Managing the required capital for market risk under Solvency II is of the utmost importance for European insurance companies. The required Solvency II capital is fixed for most asset classes. However, for equity markets the required capital changes over time due to the ‘symmetric equity adjustment mechanism’. This article explains how the symmetric adjustment mechanism works and also looks ahead to 2018.
Solvency II is the regulatory framework for European insurance companies since January 1, 2016. The solvency capital requirement (SCR) is a crucial element under Solvency II. Because Solvency II is a risk-based framework, riskier assets are typically charged with a higher SCR than less risky assets. An example is given below for different asset classes.
Figure 1: Overview of the solvency capital requirement (SCR) under Solvency II for a range of asset classes. Source: Aegon Asset Management
We consider the stand-alone SCR here, so before diversification and tax effects. We also assume that interest rate and currency risk are hedged on the overall balance sheet. This figure shows that the SCR is zero for euro sovereign bonds (and euro government related bonds) and very low for cash or money market investments. The SCR increases for bonds with longer maturities or lower ratings.
For more risky categories (like equities), the SCR is not fixed but changes over time. The maximum deviation in SCR from the base value is 10%-points. In simple terms, this means that in a bull market the SCR for equities goes up, while the SCR goes down in a bear market. This mechanism – known as the symmetric equity adjustment – makes equities more capital expensive under Solvency II in an upward market and vice versa. The idea is to suppress pro-cyclical investment behavior of insurance companies by making equities less attractive in bull markets and more attractive in bear markets.
New research by La Banque Postale Asset Management
In this context, we would like to highlight new research on this topic by La Banque Postale Asset Management in France. In a recent research paper they provide more background information on the symmetric equity adjustment and show that this adjustment can be quite volatile over time. In addition, a forecast of the symmetric equity adjustment for 2018 is provided, which gives some guidance to insurance companies who invest in equities.
Aegon Asset Management and La Banque Postale Asset Management (LBPAM) have a strategic, long-term partnership since 2015. La Banque Postale Asset Management is the fifth largest asset manager in France with €218 billion assets under management (as of October 2017) on behalf of both retail and institutional clients.
A summary of the findings:
- The symmetric equity mechanism is very volatile over time
- The equity adjustment is currently close to zero
- For 2018, a rise of 10% of equity would result in an increase of the SCR of 3%-points only
- All other things being equal, the equity asset class continues to present an opportunity in terms of asset allocation, as the SCR for equity markets is close to its standard level