asset risks. One could argue that a charge for underwriting risks needs to be taken

into account when assessing the overall capital requirement for insurers’ investments.

However, we have decided to only take into account market risk and counterparty default

30

risk when calculating the capital requirement for insurers’ investments. We advocate an

imaginary separation of the investment side and underwriting side of an insurer: the

investment side bears the capital charges for market risk and counterparty default risk, and

is allocated all investment profits above the risk-free rate. The underwriting side bears the

capital charge for all other risk modules (life, non-life, and health underwriting risk) and is

allocated the underwriting income, added to the risk-free rate as an investment return for

remunerating its policyholders. This approach is similar to the case study of Doff (2006).

Valuation of assets and liabilities

The valuation methods for assets and liabilities under Solvency II are based on fair value and are

largely in line with IFRS Phase II. Figure 12 illustrates the most important valuation practices under

Solvency II.

The risk-free rate used to calculate the best estimate of technical provisions is the swap rate,

corrected for credit risk. This adjustment for credit risk is subject to a floor of 10 bps and a cap of 35

bps.

It is widely recognised in academic literature that asset prices are more volatile than implied by their

default rates. Multiple publications4 furthermore demonstrate that interest rates do not only

remunerate for credit risk, but also include an (often considerable) remuneration for illiquidity: the

so-called “illiquidity premium”. As insurers are typically long-term investors, they are not affected by

4 A good overview is given by Moody’s Analytics (2014), Illiquid Assets and Capital-Driven Investment

Strategies.

Best estimate

of technical

provisions

Risk margin

SCR

Fair value of assets

Available own-funds

Surplus

Assets LiabilitiesCapital

requirements

Figure 12 - Valuation under Solvency II

Assets are assigned their market value or, when market values are unavailable, are "marked to model"

Present value of expected liability cash flows, including the value of embedded options and guarantees, discounted using the relevant risk-free rate.

A risk margin, or market value margin is added for non-hedgeable technical provisions. This risk margin is calculated by cost of capital method. Hence, current and future capital requirements are calculated for the run-off of non-hedgeable technical provisions. The present value of these capital requirements is then calculated. The "risk margin" is then calculated by multiplying this present value by the cost-of-capital rate (6%).

31

the artificial volatility or illiquidity premiums inherent in market prices. These considerations are

recognised under Solvency II: in order to correct for this excess volatility and/or illiquidity premium

inherent in market prices, liabilities are discounted with an additional factor. As such, the risk-free

rate, used to value liabilities, is corrected with either a “volatility adjustment” or a “matching

adjustment”. Both are detailed in the paragraphs below.

Volatility adjustment

The volatility adjustment allows insurers to increase the risk-free interest rate used to value

liabilities. The volatility adjustment is calculated by EIOPA based on a notional portfolio representing

an insurer’s typical portfolio of assets. It is calibrated to 65% of the portion of the spread of this

reference portfolio that is not attributable to "a realistic assessment of expected losses or

unexpected credit or other risk of the assets".

The volatility adjustment, calculated by EIOPA for year-end 2013, equals 22 bps for a euro portfolio.

A historical overview of volatility adjustments is given under table 21.

Table 21 - Volatility adjustment (bps) under the LTGA specifications Note: this table is based on LTGA calibrations, i.e. calculated using a 20% risk-corrected spread, not the 65% risk-corrected spread as specified in the Omnibus

II directive.

Year Volatility adjustment (bps)

2004 1

2009 6

2011 25

2012 13

The volatility adjustment may be increased for certain euro zone countries when this country faces a

significantly higher risk-corrected spread. At year-end 2013, EIOPA specified a higher volatility

adjustment for five euro zone countries:

Table 22 - Volatility adjustments (bps) at year-end 2013

Eurozone standard volatility adjustment: 22

National adjustments:

Cyprus Greece Italy Latvia Slovenia

137 72 47 64 51

Insurers are not required to hold any specific assets in order to be allowed to apply the volatility

adjustment. However, the effectiveness of the volatility adjustment may diminish when the assets

actually held by the insurer differ from the assets in the reference portfolio calculated by EIOPA. In

addition, the insurance industry has raised questions about the relatively low volatility adjustments

calculated by EIOPA for year-end 2013. A joint letter by Insurance Europe, the CFO Forum and CRO

32

Forum5 states: “The volatility adjustment at the end of 2013 would be around 15 bps lower than

industry estimations based on the latest draft for Delegated Acts. Additionally, against our

expectations, national adjustments in a period of time where sovereign debt is still under stress

were only to be applied in Italy and Greece and even in those cases, to a very limited degree.”

Matching adjustment

The matching adjustment is an adjustment to the risk-free rate used to value predictable liabilities.

The matching adjustment is equal to the spread over the risk-free rate on assets admissible to back

these predictable liabilities, less an estimate of the costs of default and downgrade of these backing

assets. Contrary to the volatility adjustment, the matching adjustment is company specific and is

calculated by the insurance undertaking itself. The matching adjustment cannot be used together

with the volatility adjustment. The size of the matching adjustment depends on:

- the type of insurance obligations

- the assets held against these insurance obligations

- the degree of matching.

The size of the matching adjustment is capped at 70% of the spread on EEA sovereign debt and 65%

of the spread on other debt. The portfolio of backing assets must comply with various requirements

in order for an insurance company to be allowed to apply the matching adjustment:

- the portfolio consists of bonds and other assets with similar cash-flow characteristics

- the expected cash-flows of the assigned portfolio replicate the expected cash-flows of the

portfolio of insurance or reinsurance obligations

- the cash-flows of the portfolio of assets are fixed and cannot be changed by the issuers of

the assets or any third parties.

In addition, the underlying insurance obligations also have to comply with a series of stringent

requirements in order to be eligible for the matching adjustment. This however makes the matching

adjustment impractical for most insurance undertakings. Figure 13 shows that the matching

adjustment can only be applied for specific annuity products in some specific countries. Even though

the matching adjustment, from a theoretical viewpoint, could incentivise long-term investing by life

insurers, figure 13 shows that, due to the limited applicability of the matching adjustment, it is

unlikely to influence insurers’ investment decisions.

5 See Joint Insurance Europe, CFO and CRO Forum letter on Solvency II –Volatility adjustment,

http://www.insuranceeurope.eu/uploads/Modules/Publications/joint-letter-on-volatility-adjustement.pdf

33

Preliminary conclusion

Solvency II has introduced major changes in the regulation of the European insurance sector. The

main innovations of Solvency II include among others the three-pillar structure, risk-based

supervision, the possibility for insurers to choose between standard approaches and internal

models, and an increasing reliance on fair value. Solvency II also includes two adjustments to the

risk-free rate used to value liabilities: the volatility adjustment and the matching adjustment. These

two measures recognise that insurers are less exposed to short-term market volatility and illiquidity

discounts related to asset pricing. Whereas Solvency I did not require any capital for insurers’

investment activities, Solvency II now imposes specific capital charges for a wide range of asset

classes. This makes Solvency II a highly relevant topic for insurers’ asset management. The next

chapter discusses the asset allocation implications of Solvency II.

0%

5%

10%

15%

20%

25%

30%

35%

UK Spain Netherlands Denmark Portugal Belgium

Figure 13 - Percentage of technical provisions eligible for the matching adjustment at year-end 2011

Source: QIS 5

34

4. SOLVENCY II IMPACT ON INSURER’S

ASSET ALLOCATION

This chapter aims to test the impact of Solvency II on an insurance company’s asset allocation. We

first attempt to build a set of portfolios with optimal risk-return characteristics, the so-called

“efficient frontier”. This chapter then describes the capital charges for these efficient portfolios

under the Solvency II standard formula. We furthermore compare and analyse these capital charges

with respect to a likely budget for market risk. We thus can determine whether the Solvency II

standard formula impedes or enhances an efficient asset allocation. This chapter ends with a

discussion of the asset allocation of an average European life insurer. We calculate the solvency

capital requirement for the portfolio of this average life insurer and determine whether it complies

with a conventional budget for market risk. We also compare the portfolio of an average life insurer

to the efficient portfolios calculated in this chapter.

Inputs for constructing the efficient frontier

We choose the indices included in our efficient frontier to be similar to the indices described in the

Solvency II calibration paper of CEIOPS (2010). We gather monthly return data for the period January

1996 – July 2014 from Bloomberg. All indices are total return indices. We calculated the geometric

mean of monthly returns and the corresponding standard deviations. The different indices and their

risk-return characteristics are depicted in table 23. All indices are denominated in Euro. In order to

proxy for money market fund returns, we use the Euribor, or, prior the the introduction of the Euro,

the German Fibor. We do not include an equity index corresponding to the “type 1 equity” Solvency

II calibration, since the most relevant equity index (MSCI total return) appears to be dominated,

under the period considered, by the MSCI EM BRIC Local index and fixed income indices. We have

chosen not to include illiquid assets such as infrastructure loans, export loans or residential

mortgage loans due to a lack of sufficient data on risk-return characteristics.

A caveat with respect to the IPD total return index is that it is based on appraised values rather than

actual sales transactions. This leads to a degree of smoothing within the index data, as appraisal

values tend to be backward-looking, depending on previous valuation prices as part of the current

reported price. Therefore, in order to obtain a correct standard deviation of the IPD returns, we “de-

smooth” the return data, using the same approach as described in the QIS 3 calibration paper of

CEIOPS (2007).

35

Table 23 - Descriptive statistics of asset classes

Asset – rating - maturity Full name (code) Monthly return Standard deviation

of monthly returns

Money market (Euribor) FIBOR DEM 1 Month (FD0001M Index) 0.2055% 0.1212%

Corporate bonds AA 1-5 years The BofA Merrill Lynch 1-5 Year AA Euro Corporate Index ( ER2V) 0.3642% 0.5468%

Corporate bonds A 1-5 years The BofA Merrill Lynch 1-5 Year Single-A Euro Corporate Index ( ER3V) 0.3673% 0.7074%

Corporate bonds BBB 1-5 years The BofA Merrill Lynch 1-5 Year BBB Euro Corporate Index ( ER4V) 0.4124% 0.8722%

Government bonds 1-5 years The BofA Merrill Lynch 1-5 Year Euro Government Index ( EG0V) 0.3696% 0.5752%

Government bonds 5-10 years The BofA Merrill Lynch 5-10 Year Euro Government Index ( EG06) 0.5254% 1.2566%

Government bonds 10+ years The BofA Merrill Lynch 10+ Year Euro Government Index ( EG09) 0.6407% 2.0792%

Government bonds 15+ years The BofA Merrill Lynch 15+ Year Euro Government Index ( EG08) 0.6467% 2.2986%

Government bonds 20+ years The BofA Merrill Lynch 20+ Year Euro Government Index ( EG0Y) 0.6504% 2.4415%

Securitised/collateralized assets The BofA Merrill Lynch Euro Non-Periphery Securitized / Collateralized

Index ( ELAX)

0.4089% 0.7109%

Covered bonds 1-5 years The BofA Merrill Lynch 1-5 Year AAA Euro Covered Bond Index ( EC1V) 0.3480% 0.5267%

Covered bonds 5-10 years The BofA Merrill Lynch 5-10 Year Euro Pfandbrief Index ( EP06) 0.5015% 1.0606%

Covered bonds 10+ years The BofA Merrill Lynch 10+ Year Euro Covered Bond Index ( ECVH) 0.5967% 1.9283%

Property UK IPD Total Return All Proper (IPDMPROP Index) 0.6833% 3.6811%

Equity emerging markets MSCI EM BRIC Local (MSELBRIC Index) 0.8410% 7.3241%

36

The efficient frontier

In order to calculate the efficient portfolios composing the efficient frontier, we solve the following,

well-known optimization problem:

(Minimise the portfolio variance. w is the vector of portfolio

weights and Σ is the variance-covariance matrix)

Subject to (The portfolio return must equal the target return, μ. M is a vector

of average asset returns)

(The portfolio weights must sum up to 1)

(No short-selling)

(The weights of corporate bonds, covered bonds, government bonds, securitisations and property investments must remain

under 20% in order to avoid asset concentrations)

55 efficient portfolios were constructed. Figure 14 displays the efficient frontier and the individual

asset indices which compose the efficient frontier. Figure 15 provides a breakdown of the efficient

portfolios. Figure 15 shows that less risky portfolios load more on money market instruments and

short term fixed income investments. Riskier portfolios, i.e. portfolios with a higher expected return,

allocate more towards equity investments, property and long-term fixed income. The index of A

rated corporate bonds is not used in the efficient frontier since, in this setting, the index is

dominated by government bond portfolios with better risk-return characteristics.

37

0,00%

0,10%

0,20%

0,30%

0,40%

0,50%

0,60%

0,70%

0,80%

0,90%

0,00% 1,00% 2,00% 3,00% 4,00% 5,00% 6,00% 7,00%

Mo

nth

ly r

etu

rn

Standard deviation (monthly)

Figure 14 - Efficient frontier Efficient frontier

Equity emerging markets

Property

Government bonds 20+ years

Government bonds 15+ years

Government bonds 10+ years

Government bonds 5-10 years

Government bonds 1-5 years

Corporate bonds AA 1-5 years

Corporate bonds A 1-5 years

Corporate bonds BBB 1-5 years

Covered bonds 10+ years

Covered bonds 5-10 years

Covered bonds 1-5 years

Securitised/collateralized assets

Euribor

38

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0 5 10 15 20 25 30 35 40 45 50

Allo

cati

on

(%

of

tota

l po

rtfo

lio)

Portfolio number

Figure 15 - Allocation of efficient portfolios Equity emerging markets

Property

Covered bonds 10+ years

Covered bonds 5-10 years

Covered bonds 1-5 years

Securitised/collateralized assets

Government bonds 20+ years

Government bonds 15+ years

Government bonds 10+ years

Government bonds 5-10 years

Government bonds 1-5 years

Corporate bonds BBB 1-5 years

Corporate bonds AA 1-5 years

Euribor

39

Calculation of a budget for market risk and market risk capital charges

In order to assess the eligibility of efficient portfolios under Solvency II, a budget for market risk is

needed. The calculation details of our budget for market risk are detailed under table 24. All

statistics are based on QIS 5. It remains an open question to which extent insurers will target a ratio

of own-funds above the solvency capital requirement. We therefore calculate two market risk

budgets: the first is based on a simple 100% SCR target ratio (€ 107.21 million). The second market

risk budget (€64.98 million) assumes a 165% SCR target ratio, based on the QIS 5 statistic that

insurers on average have 165% of own-funds compared to the SCR.

Table 24 - Calculation of a budget for market risk

Own-funds (% of balance sheet total) 12.8% (1)

Basic solvency capital requirement (% of solvency capital requirement) 148% (2)

Diversified market risk (% of basic solvency capital requirement) 56.5% (3)

Budget for diversified market risk if the insurer targets a 100% SCR € 107.21 mio

= (1)*(2)*(3)

(based on a hypothetical balance sheet total of €1000 million)

Average own-funds as a % of SCR 165% (4)

Budget for diversified market risk if the insurer targets a 165% SCR € 64.98 mio

= (1)*(2)*(3)/(4)

(based on a hypothetical balance sheet total of €1000 million)

We calculated capital charges for the market portfolios conform the method explained chapter 3.

SCR stand-alone capital charges are based on the duration of the asset portfolios and their average

rating, as displayed under table 25. These stand-alone capital charges are aggregated into an overall

capital charge for the total market portfolio taking into account interest rate risk, diversification

benefits and the loss absorbing capacity of technical provisions and deferred tax assets. We assume

that the market portfolio constitutes 90% of the asset total of the hypothetical life insurer. We

assume that another 5% of the asset total is allocated to cash with a 0 year duration and another 5%

to mortgage loans with a 10 year duration. These assumptions on the balance sheet total of an

average life insurer are based on balance sheet statistics of QIS 5. We assume a balance sheet total

of €1000 million.

We have assumed that the portfolio of securitised/collateralized assets follows the “type 2” SCR

calibration, leading to a significant stand-alone capital charge of 53.75%. Our choice for the type 2

calibration is justified since a major part of the securitised/collateralized portfolio includes assets

issued some years ago and are therefore unlikely to be structured in a way that they comply to the

numerous “type 1” requirements set out by EIOPA.

40

Table 25 - SCR stand-alone capital charges under the standard formula

Asset – rating - maturity Modified

duration

(years)

Average

Rating

SCR stand-

alone capital

charge

Money market (Euribor) 1.0 AAA 0.90%

Corporate bonds AA 1-5 years 2.7 AA 2.97%

Corporate bonds A 1-5 years 2.8 A 3.92%

Corporate bonds BBB 1-5 years 2.9 BBB 7.25%

Government bonds 1-5 years 2.8 AA- 0.00%

Government bonds 5-10 years 6.5 AA- 0.00%

Government bonds 10+ years 13.1 AA- 0.00%

Government bonds 15+ years 15.4 AA- 0.00%

Government bonds 20+ years 16.9 AA 0.00%

Securitised/collateralized assets 4.3 AAA 53.75%

Covered bonds 1-5 years 2.8 AAA 1.96%

Covered bonds 5-10 years 6.4 AAA 4.20%

Covered bonds 10+ years 10.3 A+ 10.35%

Property 25.00%

Equity emerging markets 49.00%

Analysis of capital charges for efficient frontier portfolios

Figure 16 displays the market risk charge for the 55 portfolios on the efficient frontier. A breakdown

into interest rate risk, spread risk, property risk and equity risk capital charges is provided. 39 out of

55 portfolios comply with the market risk budget if the life insurer targets a 100% SCR (black line in

figure 16). 23 out of 55 portfolios comply with the market risk budget if the life insurer targets a

165% SCR (red line in figure 16). Portfolios complying with the 100% SCR market risk budget are

characterised by a an average total asset duration of 4.6 years and a low allocation to equity and

property investments. Portfolios complying with the 165% SCR market risk budget are in addition

characterised by a low allocation to securitised/collateralised assets.

Figure 17 displays the link between interest rate risk charge, total market risk charge and the

duration of total assets. It is very clear that asset portfolios with a higher duration bear a lower

interest rate risk charge, therefore also inducing a lower total market risk charge. For portfolios 39

until 44, the duration of assets becomes higher than the duration of liabilities, leading to a local peak

for interest rate risk capital charges.

41

00%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

0 5 10 15 20 25 30 35 40 45 50

% o

f m

arke

t ri

sk b

ud

get

Portfolio number

Figure 16 - Market risk charge for efficient frontier portfolios Expressed as a share (%) of market risk budget for a 100% SCR target

% equity charge

% property charge

% spread charge

% interest rate risk

Market risk budget for a 165% SCR target

Market risk budget for a 100% SCR target

42

Figure 16 displays how the spread charge increases sharply from portfolio 17 to 19. This is entirely

due to a higher allocation towards securitised/collateralized assets. Similarly, the spread charge

decreases sharply from portfolio 27 to 33, for which the exposure to securitisations decline.

Portfolios which have a high allocation towards securitisations do not comply with the 100% SCR

budget for market risk and are therefore unlikely to be selected by the life insurer. The high market

risk charge for portfolios containing securitisations contradicts with the relatively low standard

deviation of these portfolios. Even though the Solvency II standard formula aims not to drive

insurers’ investment decisions6, it is clear that the current SCR calibrations effectively incentivise

insurers not to allocate towards securitised exposures.

The efficient frontier portfolio which entails the lowest market risk capital charge is given by

portfolio 13. Details of this portfolio composition are given under table 26.

6 Carlos Montalvo, Executive Director of EIOPA, recently claimed in an interview with Blackrock that “Capital

charges cannot be the same because risks are not the same, but if there were incentives to allocate assets in a given way, it would not be right”. See Blackrock, 2013, Global insurance investment strategy at an inflection point, p. 21.

0

2

4

6

8

10

0

20

40

60

80

100

120

140

160

180

200

0 5 10 15 20 25 30 35 40 45 50

Mo

dif

ied

du

rati

on

(ye

ars)

Cap

ital

ch

arge

(€

mill

ion

)

Portfolio number

Figure 17 - Market risk charge, interest rate risk charge & asset duration

interest rate risk capital charge (left scale)

market risk capital charge (left scale)

average duration of assets (right scale)

43

Table 26 - Characteristics of the minimum market risk charge portfolio

Asset Allocation Return (monthly) 0.3900%

Money market (Euribor) 19.68% Standard deviation (monthly) 0.4918%

Corporate bonds AA 1-5 years 15.39% Duration fixed income

investments (years)

3.08

Corporate bonds BBB 1-5 years 14.06%

Government bonds 1-5 years 20.00% Average duration of total

assets (years)

3.06

Covered bonds 1-5 years 6.09%

Covered bonds 5-10 years 17.02% Market risk capital charge (€

million)

46.43

Property 6.46%

Equity emerging markets 1.29% % of market risk budget 43.30%

Portfolio 13 bears the lowest capital charge but is unlikely to be selected by the life insurer. Indeed,

if the life insurer chooses to optimise the ratio of monthly return/market risk charge, depicted in

figure 18, portfolio 36 should be preferred above portfolio 13. Portfolio 36 has a comparatively

lower allocation to money market instruments, and a higher allocation towards long-term fixed

income, property and equity.

We can conclude from the above paragraphs that the Solvency II standard formula is indeed risk-

based. Solvency II charges a higher market risk capital when assets are not properly matched to

liabilities and when the insurer allocates heavily towards risky exposures (e.g. property or equity). As

an example, portfolios 44 until 54 have a relatively low duration and allocate heavily to property and

emerging market equity, which induces high market risk capital charges and makes the portfolios

inadmissible under the market risk budget. As Solvency II has an excessive stress calibration for type

2 securitisations, insurers are incentivised not to include these securitisations in their portfolio, even

though such securitisations may enhance the portfolio’s risk-return characteristics.

0,00000

0,00002

0,00004

0,00006

0,00008

0,00010

0,00012

0 5 10 15 20 25 30 35 40 45 50Portolio number

Figure 18 - Monthly return/market risk charge

44

Does an average life insurer’s market portfolio comply with the market risk budget?

This section assesses whether an average European life insurer’s asset portfolio complies with the

market risk budget used in the previous sections. Data on the asset allocation of an average

European life insurer are provided in recent publication of Höring (2013). This study based its data

on a sample7 of individual insurance companies’ annual reports and investor presentations from

2009 and 2010. The average allocation, rating and duration of the asset portfolio is described under

tables 27 and 28.

Table 27 - Asset allocation of an average life insurer

Asset Allocation

(%)

Capital

charge (%)

Type 1 equity 4.50% 39.00%

Type 2 equity 2.50% 49.00%

Property 11.00% 25.00%

Sovereign debt EEA 31.98% 0.00%

Sovereign debt non-EEA 8.04% 2.18%

Corporate debt 29.52% 8.67%

Covered bonds 12.46% 4.45%

Average duration of asset portfolio (years)

5.1

The stand-alone Solvency II capital charges for each asset are also given in tables 27 and 28. The

method for calculating the overall market risk capital charge is similar to the method used in the

previous paragraphs. Again, we take into account interest rate risk, diversification benefits and the

loss absorbing capacity of technical provisions and deferred tax assets. Similar to the calculations

under the previous paragraphs, we assume that the market portfolio constitutes 90% of the asset

total of the life insurer. Furthermore, we assume that another 5% of the asset total is allocated to

cash with a 0 year duration and another 5% to mortgage loans with a 10 year duration. Our final

results of the market risk capital charge calculations are given under table 29.

7 The sample consists of Allianz, AXA, Ageas, Aviva, Baloise, CNP Assurances, Fondaria SAI, Fortis, Generali,

Helvetia, Legal & General, Swiss Life, Vienna Insurance and Zurich.

45

Table 28 - Rating and duration breakdown of fixed income portfolio

sovereign debt EEA sovereign debt non-EEA corporate debt covered bonds

Allocation

(%)

Capital

charge (%)

Allocation

(%)

Capital

charge (%)

Allocation

(%)

Capital

charge (%)

Allocation

(%)

Capital

charge (%)

AAA 58.8% 0.00% 65.0% 0.00% 17.5% 4.70% 92.0% 4.10%

AA 20.6% 0.00% 17.5% 0.00% 15.0% 5.74% 4.0% 5.10%

A 18.1% 0.00% 2.5% 6.64% 40.0% 7.28% 2.0% 7.84%

BBB 0.6% 0.00% 10.0% 8.33% 20.0% 13.10% 1.0% 14.30%

BB 1.9% 0.00% 0.0% 15.35% 2.0% 23.50% 0.0% 25.50%

B or lower 0.0% 0.00% 3.0% 27.25% 0.5% 39.18% 0.0% 42.54%

Unrated 0.0% 0.00% 2.0% 18.23% 5.0% 15.68% 1.0% 17.04%

Average duration (years) 6.9 6.9 5.4 6.2

Table 29 - Market risk capital charges for an average life insurer's portfolio (in million EUR)

interest

rate risk

Spread

charge

Equity

charge

Property

charge

Diversified market

risk charge

Budget for diversified market risk

charge under a 165% SCR target

Budget for diversified market risk

charge under a 100% SCR target

27.31 29.59 25.14 24.75 57.51 64.98 107.22

46

Table 29 shows that the market portfolio of an average European life insurer induces a market risk

capital charge of €57.51 million. This is below the 165% SCR market risk budget of €64.98 million.

Hence, we can conclude that the Solvency II standard formula for market risk should not lead to

significant reallocations of the market portfolio for the average life insurer.

In order to test the relevance of the efficient frontier calculated under the previous paragraphs, it

would be interesting to check whether a portfolio of this efficient frontier corresponds to the

average European life insurer’s portfolio. Annex V indeed shows that portfolio 38 on the efficient

frontier is very similar to the average European life insurer’s portfolio. This points out that 1) the

average European life insurer is likely to hold a portfolio with optimal risk-return characteristics

and/or 2) the efficient frontier calculated in the previous paragraphs is relevant in the real world as

it is able to broadly capture the average life insurer’s asset portfolio.

Preliminary conclusion

This chapter assessed the implications of Solvency II on the asset allocation of insurance companies.

We built an efficient frontier based on 15 asset indices and calculated the market risk capital charges

for the portfolios of this efficient frontier. We furthermore calculated the market risk capital for the

portfolio of an average European life insurer and compared this portfolio to our efficient frontier.

Our results showed that:

- A considerable share of efficient portfolios (23 out of 55) comply with a stringent budget for

market risk;

- Portfolios with a higher duration will, on average, bear lower market risk capital

requirements;

- Portfolios which allocate heavily towards securitisations are likely to be inadmissible under a

budget for market risk, even though the true spread risk of these portfolios remains

reasonable;

- Portfolios which allocate heavily towards equities and property investments are likely to be

inadmissible under a budget for market risk;

- A life insurer which chooses to optimize the return/market risk charge ratio, would select a

market portfolio composed of 71.4% fixed income (average duration 10.1 years, 40% AAA,

31% AA, 2% A and 27% BBB) and 28.6% property and equity investments (i.e. portfolio 36 of

the efficient frontier);

- The market portfolio of an average European life insurer is likely to comply with a stringent

budget for market risk.

47

5. BASEL III VS. SOLVENCY II

Several similarities exist between the Basel III and Solvency II regulations. As an example, both

frameworks are structured in three pillars, both frameworks allow for standardised as well as

internal models, and both frameworks structure eligible capital items in different tiers. A detailed

comparison of Solvency II and Basel III nevertheless shows important differences, and this for all

three pillars of the regulatory frameworks. In this section, we will focus mainly on the differences

between Solvency II and Basel III that could have an influence on investment decisions.

This chapter compares Solvency II and Basel III with respect to requirements for the quality of

capital, risk types included in both frameworks and the calibration of these risk types. We will focus

on the banking book, and not on the trading book when comparing different regulations. The

paragraphs below are based on the most recent technical specifications published by EIOPA.

Quality of capital

Basel III as well as Solvency II define various tiers of capital, but these tiers are not consistent with

one another in terms of definition of the allowed capital instruments, nor in terms of the relative

proportions of the different tiers. The most significant differences in capital tier characteristics are

presented in table 30.

Table 30 - Differences in capital instrument characteristics under Basel III and Solvency II

Basel III capital Solvency II basic own-funds (BOF)

Tier 1 Broadly similar characteristics under Basel III and Solvency II

Tier 2 Items need to be paid in Includes called upon but unpaid items

Original maturity of at least 5 years Original maturity of at least 10 years

No mandatory suspension of

repayment in the event of non-

compliance with capital ratios

Suspension of repayment in the event

of non-compliance with the SCR

Tier 3 Phased out Includes e.g. deferred tax assets

Ancillary own-

funds

Not included Includes items such as unpaid share

capital that has not been called up,

letters of credit or guarantees, or any

other legally binding commitments

received by insurance and

reinsurance undertakings. These

items are subject to prior supervisory

approval.

These differences in definitions of capital instruments seem to be in favour of insurers. Indeed,

Solvency II seems to put less emphasis on quality of capital, as e.g. deferred tax assets (DTA) are

allowed to be considered as basic own-funds (BOF) under Solvency II, while DTA are deducted from

48

capital under Basel III. Furthermore, all capital instruments under Basel III are included on the banks’

balance sheet, while this is not the case for the “ancillary own-funds” allowed under Solvency II.

Moreover, the relative share of capital tiers differs heavily under Basel III and Solvency II. Table 31

provides weights of the capital tiers under both regulatory frameworks:

Table 31 - Basel III and Solvency II weights of capital tiers

Basel III Solvency II

Common Equity Tier 1: 4.5% of risk-weighted

assets (RWA) + 2.5% RWA for the capital

conservation buffer.

Tier 1 basic own-funds must be at least 50% of

the Solvency Capital Requirement (SCR).

Total Tier 1: 6% RWA + 2.5% RWA for the capital

conservation buffer.

Tier 1 restricted own-funds: less than 20% of all

Tier 1 items.

Tier 1 + Tier 2: 8% RWA+ 2.5% RWA for the

capital conservation buffer.

Tier 2 &3 basic own-funds + Tier 2 &3 ancillary

own-funds: less than 50% of the SCR.

Tier 3 capital is being phased out under Basel III. Tier 3 basic own-funds + Tier 3 ancillary own-

funds: less than 15% of the SCR.

Countercyclical buffer: up to 2.5% in CET1. Not included

Capital surcharge for SIFIs: 1% to 2.5% in CET1 + an additional surcharge of 1% for certain banks.

Not included

Table 31 clearly indicates that Basel III focuses more on the higher quality tier of capital compared to

Solvency II. Indeed, Basel III requires 6% of RWA for Tier 1 capital, added to 2.5% for the capital

conservation buffer. The countercyclical buffer and capital surcharge for SIFIs further emphasize the

importance of CET1. Solvency II, on the other hand, allows to put significant weight for lower quality

capital tiers: Tier 2 and Tier 3 can constitute up to 50% of the SCR under Solvency II.

Risk types

Basel III and Solvency II include different risk types into their respective pillars. Table 32 summarizes

the main differences.

Table 32 – Differences in risk types included under pillar 1 of Basel III and Solvency II

Risk type Basel III – included under pillar 1? Solvency II – included under pillar 1?

Interest rate risk No Yes

Concentration risk No Yes

Liquidity risk Yes No

Basel III focusses on market risk, credit risk, liquidity risk and operational risk. As depicted in figure 9,

Solvency II has a somewhat more comprehensive approach by taking into account nearly all major

risk types, i.e. underwriting risk, market risk (including e.g. interest rate risk and concentration risk),

counterparty default risk and operational risk. Basel III addresses concentration risk and interest rate

risk of the banking book under pillar 2 (the risk management and supervision pillar), while Solvency II

addresses these risks in pillar 1 (the financial requirements pillar).

49

This differing treatment of interest rate risk under Basel III and Solvency II has important asset

management implications. Indeed, the interest rate risk module of Solvency II effectively incentivises

insurers to match the duration of assets with the duration of liabilities. As life insurer’s liabilities are

generally long-term, Solvency II effectively incentivises life insurers to hold more long-term assets.

Banks, on the other hand, face no specific constraint on their asset-liability management, since

interest rate risk is absent in pillar 1 of Basel III. However, implicitly the liquidity ratios will force

banks to implement an ALM management.

Another remarkable difference in the risk types considered under Basel III vs. Solvency II is liquidity

risk. Basel III specifically aims at reducing liquidity risks with the introduction of the NSFR, LCR, and

the publication of the “Principles for Sound Liquidity Risk Management and Supervision”. These

enhanced liquidity risk measures were deemed necessary considering the various liquidity problems

encountered by banks during the recent financial crisis. Additionally, liquidity risks are abundant in

the business of issuing long-term loans financed with short term deposits. Solvency II does not

include such liquidity risk measures, since the business model of insurers does not rely on maturity

transformation whereas banks do. This absence of liquidity risk measurement under Solvency II

again entails that insurers are incentivised to invest in long-term, illiquid investments. In other

words, insurers can benefit more from the illiquidity premium embedded in certain long-term assets

compared to banks. This fundamental insight is of critical importance in the discussion of asset

allocation implications in the next chapter.

Risk measure and calibration

The method of calculating capital requirements for a particular asset differs substantially under

Basel III and Solvency II. Table 33 summarizes the main differences.

Table 33 - Differences in calculation steps under Basel III and Solvency II

Calculation step Basel III Solvency II

Diversification benefits Only includes diversification

within a risk class

Includes different types of

diversification benefits

Loss absorbing capacity of

technical provisions (TP) and

deferred tax assets (DTA)

Not included Included

Interest rate risk Not included Included

Basel III addresses risks in a fairly simple way by giving a risk weight to different asset classes.

Solvency II, on the other hand, requires to aggregate several modules and calculation steps for each

asset class. As detailed under chapter 3, when calculating capital requirements for different asset

50

classes under Solvency II, one has to take into account the Solvency II stress calibrations, asset-

liability matching, diversification benefits, and the loss absorbing capacity of TP & DTA.

Comparison of capital charges under Basel III and Solvency II

Table 34 provides a first view on the differences between capital charges under Basel III and

Solvency II for certain asset classes. This comparison of Basel III and Solvency II capital charges will

be used in higher detail in the next chapter in order to assess insurers’ asset allocation implications.

The column “Solvency II all-in capital charge” provides the capital requirement for making a certain

investment, taking into account the Solvency II stress calibrations, diversification benefits, loss

absorbing capacity, and the matching of assets and liabilities (i.e. interest rate risk). These capital

charges can be compared to the “stand-alone” Solvency II capital charge. The latter is merely based

on the spread risk or counterparty default modules of Solvency II. These capital charges for insurers

are compared to Basel III capital charges under standard- and internal ratings-based approaches. The

internal ratings-based data is derived from a study by the Institute of International Finance and

Oliver Wyman (2011)8.

Table 34 - Comparison of Solvency II and Basel III capital charges

Asset class – rating– duration Solvency II

stand-alone

capital charge

Solvency II all-

in capital

charge

Basel III

standard

capital charge

Basel III

internal

capital charge

Corporate bond A 5 years 7% 4.25% 5.25% 4.46%

Corporate bond A 10 years 10.5% 3.86% 5.25% 4.46%

Corporate bond A 15 years 13% 3.00% 5.25% 4.46%

Government bond AA 10

years

0.0% -2.10% 0% 1.95%

Residential mortgage loan A

15 years, 80% LTV

0% -5.58% 3.68% 0.3%

Covered bond AAA 5 years 3.5% 2.55% 1.05%

Type 1 securitisation A 3 years 22.20% 12.53% 5.25%

An important finding deducted from our calculations is that Solvency II leads to a lower capital

charge for a wide range of assets, the more so for longer term investments. However, some caution

has to be taken into account when comparing Solvency II and Basel III capital charges based on the

table above. The main limitations in our calculations are listed below:

- Our calculations assume a capital ratio of 10.5% for banks and a 100% SCR for insurers.

However, banks and insurers are likely to target a higher capital than this minimum imposed

8 This study calculates capital charges under the advanced internal ratings-based (IRB) approach, where the

capital charge formula is given under the Basel II framework and the data for probability of default (PD) and loss given default (LGD) is given by Oliver Wyman benchmarks.

51

by Basel III or Solvency II. Insurers may target a higher or lower capital surplus compared to

banks, and this may affect the interpretation of table 34.

- Our Basel III capital charge calculations do not take into account the countercyclical buffer,

nor the capital surcharge for SIFIs. Both of these capital requirements can affect capital

charge calculations for certain banks in certain periods.

- Solvency II generally has lower requirements for capital quality compared to Basel III. As an

example, Solvency II allows to include deferred tax assets and ancillary own-funds as a part

of capital. Solvency II also allows to hold a larger share of Tier 2 and Tier 3 capital compared

to Basel III. Hence, even though Solvency II may charge more capital for some assets

compared to Basel III, the overall capital cost can still be lower under Solvency II due to

lower standards for capital quality.

- Capital requirements are surely not the only factor that has to be assessed when making

investment decisions. Other major issues are the risk-return characteristics, liquidity,

complexity of the investments, accounting requirements etc. A recent study by Höring

(2013) also pointed out that investment decisions are largely dependent on the rating which

the insurance undertaking wants to achieve.

Preliminary conclusion

This chapter identified several differences between Basel III and Solvency II regulations that could

have an impact on asset allocation decisions.

First of all, this chapter identified lower capital quality standards for insurers compared to banks.

Indeed, the definitions of the different capital tiers, together with the weights put on these capital

tiers are both in the advantage for insurers.

Our comparison of risk types included under Basel III and Solvency II shows that Basel III focuses

heavily on liquidity risk, whereas it is absent of interest rate risk measures. The opposite holds for

Solvency II. As such, insurers are incentivised to hold long-term, illiquid assets.

A comparison of capital charges calibrations shows that Basel III and Solvency II have a very different

approach towards diversification, interest rate risk and loss absorbing capacity of technical

provisions and deferred tax assets. Furthermore, we show that Solvency II leads to a lower capital

charge for a wide range of assets, the more so for longer term investments. This is due to the

combined effect of diversification benefits, asset and liability matching, loss absorbing capacity of

liabilities, and specific risk calibrations which are all in the benefit for insurers. This advantage over

banks for certain investments is further enhanced by the fact that insurers face lower capital quality

requirements, and that insurers do not face a countercyclical buffer, nor a capital surcharges for

52

SIFIs. These lower capital charges under Solvency II create possibilities for shifting assets from banks

to insurers. The next chapter will go deeper into certain asset classes and their regulatory arbitrage

potential for insurers.

53

6. DIFFERENCES IN CAPITAL REQUIREMENTS

FOR BANKS AND INSURERS

This chapter will identify whether insurers can benefit from differences in Basel III and Solvency II

regulations when making investment decisions. We will compare the Basel III and Solvency II capital

charges for the separate asset classes to see whether insurers have a comparative advantage over

banks, from a regulatory perspective. We will also assess the pricing, risk, liquidity and insurers’

allocation to these investments, when applicable.

However, it should be noted that relative capital charges for certain investments, and the

corresponding risk, return and liquidity profile are not the only motives for making asset allocation

decisions. As an example, a recent study by Höring (2013) shows that Solvency II capital charges are

unlikely to influence asset allocation, since investment decisions are also driven by the need of

achieving a certain rating for the insurance group. Other issues such as tax, accounting, or general

strategic considerations can also play a significant role in making investment decisions.

Securitisations9: insurers face prohibitively high capital charges

Securitisations can provide a solution for banks’ lending constraints identified in the previous

chapters. Insurers benefit from securitisations as they gain access to diversified loan portfolios which

would have otherwise been the exclusive business of banks. As such, insurers can use banks’

expertise in performing loan underwriting, risk monitoring and resolution of non-performing loans.

Previous chapters in this report have shown that banks are divesting their securitisations as a result

of the higher risk weights introduced by Basel III. The origination of securitisations has also become

more expensive as the “skin in the game” rule increases risk exposure to securitisations for

originating banks.

Insurers, just like banks, also face high capital charges for securitisations. Table 35 compares the

capital charges for securitisations under Solvency II and Basel III:

9 In this report, securitisations are defined as investments such as asset backed securities (ABS) and mortgage

backed securities (MBS). Covered bonds do not fall under our definition of securitisation and will be discussed later in this report.

54

Table 35 - Comparison of Solvency II and Basel III capital charges for securitisations

Asset class – rating - duration Solvency II stand-

alone capital charge

Solvency II all-in

capital charge

Basel III external

ratings-based

capital charge

Securitisation AAA 1 year 12.50% 8.62% 1.58%

Securitisation AAA 2 years 25.00% 14.33% 1.84%

Securitisation AAA 3 years 37.50% 20.07% 2.10%

Securitisation AAA 5 years 62.50% 31.64% 2.63%

Securitisation AA 1 year 13.40% 9.06% 2.63%

Securitisation AA 2 years 26.80% 15.21% 3.28%

Securitisation AA 3 years 40.20% 21.40% 3.94%

Securitisation AA 5 years 67.00% 33.88% 5.25%

Securitisation A 1 year 16.60% 10.63% 5.25%

Securitisation A 2 years 33.20% 18.37% 5.91%

Securitisation A 3 years 49.80% 26.16% 6.56%

Securitisation A 5 years 83.00% 41.90% 7.88%

Securitisation BBB 1 year 19.70% 12.15% 9.45%

Securitisation BBB 2 years 39.40% 21.43% 10.50%

Securitisation BBB 3 years 59.10% 30.78% 11.55%

Securitisation BBB 5 years 98.50% 49.70% 13.65%

Securitisation BB 1 year 82.00% 43.06% 16.80%

Securitisation BB 2 years 100.00% 51.71% 18.64%

Securitisation BB 3 years 100.00% 51.29% 20.48%

Securitisation BB 5 years 100.00% 50.46% 24.15%

Securitisation B 1 year 100.00% 52.12% 32.55%

Securitisation B 2 years 100.00% 51.71% 35.44%

Securitisation B 3 years 100.00% 51.29% 38.33%

Securitisation B 5 years 100.00% 50.46% 44.10%

Table 35 demonstrates that, Solvency II “all-in” capital charges are often multiple times higher

compared to the Basel III standard risk weights. However, Solvency II recently introduced a separate,

less punitive calibration for so-called “Type 1” securitisations. Such securitisations have to comply

with stringent requirements based on the quality of the underlying assets, underwriting processes,

structural features, rating, seniority, listing and transparency for investors. The capital charges for

these type 1 securitisations are given in table 36.

55

Table 36 - Comparison of Solvency II and Basel III capital charges for type A securitisations

Asset class – rating - duration Solvency II stand-

alone capital charge

Solvency II all-in

capital charge

Basel III external

ratings-based

capital charge

Type 1 securitisation AAA 1Y 2.10% 3.55% 1.58%

Type 1 securitisation AAA 2Y 4.20% 4.15% 1.84%

Type 1 securitisation AAA 3Y 6.30% 4.75% 2.10%

Type 1 securitisation AAA 5Y 10.50% 5.96% 2.63%

Type 1 securitisation AA 1Y 4.20% 4.57% 2.63%

Type 1 securitisation AA 2Y 8.40% 6.20% 3.28%

Type 1 securitisation AA 3Y 12.60% 7.83% 3.94%

Type 1 securitisation AA 5Y 21.00% 11.10% 5.25%

Type 1 securitisation A 1Y 7.40% 6.13% 5.25%

Type 1 securitisation A 2Y 14.80% 9.33% 5.91%

Type 1 securitisation A 3Y 22.20% 12.53% 6.56%

Type 1 securitisation A 5Y 37.00% 18.98% 7.88%

Type 1 securitisation BBB 1 years 8.50% 6.67% 9.45%

Type 1 securitisation BBB 2 years 17.00% 10.40% 10.50%

Type 1 securitisation BBB 3 years 25.50% 14.16% 11.55%

Type 1 securitisation BBB 5 years 42.50% 21.70% 13.65%

Also these recently introduced capital charges displayed in table 36 are rather expensive for

insurance companies, definitely when taking into account the wide range of requirements that type

1 securitisations have to comply with. Investing in securitisations is unattractive compared to the

capital charges for other investments such as covered bonds (3.03% all-in charge for 5 year AA rated

covered bonds) or corporate loans (3.52% all-in charge for 5 year AA rated corporate bonds). The

Solvency II capital charges are often a multiple of the Basel III requirements for similar

securitisations, even when taking diversification and loss absorbency into account.

A possible solution to avoid high capital charges for securitisations is the use of internal models.

However, it remains to be seen whether regulators will authorise calibrations which diverge

significantly from the standard capital charges.

A recent study by Fitch Ratings (2012) has shown that these Solvency II capital charges are largely

unrelated to realised credit losses. As an example, the new Solvency II calibrations require a 62.5%

(10.5%) stand-alone capital charge for 5 year AAA rated (type 1) securitisations. This is remarkably

high compared to Fitch’s ratings portfolios at end-July 2007 indicating a total loss of 6.5% for AAA US

RMBS or a 0.8% loss for AAA EMEA RMBS portfolios.

Empirical evidence also indicates a retreat of insurers from securitisations. A recent survey by the

AFME (2012) of 27 Europe-based insurance companies and asset managers has shown that a 33% of

56

the insurers polled planned to stop securitisation investments, while the remaining 67% planned to

drastically reduce investments in the securitisation sector.

In sum, the Solvency II calibration of securitisations is prohibitively high compared to the Basel III

calibration. Furthermore, the Solvency II capital charges for securitisations are a multiple of the

Solvency II capital charges for similar investments such as covered bonds. From a regulatory capital

perspective, securitisations do not represent an attractive asset class.

Government bonds

The previous chapters have pointed at the low capital charges for sovereign debt under Basel III:

government debt with a rating of AA- or higher gets a risk weighting of 0%. This low risk weight,

together with the beneficial liquidity treatment of sovereign debt under Basel III, has made banks

increase their exposure to this asset class over the past years.

Solvency II capital charges are equally skewed towards sovereign exposures. Bonds issued by EU

member states are exempted from the credit spread sub-module. This exemption applies

irrespective of the sovereign’s credit rating. Non-EU government debt is also treated favourably

under the credit risk sub-module, as exposures rated AA or higher have a 0% capital charge.

Government bonds are often available at longer maturities, hence sovereign debt effectively enables

matching with insurers’ long‐dated liabilities. The resulting low interest rate risk, combined with

diversification benefits often result in a negative capital charge for sovereign bonds, as displayed in

table 37.

Table 37 - Solvency II capital charges for government bonds

Asset class – rating – duration Solvency II stand-

alone capital charge

Solvency II all-in

capital charge

Sovereign debt 5 years 0.00% 0.84%

Sovereign debt 10 years 0.00% -2.10%

Sovereign debt 15 years 0.00% -5.58%

Sovereign debt 20 years 0.00% -9.06%

Sovereign debt 25 years 0.00% -12.52%

Sovereign debt 30 years 0.00% -15.96%

These low capital charges provide a strong incentive for insurers to invest in sovereign debt, even

when it is below investment grade. This means that returns for sovereign exposures, and especially

lower rated sovereign exposures, are attractive for insurers under Solvency II. Figure 19 below tracks

interest rates of 10 year Euro zone sovereign bonds.

57

The sovereign debt crisis has shown that EU debt is not risk-free, and can be highly correlated.

Larger insurers are likely to incorporate these findings in their internal models.

Furthermore, EU member states and non-EU members rated AA or higher are exempt from the

concentration risk module. Hence, large exposures to a single government are not penalised with a

higher capital charge.

The beneficial treatment of sovereign debt under Solvency II is also reflected in the asset holdings of

insurers: QIS 5 has shown that government bonds constitute 25.3% of insurers’ total assets

(excluding united linked assets).

In sum, the low capital charges, exemption from concentration risk, and the long maturities available

enhance the role which insurers historically have played in funding governments.

Residential Mortgages

The Basel III standardised approach applies a relatively low risk weight of only 35% for mortgage

loans. The Basel III internal ratings based (IRB) approach generally results in even lower risk weights

compared to standardised approach. We identified in previous chapters that, due to these low

capital charges, banks were able to increase their exposure to residential mortgage loans over the

past years.

Figure 20 compares the Solvency II capital charges with the Basel III standard and IRB approach

charges for residential mortgage loans as a function of their loan-to-value (LTV) ratio.

0

2

4

6

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Figure 19 - Government bond yields In basis points. Source: Bloomberg

Germany 10 years Belgium 10 years Avg 10 year Eurozone

58

Comparing and Basel III Solvency II stand-alone capital charges in figure 20 leads to some remarkable

insights:

- Solvency II imposes a 0% stand-alone capital charge for residential mortgage loans with a

LTV ratio up to 80%. Taking into account diversification benefits and matching with long-

term liabilities, marginal capital charges even are likely to be negative for such low LTV

mortgages under Solvency II.

- Large differences exist between the capital charges implied by Basel III standardised

approach and the Basel III IRB method. This difference in capital charges is especially

apparent for high rated mortgage exposures.

- The Basel III IRB capital charges are significantly lower compared to Solvency II for high

rated, high LTV mortgages. This implies that banks using the IRB approach have a

comparative advantage over insurers for high rated, high LTV segment of the residential

mortgage loan market.

- Insurers have a comparative advantage over banks for loans with a low LTV ratio,

irrespective of the mortgage loan rating.

- This difference in Basel III and Solvency II capital charges could lead to a co-financing model

where banks originate residential mortgage loans and transfer the low rated, high LTV loans

to insurers.

It should be noted that the Solvency II stand-alone capital charge displayed in the figure 20 is solely

based on the counterparty default module, not taking into account any other risk module under

Solvency II. Table 38 provides the “all-in” capital charge of residential mortgage loans under

Solvency II, taking into account diversification benefits, loss absorbing capacity and interest rate risk

charges:

0,00%

1,00%

2,00%

3,00%

4,00%

5,00%

6,00%

70% 75% 80% 85% 90% 95% 100%

Loan-to-value

Figure 20 - Residential morgage capital charges Source: IIF and Oliver Wyman (2011) and own calculations

Basel III AAA

Basel III AA

Basel III A

Basel III BBB

Basel III BB

Basel III standardised approach

Solvency II stand-alone charge

59

Table 38 - Solvency II "all-in" capital charge for residential mortgage loans

Loan-to-value (LTV)

Duration 80% LTV 85% LTV 90% LTV 95% LTV 100% LTV

5 years 0.84% 1.04% 1.22% 1.38% 1.53%

10 years -2.10% -1.76% -1.46% -1.20% -0.95%

15 years -5.58% -5.25% -4.95% -4.68% -4.44%

20 years -9.06% -8.72% -8.42% -8.15% -7.91%

25 years -12.52% -12.18% -11.88% -11.61% -11.37%

30 years -15.96% -15.62% -15.33% -15.06% -14.81%

Given that mortgage loans are available up to high durations, interest rate risk charges under

Solvency II can be highly negative, resulting in negative “all-in” capital charges as displayed in Table

38.

Residential mortgage loans could be seen as an attractive investment for insurers from a perspective

of return on equity, given the very low capital charges as displayed in figure 20 and table 38. Figure

21 displays interest rates for retail mortgages in the euro zone. This graph shows that credit spreads

have largely remained constant over the past years.

Valuation methods appear to be beneficial for residential mortgage loans. Indeed, illiquid

investments such as mortgages do not have market prices available, hence less volatile appraisal

values are likely to be used. This in turn can reduce the volatility of insurers’ own-funds.

Our interviews with 10 European banks corroborate our findings above. Several interviewees

explicitly noted that insurers are more suitable investors in certain segments of the residential

mortgage market. Interviewees noted that insurers have an advantage over banks for long-term

mortgages, fixed rate mortgages, and mortgages with a low LTV.

Several interviewees see that in practice, insurers are becoming more active in the market for

residential mortgage loans. Insurers can create a bilateral fund with a bank, invest in a fund of

-50

0

50

100

150

200

250

300

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

spread over 10 year German govt bonds spread over average 10 year Eurozone govt bonds

Figure 21 - Retail mortgage credit spread Euro zone retail mortgage credit yield in basis points over sovg bond yields. Source: ECB and Bloomberg

60

mortgages, or source mortgages independently from banks through brokers. As an example, Belfius

insurance has bought Elantis, a broker in mortgage loans, together with a 3.5 bn EUR mortgage loan

portfolio from Belfius Bank in 2012. As such, mortgage loans comprised 19% of total assets of Belfius

Insurance in 2012.

Our interview with 10 European banks also showed that especially the Dutch mortgage loan market

may be attractive for insurance companies. Dutch mortgage loans are particularly long term and

repayments are few. Furthermore, Dutch banks are seeking disintermediation opportunities due to

their high loan-to-deposit ratio, as identified in table 3.

Figure 22 illustrates the mortgage loan holdings of euro zone insurers, which still appear to be quite

low at 4% of total investments. Insurers therefore appear to have some potential to increase their

allocation to retail mortgages loans.

In sum, the inherently lower risk of mortgage loans (mortgages are per definition secured), the low

capital charges under Solvency II and the spreads over government bonds make retail mortgages an

attractive investment for insurers. Practice also shows that insurers are becoming more active in the

market for residential mortgages.

Corporate bonds and loans

The previous chapters have indicated how Basel III negatively affects lending to corporates. Higher

capital ratios, capital quality standards and liquidity ratios have increased the cost of holding

corporate loans. Banks facing a shortage in stable funding may be inclined towards

disintermediation of their corporate loans. Spread graphs (see figures 23 and 24) show how

corporate lending was stressed during the period 2009-2012. Nevertheless, spreads seem to have

returned to their pre-crisis levels in recent months.

0,00%

1,00%

2,00%

3,00%

4,00%

5,00%

6,00%

2004 2005 2006 2007 2008 2009 2010 2011 2012

Figure 22 - Mortgage loan share of total insurers' investments Euro zone life and non-life insurers. Source: OECD

61

Table 39 provides the capital charges for corporate debt under Solvency II and Basel III. The Solvency

II capital charge generally increases with durations going up from 1 year to 5 years due to the higher

capital charge of the spread sub-module. The all-in capital charge generally decreases for higher

durations than 5 years due to improved asset-liability matching, where the decrease in interest rate

risk charge offsets the increase in spread risk charge. Table 39 shows that the capital charges under

Basel III and Solvency II are broadly similar. Solvency II only grants a lower capital charge compared

to Basel III for low rated corporate debt for some specific durations.

Table 39 - Comparison of Solvency II and Basel III capital charges for corporate debt

Asset class – rating – duration Solvency II

stand-alone

capital charge

Solvency II

all-in capital

charge

Basel III

standard

capital charge

Basel III

internal

capital charge

Corporate debt AAA 1 years 0.90% 2.96% 2.1% 0.36%

Corporate debt AAA 3 years 2.70% 3.00% 2.1% 0.86%

Corporate debt AAA 5 years 4.50% 3.03% 2.1% 1.69%

Corporate debt AAA 7 years 5.56% 2.71% 2.1% 1.69%

Corporate debt AA 1 years 1.10% 3.06% 2.1% 0.63%

Corporate debt AA 3 years 3.30% 3.29% 2.1% 1.30%

0

100

200

300

400

500

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

A 5 year corp spread BBB 5 year corp spread

Figure 23 - Corporate bond credit spreads 10 year Euro zone corporate bond yield in basis points over 10 year German bond yields. Source: Bloomberg

0

50

100

150

200

250

300

350

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

spread over average 5 year Eurozone govt bonds spread over 5 year German govt bonds

Figure 24 - Corporate loan spreads Euro zone corporate loan yield in basis points over sovg bond yields. Source: ECB and Bloomberg

62

Corporate debt AA 5 years 5.50% 3.52% 2.1% 2.41%

Corporate debt AA 7 years 6.66% 3.25% 2.1% 2.41%

Corporate debt A 1 years 1.40% 3.21% 5.25% 1.59%

Corporate debt A 3 years 4.20% 3.73% 5.25% 2.67%

Corporate debt A 5 years 7.00% 4.25% 5.25% 4.46%

Corporate debt A 7 years 8.40% 4.10% 5.25% 4.46%

Corporate debt BBB 1 years 2.50% 3.74% 10.5% 4.07%

Corporate debt BBB 3 years 7.50% 5.34% 10.5% 5.78%

Corporate debt BBB 5 years 12.50% 6.94% 10.5% 8.63%

Corporate debt BBB 7 years 15.50% 7.57% 10.5% 8.63%

Corporate debt BB 1 years 4.50% 4.72% 10.5% 9.06%

Corporate debt BB 3 years 13.50% 8.27% 10.5% 11.25%

Corporate debt BB 5 years 22.50% 11.84% 10.5% 14.90%

Corporate debt BB 7 years 27.52% 13.47% 10.5% 14.90%

Corporate debt unrated 1 years 3.00% 3.99% 10.5% 4.07%

Corporate debt unrated 3 years 9.00% 6.07% 10.5% 5.78%

Corporate debt unrated 5 years 15.00% 8.16% 10.5% 8.63%

Corporate debt unrated 7 years 18.36% 8.97% 10.5% 8.63%

Table 40 provides the risk-adjusted return on capital (RAROC) for investments in corporate bonds,

divided into their rating and duration characteristics. The RAROC is calculated using the following

formula:

ield10‐ expected loss11‐funding cost12

All‐in SCR (1‐tax rate13)

Table 40 shows that the RAROC is the highest for A rated bonds and bonds with a low duration. The

generally low RAROCs are a sign that the duration provided by corporate bonds is not high enough

to provide significant benefits from asset-liability matching (i.e. reduced interest rate risk charges).

The generally low RAROCs are also a sign of the current low yield environment.

Table 40 – RAROC for corporate debt investments under Solvency II

Asset – rating – duration Yield All-in SCR RAROC

Corporate debt AAA 1Y 0.32% 2.96% 3.08%

Corporate debt AAA 3Y 0.56% 3.00% 3.72%

Corporate debt AAA 5Y 0.98% 3.03% 3.07%

10 yields are derived from Bloomberg's Euro zone composite option-free fair market curves. Yields were

gathered end of April 2014. 11

Expected losses are derived from Altman E.I. and Keugne B.J., 2012, Special report on default and return in the high-yield bond and distressed debt market: the year 2011 in review and outlook. 12

We assume that the risk free rate, i.e. the rate on Belgian government bonds is transferred to the underwriting department as a remuneration for policyholders. 13

We assume the tax rate to be 25.8% This is the average tax rate of Ageas over FY2013 and FY2012.

63

Corporate debt AAA 7Y 1.40% 2.71% 3.51%

Corporate debt AA 1Y 0.41% 3.06% 5.29%

Corporate debt AA 3Y 0.79% 3.29% 8.27%

Corporate debt AA 5Y 1.21% 3.52% 7.27%

Corporate debt AA 7Y 1.67% 3.25% 5.39%

Corporate debt A 1Y 0.53% 3.21% 7.88%

Corporate debt A 3Y 0.95% 3.73% 10.30%

Corporate debt A 5Y 1.42% 4.25% 9.14%

Corporate debt A 7Y 1.89% 4.10% 7.83%

Corporate debt BBB 1Y 0.76% 3.74% 5.68%

Corporate debt BBB 3Y 1.25% 5.34% -1.98%

Corporate debt BBB 5Y 1.76% 6.94% 2.29%

Corporate debt BBB 7Y 2.23% 7.57% 3.47%

Corporate debt BB 1Y 1.05% 4.72% 4.39%

Corporate debt BB 3Y 1.50% 8.27% -2.03%

Corporate debt BB 5Y 2.00% 11.84% -0.13%

Corporate debt BB 7Y 2.86% 13.47% 3.29%

Our interviews with 10 European banks have generally shown an appetite of banks for

disintermediation of corporate lending. Furthermore, our interviews also showed examples of how

banks can transfer parts of corporate lending to insurers. As such, Axa has recently set up

partnerships with SocGen and ING to co-finance longer term corporate loans. The targeted loans in

these partnerships have a maturity between 5 and 10 years. Hence, AXA can benefit from the credit

assessment expertise of banks and obtains loans with a sufficiently high maturity to match with

AXA’s longer term liabilities. Furthermore, insurers can obtain an illiquidity premium through such a

co-financing structure, as illiquid loan should provide a premium above more liquid corporate bond

investments. Banks can benefit from such a co-financing partnership as they do not have to hold

large amounts of capital or stable funding for this type of loan origination. Furthermore, this

partnership enables banks to offer their clients loans at longer maturities compared to standard loan

contracts.

Another example of a bank-insurer partnership is the recent deal between Pensioenfonds Zorg en

Welzijn (PFZW) and Rabobank. In this deal, corporate loans remained on the balance sheet of

Rabobank, but the first losses, up to a certain value, are transferred to the pension fund PFZW. This

structure is therefore similar to a credit default swap. Rabobank benefits from this deal as it enables

to significantly reduce the RWA of their corporate loan portfolio. PFZW, on the other hand, obtains a

high expected return for such contracts.

64

Practice also shows a strong appetite of insurers for commercial real estate loans14, due to their

longer maturity compared to standard corporate debt. As an example, Aviva, UK’s largest insurer,

manages a portfolio of over £10 billion in commercial mortgages15.

As a preliminary conclusion, we have shown that banks’ corporate lending can be constraint due to

higher capital ratios, capital quality requirements, and stringent liquidity ratios. Banks therefore

often seek disintermediation through bond issuance or partnerships with institutional investors.

Insurers can benefit from such a partnership trough banks’ superior credit assessment expertise and

their long standing relationships with corporate clients. Through such co-financing partnerships,

insurers can also capture the “illiquidity premium” inherent in corporate loan spreads. However,

Solvency II capital charges for corporate exposures are not necessarily lower compared to banks’

Basel III capital requirements. Indeed, because standard corporate debt is not available for long

durations, insurers cannot significantly reduce their interest rate risk charges trough corporate debt

investments. This results in broadly the same capital charges for insurers under Solvency II compared

to banks under Basel III.

Mortgage covered bonds

Mortgage covered bonds with a rating of AA or better are given lower capital charges under

Solvency II compared to plain vanilla corporate bonds. Table 41 compares capital charges under

Basel III/CRD IV and Solvency II for these AAA or AA rated mortgage covered bonds. Table 41 shows

that, for covered bonds with very high durations, the Solvency II all-in capital charge can become

lower compared to the Basel III/CRD IV standard capital charge.

Table 41 - Comparison of Solvency II and Basel III capital charges for mortgage covered bonds

Asset – rating – duration Solvency II

stand-alone

capital charge

Solvency II all-in

capital charge

Basel III/CRD IV

standard

capital charge

Covered bond AAA 5Y 3.50% 2.55% 1.05%

Covered bond AAA 10Y 6.00% 1.67% 1.05%

Covered bond AAA 15Y 8.50% 0.80% 1.05%

Covered bond AA 5Y 4.50% 3.03% 1.05%

Covered bond AA 10Y 7.00% 2.15% 1.05%

Covered bond AA 15Y 9.50% 1.29% 1.05%

14 Commercial real estate loans are given the same capital charges under Solvency II compared to standard

corporate debt. 15

See http://media.avivainvestors.co.uk/aviva-investors-launches-uk-commercial-real-estate/

65

Mortgage covered bonds are generally viewed as a very low risk investment. Multiple factors

attribute to this finding:

- Low credit risk: the credit risk of mortgage covered bonds is inherently lower compared to

unsecured bonds as they have a double recourse to both the issuer and to the cover pool in

case of issuer insolvency.

- Low migration risk: the risk of downgrades is lower compared to the risk of downgrades for

unsecured bonds of the same issuer (see ECBC, 2013).

- Exempt from bail-in arrangements: covered bonds are exempted from bail-in arrangements

due to their secured nature. Indeed, the latest version of the proposal for “the recovery and

resolution of credit institutions and investment firms” by the European Commission excludes

covered bonds from write down and conversion to equity to the extent that the value of the

covered bonds does not exceed the value of the collateral.

- Low spread volatility: covered bond spreads generally have a lower spread volatility

compared to the spreads of their respective sovereigns (see ECBC, 2013).

- Low risk compared to sovereign bonds: at certain points in the sovereign debt crisis, covered

bonds were higher rated than their respective sovereign. This was mainly apparent in

peripheral euro zone countries.

Figure 25 provides information on the pricing of German covered bonds16. It is apparent that pricing

of covered bonds can become very tight compared to their respective sovereign yield in certain

periods.

Insurance companies generally hold significant amounts of covered bonds in their books. A survey

with 13 European insurers conducted by Insurance Europe and Oliver Wyman (2013) has shown that

covered bonds constitute nearly 10% of their total assets. Similarly, a report by the ECBC (2013) has

16 Germany represents nearly 20% of all covered bond amounts outstanding, see ECBC, 2013.

0

2

4

6

2008 2009 2010 2011 2012 2013 2014

Figure 25 - German covered bond yield vs. sovereign yield Source: Bloomberg

3-5 year German covered bond yield 4 year German government bond yield

66

shown that insures account for 10% of the aggregated demand in euro denominated covered bonds

over the period January 2011 to April 2013. For covered bonds with a maturity higher than 10 years,

the share of insurers increases to 36%.

In sum, covered bonds could be seen as an alternative to government bonds as they provide a low

risk, long-term investment with a potential to match long-term liabilities. The all-in capital charge

under Solvency II can become lower compared to Basel III charges for covered bonds with very high

durations. Covered bonds are also highly liquid investments, as their issue size is often larger

compared to senior unsecured bonds (see ECBC, 2013). Nevertheless, Solvency II does not appear to

excessively promote investments in covered bonds. Solvency II only provides a slight advantage in

spread risk charge for covered bonds compared to corporate bonds. We also show that the yield

pickup of covered bonds compared to sovereigns can be very tight. Hence, from a pure return on

capital view, covered bonds appear to be less attractive compared to mortgage loans or corporate

bonds.

Long-term lending: infrastructure loans

The previous chapters have shown how the Basel III capital ratios, capital quality standards, and

liquidity ratios have reduced the attractiveness of infrastructure debt. The current uncertainty about

the NSFR calibration provides an additional challenge for the infrastructure loan market.

Infrastructure debt is generally viewed as a low risk asset class. Moody’s recently published a report

assessing the performance of infrastructure debt over the period 1983 – 2012. The main findings

include:

- Cumulative default rates (CDRs) for investment-grade infrastructure debt and non-financial

corporate debt are very similar for horizons up to 4 years. Beyond 4 years, CDRs are

significantly lower for infrastructure exposures, demonstrating the greater stability of this

asset class.

- The average recovery rates for infrastructure debt are higher than for non-financial

corporates.

- Infrastructure debt and non-financial corporate debt show similar credit loss rates for

horizons up to 4 years. Beyond 4 years, loss rates are significantly lower for infrastructure

debt compared to like-rated non-financial corporates, demonstrating the greater stability of

infrastructure.

Even though infrastructure debt demonstrates low risk characteristics, infrastructure loans seem to

provide a higher yield compared to A rated corporate debt, as shown in figure 26.

67

Table 42 provides a comparison of Basel III and Solvency II capital charges for infrastructure debt:

Table 42 - Comparison of Solvency II and Basel III capital charges for long-term lending

Asset class – rating – duration Solvency II

stand-alone

capital charge

Solvency II

all-in capital

charge

Basel III

standard

capital charge

Basel III

internal

capital charge

Corporate debt AAA 10 years 7.15% 2.23% 2.1% 1.69%

Corporate debt AAA 15 years 9.65% 1.36% 2.1% 1.69%

Corporate debt AAA 20 years 12.15% 0.50% 2.1% 1.69%

Corporate debt AAA 25 years 14.65% -0.58% 2.1% 1.69%

Corporate debt AA 10 years 8.40% 2.84% 2.1% 2.41%

Corporate debt AA 15 years 10.90% 1.97% 2.1% 2.41%

Corporate debt AA 20 years 13.40% 1.11% 2.1% 2.41%

Corporate debt AA 25 years 15.90% 0.27% 2.1% 2.41%

Corporate debt A 10 years 10.50% 3.86% 5.25% 4.46%

Corporate debt A 15 years 13.00% 3.00% 5.25% 4.46%

Corporate debt A 20 years 15.50% 2.14% 5.25% 4.46%

Corporate debt A 25 years 18.00% 1.30% 5.25% 4.46%

Corporate debt BBB 10 years 20.00% 8.52% 10.5% 8.63%

Corporate debt BBB 15 years 25.00% 8.89% 10.5% 8.63%

Corporate debt BBB 20 years 30.00% 9.28% 10.5% 8.63%

Corporate debt BBB 25 years 32.50% 8.44% 10.5% 8.63%

Table 42 shows how “all-in” capital charges for infrastructure debt under Solvency II are generally

lower compared to the Basel III standard calibrations. Indeed, the long durations possible in the

infrastructure market provide potential for asset-liability matching, hence a lower interest rate risk

capital charge. As an example, 20 year A rated infrastructure debt is given an “all-in” capital charge

of 2.14%, which is significantly lower compared to Basel III calibrations. It should be noted that

Solvency II does not provide specific spread risk charges for infrastructure loans, hence the

calculations in table 42 use the standard corporate debt spread risk calibrations. Insurers using

0

50

100

150

200

250

300

350

400

450

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

AA 10 year

A 10 year

Infrastructure debt

Figure 26 - Credit spreads of infrastructure debt and coporate bonds Spreads are measured in basis points over the 12 month Euribor or Libor. Euro area corporate bonds vs. worldwide infrastructure debt.

Source: Bloomberg and Projectware

68

internal models may use lower spread risk charges, thereby further reducing the “all-in” Solvency II

capital charge for insurers.

Another relevant factor is the valuation of illiquid investments such as infrastructure debt. Market

prices for such loans are often unavailable, and the appraisal values used to value such loans are

often less volatile. Hence, investments in infrastructure loans effectively reduce the volatility of the

insurer’s own-funds.

Practice confirms the attractiveness of infrastructure debt for insurance companies. As an example,

six UK insurers have recently announced plans to invest £25 billion in UK infrastructure projects over

the next 5 years17. The insurers involved are Legal & General, Prudential, Aviva, Standard Life,

Friends Life and Scottish Widows.

Our interviews with 10 European banks also confirm the findings above. It has been noted during

one of the interviews that banks are not competitive compared to insurers for long dated, high rated

infrastructure projects with fixed cash flows. Banks are more competitive for floating rate financing,

assets with construction risk, or assets with refinancing in the future. Several banks also admit to

have set up partnerships with insurers to co-finance infrastructure debt, where banks often finance

the construction period, and insurers finance the lower risk, long-term maintenance phase. An

example of a partnership between a bank and insurer is the co-financing agreement between Natxis

and Ageas; in this partnership, the bank and insurer are both financing the construction and the

operation phase together.

In sum, the low risk, attractive yields, high durations possible, and relatively low capital charges

under Solvency II make infrastructure loans an attractive asset class for insurers. The emergence of

project bonds, infrastructure debt funds and partnerships between banks and insurers are all signs

of a shift of infrastructure lending from banks to insurers.

Long-term lending: export finance and public sector entity debt

Both export finance and debt raised by non-central government public sector entities (PSEs) are

available at longer maturities. Such loans often include guarantees, either provided by the central

government or by export credit agencies. Their capital requirements under Basel III and Solvency II

are very similar to the high rated exposures presented under table 42. It appears that, from a capital

charge viewpoint, such loans are often cheaper for insurers compared to banks. Furthermore,

insurers do not bear the increased liquidity costs of the LCR and NSFR introduced by Basel III.

17 Reuters, 4 December 2013, UK insurers plan to invest 25 billion pounds in infrastructure,

http://uk.reuters.com/article/2013/12/04/uk-britain-infrastructure-idUKBRE9B300M20131204

69

A common example of PSE debt are loans provided to social housing corporations. Such loans often

benefit from an (implicit) government guarantee and are available at very long maturities. Insurers

have shown a strong appetite for such loans over the past years. As an example, the UK insurer Legal

& General has provided a total of £455 million in loans to social housing corporations over the past

18 months18.

Our interviews with 10 European banks also showed an increased competition from insurers in the

segments of export finance and PSE debt. Certain banks indeed noted that insurers can offer a more

competitive pricing than banks in these segments. One bank also admitted to fund their long-term

export loans through institutional investors. In this particular financing scheme, the export loan

remains on the banks’ balance sheet, while an institutional investor funds this loan. The institutional

investor gets a state guarantee in return. The bank benefits from this deal as it is able to fund its

loans at lower interest rate compared to normal bank bonds. The institutional investors basically

bears a sovereign risk on its investment, but still gets a yield pickup compared to investing in normal,

liquid, government bonds. Hence, such a financing scheme is a good example of how insurers can

benefit from the illiquidity premium inherent in certain loans.

18 Legal & General, 2 June 2014, L&G expands commitment to the social housing sector with £50M loan to

housing solutions, http://www.legalandgeneralgroup.com/media-centre/press-releases/2014/lgim-pressrelease-lgexpandscommitmenttothesocialhousingsectorwith50mloantohousingsolutions.html

70

CONCLUSION

This report identified the impact of Basel III and Solvency II on asset allocation decisions of banks

and insurers. We analysed Basel III regulations, how these influence banks’ funding costs, and what

the specific Basel III implications are for several asset classes.

We furthermore presented an overview of Solvency II framework for insurers, and assessed to which

extend Solvency II may affect an efficient asset allocation of insurance undertakings. We found that

a wide range of portfolios of our efficient frontier were admissible under a budget for market risk

capital, while portfolios which allocated heavily towards securitization exposures were inadmissible.

We also found that the market portfolio of an average European life insurer is likely to comply with a

stringent budget for market risk capital.

This report also compared the Solvency II framework with Basel III. The core of this report was to

compare Basel III and Solvency II capital charges for different asset classes. We found that the

incentives provided by Basel III and Solvency II are largely consistent with the business model of

banks and insurers. As such, Solvency II directs insurers towards long-term fixed income

investments, which match the long-term liabilities of insurance companies. Basel III, on the other

hand, favours investments with a shorter maturity.

More specifically, this report showed that insurers face significantly lower capital charges compared

to banks for residential mortgage loans and other long-term lending segments such as infrastructure

debt, long-term export finance, and long-term loans to local authorities. We found that sovereign

debt is treated favourably under both Basel III and Solvency II. The treatment of other, shorter term

asset classes was found to be similar under both regulatory frameworks. As such, we reported that

capital charges for short- and medium-term corporate exposures are largely comparable under both

Basel III and Solvency II. Securitised assets proved to be an exception to this rule: capital charges for

securitisations are highly unattractive for insurers compared to banks. On a final note, figure 27

visually represents the attractiveness of Basel III and Solvency II capital charges for different asset

classes.

71

securitisations

corporate debt

Mortgage loans Long term

lending

Sovereign debt

covered bonds

Figure 27 - Attractiveness of Basel III and Solvency II capital charges

Less interesting for banks More interesting for banks

Less

inte

rest

ing

for

insu

rers

M

ore

inte

rest

ing

for

insu

rers

72

ANNEX I - BASEL II VS. BASEL III

This annex presents an overview of the core modifications introduced by Basel III. We focus on the

regulatory modifications relating to the banking book and do not cover regulations for trading

activities. We start with discussing the new capital quality and quantity standards imposed by Basel

III, followed by a discussion of the increased risk weights for certain asset classes. New liquidity

ratios, including the LCR and NSFR are also major modifications in the new framework. This annex is

based on the most recent publications of the Basel Committee on Banking Supervision (BCBS).

CAPITAL RATIOS

Common equity, Tier 1 and Tier 2 capital ratios

New Basel III rules require banks to hold additional capital, compared to Basel II, for the same risks.

Traditionally, banks were obliged to hold 8% of capital, with a minimum common equity ratio of only

2%. Under the new framework, Common Equity Tier 1 (CET1)19 has to attain at least 4.5% of risk-

weighted assets. The minimum of Tier 1 capital is set at 6%. Similar to Basel II, the sum of Tier 1 and

Tier 2 capital must be at least 8%.

Capital conservation buffer

The capital conservation buffer is a new instrument that should provide banks with an additional

safety net. It consists of common equity of 2.5% in risk-weighted assets, bringing the total common

equity ratio to 7%. When a bank falls into this buffer range, supervisors can intervene gradually by

restricting discretionary distributions.

Countercyclical buffer

The countercyclical buffer is a common equity tranche ranging between 0 and 2.5%. It is imposed by

national supervisory authorities during periods of excessive credit growth and build-up of systematic

risk. Figure 28 summarises the changes in capital ratio requirements imposed by Basel III.

19 CET1 is the capital tranche of the highest quality. It consists of the sum of common shares, share premium

related to CET1 instruments, retained earnings, accumulated other comprehensive income and other disclosed reserves, and common shares issued by consolidated subsidiaries of the bank and held by third parties that meet the criteria for inclusion in CET1.

73

Capital quality

Basel III also introduces more rigorous requirements regarding the quality of capital instruments

which compose the different tiers. Innovative step-up hybrid capital previously included under Tier 1

will now be phased out. The classification of Tier 2 capital into higher and lower Tier 2 capital will be

removed in order to simplify the framework. Tier 3 capital, consisting of short term subordinated

debt, is now eliminated. This capital tranche was previously only available to cover market risks.

In addition, Basel III requires banks to deduct several balance sheet items from common equity tier 1

capital. The most important deductions are goodwill (previously deducted from Tier 1 under Basel

II), other intangibles and deferred tax assets.

Systemically important financial institutions (SIFIs)

Basel III imposes higher capital ratios on systemically important financial institutions (SIFIs) in order

to reflect their higher risks and externalities imposed on the financial system. Depending on the

bank’s systemic importance, a common equity surcharge ranging from 1% to 2.5% will be applied. An

additional surcharge of 1% may be imposed as a disincentive for certain banks to materially raise

their global systemic risk in the future.

Capital loss absorption at the point of non-viability

All capital instruments (Tier 1 and Tier 2) can be imposed a full write-off or conversion to common

shares when a supervisory authority judges a financial institution to be non-viable.

2,0% 4,5%

2,0%

1,5% 4,0%

2,0%

2,5%

0 - 2.5%

B A S E L I I B A S E L I I I

Common equity

Additional Tier 1

Tier 2

Capital Conservation Buffer

Countercyclical Buffer

Figure 28 - Basel II vs. Basel III capital ratios

74

Non-risk-based leverage ratio

Basel III introduces a non-risk based maximum of total leverage, which will serve as a floor to the risk

based capital ratios. Its purpose is to impede system wide build-up of leverage as observed prior to

the financial crisis. The Basel III leverage ratio is defined as:

Tier 1 capital

exposure measure≥3%

The exposure measure is the sum of on-balance sheet items (including repurchase agreements,

securities financing transactions and derivatives) and off-balance sheet items (calculated with a

credit conversion factor20 between 10% and 100%). The current Basel III calibrations propose a 3%

leverage ratio.

Phase-in arrangements

Imposing these capital requirements immediately would have forced banks to raise capital or

deleverage portfolios vigorously. In order to avoid these difficulties, a long transition phase has been

chosen. The phase-in period started in 2013 and ends in 2019 when all capital requirements should

be in place. For instance, the minimum capital conservation buffer will gradually increase from 0% in

2013 to 2.5% in 2019.

RISK WEIGHTS

The Basel III reforms reported in this section discuss the increased risk weights for (re)securitisations

and interbank exposures.

(Re)securitisations

The Basel III calibrations for (re)securitisation exposures are currently still under revision. The most

recent consultative document (BCBS, 2013) indicates increased risk weights for a wide range of

securitisations.

Table 43 specifies the risk weights for long-term senior securitisations under the external ratings-

based approach. This table shows that risk weights under Basel III for investment grade

securitisations have risen considerably compared to Basel II. Furthermore, whereas Basel II

calibrations were insensitive to maturity, Basel III risk weights rise with longer maturities. More

specifically, banks have to linearly interpolate between the risk weights for one and 5 years, as

specified under table 43.

20 The credit conversion factor (CCF) is the estimated exposure at default divided by the off-balance sheet

exposure.

75

Table 43 - Ratings-based approach risk weights for long-term senior securitisations

Rating Basel III 1 year Basel III 5 years Basel II

AAA 15% 25% 7%

AA 25% 50% 8%

A 50% 75% 12%

BBB 90% 130% 60%

BB 160% 230% 425%

B 310% 420% deduction from capital

CCC 460% 530% deduction from capital

Below CCC– 1,250% 1,250% deduction from capital

Basel III also imposes stronger risk weights for resecuritisations. In the past, a resecuritisation (e.g.

CDO or CDO²) would have been treated similarly to a securitisation (e.g. ABS or MBS), but Basel III

introduces two separate regimes. More specifically, Basel III requires resecuritisations to be treated

under the standardised approach. In addition, this standardised approach specifies stressed

calibrations for resecuritisations compared to ordinary securitisations. These calibrations result in

significantly higher capital charges for resecuritisations. Table 44 illustrates these risk weights for

(re)securitisations under the standardised approach of Basel III.

Table 44 - Risk weights for (re)securitisations under the standardised approach of Basel III21

Rating Basel III resecuritisations Basel III securitisations

AAA 69% 28%

AA 693% 525%

A 1111% 1049%

BBB 1250% 1250%

BB 1250% 1250%

Interbank lending

Basel III raises risk weights on exposures to financial institutions relative to the non-financial

corporate sector, since these financial exposures are more highly correlated than non-financial ones.

More specifically, Basel III introduces the so-called “asset value correlation multiplier”, which

increases correlation assumptions for large financial institutions by 25%. Such correlation

assumptions significantly increase risk weights for banks using the internal ratings-based approach

for interbank exposures.

21 The inputs for attachment points and detachments points are based on Bank of America Merill Lynch (2012).

76

LIQUIDITY RATIOS

The liquidity requirements must be one of the most important changes introduced by Basel III.

Capital requirements alone have proven to be insufficient in order to prevent the past financial

crisis. Basel II did not include any specific liquidity measure, while liquidity risk can have a substantial

impact during periods of financial distress. Therefore, two new ratios are included with Basel III: the

liquidity coverage ratio (LCR), which focuses on short-term stress, and the net stable funding ratio

(NSFR), which requires to map illiquid assets to long-term, stable funding sources.

Liquidity coverage ratio (LCR)

The liquidity coverage ratio (LCR) requires banks to hold a sufficient amount of high-quality, liquid

assets (HQLA) that can be used to offset net cash outflows under an 30-day stress scenario. The LCR

is defined as:

Stock of high‐quality liquid assets ( QLA)

Net cash outflows over a 30‐day period≥100%

The numerator of the LCR are unencumbered high-quality liquid assets (HQLA), which consist of

assets that can be converted into cash at little or no loss of value during times of stress. Table 45

defines the main assets considered as HQLA, and the factor of the total amount of the respective

assets which can be included as HQLA.

Table 45 - High quality liquid assets (HQLA)

High-quality liquid assets (HQLA) Factor

Level 1 assets: coins, bank notes, central bank reserves, securities from

sovereigns, central banks, public sector entities and multilateral development

banks, sovereign and central bank debt with a 0% risk weighting

100%

Level 2A assets: sovereign, central bank, multilateral development bank or

public sector entity assets with a 20% risk weighting, corporate debt securities

rated AA- or higher, covered bonds rated AA- or higher

85%

Level 2B assets: RMBS, corporate debt securities rated between A+ and BBB-,

common equity shares

50% - 75%

Net cash outflows in the formula of the LCR are defined as the total estimated cash outflows minus

the total estimated cash inflows under a 30-day stress scenario. These cash flows are calculated by

multiplying the outstanding balances of various types of receivables and liabilities by the rates at

which they are expected to run off or flow in. Some examples of receivables and liabilities and their

respective rates are displayed under Table 46.

77

Table 46 - Cash in- and outflows

Cash outflows Factor

Stable retail deposits 3% Stable term deposits provided by SMEs 5% Operational deposits generated by cash management activities 25% Undrawn committed credit lines provided to SMEs 5% Undrawn committed credit lines provided to regulated banks 40%

Cash inflows Factor

Maturing lending transactions backed by Level 1 assets Maturing lending transactions backed by Level 2A assets Maturing lending transactions backed by Level 2B assets Credit or liquidity facilities provided to the reporting bank Net derivative cash inflows

0% 15% 50% 0% 100%

Total cash inflows are subject to an aggregate limit of 75% of total estimated cash outflows, thereby

ensuring a minimum level of liquid assets under the stress scenario.

Net stable funding ratio

The net stable funding ratio (NSFR) is a longer-term structural ratio designed to address liquidity

mismatches. The NSFR promotes more medium and long-term funding for banks and aims to limit

over-reliance on wholesale funding during periods of readily available market liquidity. The NSFR is

defined as:

Available stable funding

Required stable funding≥100%

The available stable funding (ASF) is determined by weighting the liabilities of the bank by the so-

called “ASF Factor”. Table 47 specifies the most important components of each ASF category.

Table 47 - Available stable funding (ASF)

Components of ASF category ASF factor

Total regulatory capital

Other capital instruments and liabilities with effective residual maturity of one year or

more

100%

Stable deposits and term deposits with residual maturity of less than one year

provided by retail and SME customers

95%

Funding with residual maturity of less than one year provided by non-financial

corporate customers

Operational deposits

Funding with residual maturity of less than one year from sovereigns, public sector

entities , and multilateral and national development banks

Other funding with residual maturity between six months and one year

50%

Other liabilities 0%

78

The amount of required stable funding (RSF) is calculated by taking the sum of the assets weighted

by the respective RSF factor. Some examples of asset categories and their RSF factors are displayed

in table 48.

Table 48 - Required stable funding (RSF)

Components of RSF category RSF factor

Coins and banknotes, central bank reserves, unencumbered loans to banks with

residual maturities of less than six months

0%

Unencumbered Level 1 assets, excluding coins, banknotes and central bank reserves 5%

Unencumbered Level 2A assets 15%

Unencumbered Level 2B assets

Other assets with residual maturity of less than one year

50%

Unencumbered residential mortgages

Other unencumbered loans with a risk weight of less than or equal to 35%, excluding

loans to financial institutions

65%

Unencumbered securities that are not in default, physical traded commodities, other

unencumbered performing loans excluding loans to financial institutions

85%

All other assets not included in the above categories 100%

Phase-in arrangements

The LCR will start to be effective in 2015 with a minimum requirement of 60%. This ratio will

gradually increase to 100% in 2019. The NSFR is currently under revision; its minimum standard will

be introduced in 2018.

79

ANNEX II – LIST OF INTERVIEWEES

Name (fuction) Bank

Simon Barnasconi (Head of Financial Institutions

Group) and Udo van der Linden (Debt Solutions)

ABN AMRO

Dirk Gyselinck (Member of the Executive

Committee, Public & Wholesale Banking and

Financial Markets)

Belfius

Hedwige Nuyens (Head of Group Prudential

Affairs)

BNP Paribas

Yvan De Cock (Head of Corporate & Public Bank

Belgium)

BNP Paribas Fortis

Michel Verstraeten (Head of corporate lending

Belgium and Luxemburg) and Bart Eekhaut (Head

of business lending)

ING

Bart Guns (Senior General Manager Group Credit

Risk Directorate), Carl De Bourdeaud’huy ( ead

Credit Risk Management)

KBC

Benjamin Sirgue (Global head of aircraft, export

& infrastructure finance)

Natixis

Peter Van Raemdonck (Director corporate

finance – debt capital markets)

Petercam

Jan-Jaap Meindersma (Head of Alternative Credit

Solutions)

Rabobank

Eric Viet (Head Financial Insitututions Advisory) Société Générale

80

ANNEX III – PRODUCT COST INCREASE DUE

TO BASEL III

This annex details the product cost increases due to Basel III mentioned in tables 1, 4, 5, 6, 7 and 8.

These calculations are based on our own methodology.

Changes in capital costs are based on the following assumptions:

- Required return on capital: 10%

- Basel II target capital ratio: 8%

- Basel III target capital ratio: 10.5%

- Costs due to higher capital quality: 20.0%

As a reference: the monitoring exercise as of 30 June 2011 conducted by the Basel

Committee on Banking Supervisions indicates that capital deductions not previously applied

under Basel II reduce the gross CET1 of Group 1 banks under the Basel III framework by

32.0%. We conservatively estimate that the total of measures which increase in capital

quality - including capital deductions, a larger focus on CET1 capital, phasing out of some

capital instruments and the elimination of Tier 3 capital – increase the costs of holding

capital by 20%.

- Risk weights under the standardised approach are assumed for most asset classes. For

securitisations, the ratings based approach is used. For resecuritisations, the standardised

approach is used assuming the attachment points and detachments points provided by Bank

of America Merill Lynch (2012).

The change in capital costs is measured as: risk weight * Basel III target capital ratio * Required

return on capital * costs due to higher capital quality - standard risk weight * Basel II target capital

ratio * required return on capital

The change in liquidity costs is measured as the sum of costs due to the LCR and NSFR. LCR and NSFR

costs partly offset each other.

LCR costs are measured as follows:

- Shortfall of high quality liquid assets (HQLA) compared to the balance sheet total: 4%.

The monitoring exercise as of 30 June 2011 conducted by the Basel Committee on Banking

Supervision indicates a shortfall of liquid assets of €1.76 trillion, compared to a €58.5 trillion

total assets of the aggregate sample. This implies a HQLA shortfall of 3% compared to the

balance sheet total. Since banks are likely to target a LCR of higher than 100%, we assume a

HQLA shortfall of 4%.

81

- Yield reduction due to a shift in HQLA: 2.72%.

A shift in allocation from loans to HQLA will reduce the yield such assets. We assume that

bank loans yielding 3.33% (ECB statistics of February 2014 on the interest rates of Euro area

loans to non-financial corporations over 1 and up to 5 years) are shifted to government

bonds yielding 0.61% (FTSE Euro zone government bond index 3 to 5 years maturity).

- LCR costs are calculated as: shortfall of HQLA*yield reduction due to a shift in HQLA

NSFR costs are measured as follows:

- NSFR target ratio: 105%

- NSFR ratio prior to Basel III: 94%

The monitoring exercise as of 30 June 2011 conducted by the Basel Committee on Banking

Supervision indicates that the weighted average NSFR for each of the bank sub-groups is

94%.

- Yield increase due to a shift from non-stable to stable funding: 0.203%.

We assume that banks incur costs when shifting from non-stable to stable funding. We

assume a yield of non-stable funding of 0.443% (Bloomberg BFV EUR finance A 3 months

yield, 0% ASF factor) and a yield of stable funding of 0.646% (Bloomberg BFV EUR finance A 2

years yield, 100% ASF factor).

- We assume that banks which invest more in HQLA will equally reduce their required stable

funding (RSF).

- LCR costs are calculated as: RSF factor of the particular asset * yield increase due to a shift

from non-stable to stable funding *[NSFR target ratio – NSFR ratio prior to Basel III / (1 –

shortfall of HQLA * RSF factor of the particular asset)]

82

ANNEX IV – SOLVENCY II CAPITAL CHARGE

CALCULATIONS

Most of our assumptions regarding our calculations of the Solvency II “all-in” capital charge are

derived from a model provided by EIOPA in their “Technical Report on Standard Formula Design and

Calibration for Certain Long-Term Investments”, p. 157. The most important calculation steps and

assumptions of our model included the following:

- We calculate the capital charge for an average European life insurer making a €10 million

investment on a balance sheet total of €1000 million.

- The initial balance sheet of this insurer has the following structure:

Assets Market value

Corporate Bonds 340

Government bonds 260

Covered bonds 60

Equity 120

Property 40

Mortgage Loans 50

Cash 50

Reinsurance asset 80

Total assets 1000

We assume that the fixed income portfolio of this insurer has a duration of 7 years, the

market value of the liability portfolio is 850 and its duration is 9 years, and that the insurer

has aggregate own-funds of 15% of total assets.

- The calibrations for spread risk, counterparty default risk and interest rate risk are based on

EIOPA’s “Technical Specification for the Preparatory Phase (Part I)”.

- Interest rate risk: we gather risk-free interest rates from the Euro swap curves (EUSAYY

Curncy) from Bloomberg. Given these currently low risk-free interest rates, Solvency II

calibrations ask to apply a 100 bps stress on the value of assets and liabilities. We assume

that the insurer substitutes €10 million from its fixed income book (average duration of 7

years) with another €10 million investment. If this investment has duration different from 7

years, than the average duration of the fixed income book changes, and the capital charge

for interest rate risk will change, too. As such, if the €10 million investment has a duration

lower (higher) than 7 years, the capital charge for interest rate risk will increase (decrease).

- Diversification: we account for diversification using the correlation tables provided in the

Solvency II technical specification.

83

- The loss absorbing capacity of deferred tax assets and technical provisions is estimated at

40% of the Basic Solvency Capital Requirement (BSCR).

Special reference too residential mortgage loans under the counterparty default module

The Solvency II capital charge for residential mortgage loans is given under the counterparty default

risk module. The following capital charge is applied to residential mortgage loans:

15%*E+ 90%*Epast-due

Where E is the sum of the values of the exposures and Epast-due is the sum of the values of the

exposures which are due for more than 3 months. The value of the exposures may be reduced by

the risk-adjusted value of the collateral. The standalone risk charge for property investment is 25%.

We assume the value of receivables due for more than 3 months to be 0. We assume diversification

benefits for property investment to be at 20%. For a loan-to-value of 80% (i.e. the value of the

collateral is 125% of the value of the loan), the stand-alone risk charge for mortgage loans under

Solvency II then becomes:

15%*(100%-(125%-125%*25%*80%)) +90%*0 = 0.00%

84

ANNEX V – COMPARISON BETWEEN

EFFICIENT FRONTIER AND THE AVERAGE

LIFE INSURERS’ PORTFOLIO

This annex compares portfolio 38 of the efficient frontier calculated in chapter 4 with the market

portfolio of an average European life insurer, as documented by Höring (2013). We conclude that

both portfolio have largely similar allocations, rating and duration characteristics.

Asset Allocation of portfolio 38

Allocation of the average life insurer

Government bonds 40.0% 40.0%

Covered bonds 25.4% 12.5%

Corporate bonds and securitized assets

11.6% 29.5%

Property 17.0% 11.0%

Equity 6.0% 7.0%

The table above shows that both portfolios are largely similar. Portfolio 38, however, seems to

allocate less to corporate bonds to the benefit of covered bonds.

Rating breakdown portfolio 38

Rating breakdown for the average life insurer

AAA 36.4% 49.6%

AA 68.3% 15.8%

A 5.5% 22.0%

BBB 16.4% 8.6%

BB or lower 0.0% 2.0%

Unrated 0.0% 2.1%

Average rating AA- AA

The table above shows that both portfolios have the same average rating of AA. However, portfolio

38 seems to be concentrated around AA investments, whereas the average European life insurer

holds fixed income more evenly among AAA, AA and A.

Maturity breakdown portfolio 38%

Maturity breakdown for the average life insurer

1-5 years 14.1% 35.6%

5-10 years 52.9% 33.7%

10+ years 33.0% 30.7%

Duration fixed income (years) 7.94 6.25

Duration total assets (years) 6.01 5.12

85

The table above shows very similar maturity and duration characteristics for both portfolios.

Portfolio 38 does seem to allocate slightly more to 5-10 year maturities and less to 1-5 year

maturities, which also explains the slightly higher duration of portfolio 38.

86

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