Niels Jensen: The Absolute Return Letter October 2010

The Absolute Return Letter October 2010

Insolvency Too

“There are those who don’t know and those who don’t know they don’t know.”
- John Kenneth Galbraith

On 1^st January 2013, a new directive regulating insurance companies which conduct business within the EU will come into effect. It is called Solvency II and unless you work in the insurance or the pension industry the chances are that you will never have heard of it before. I suggest you do your home work as this is important stuff. The indications are that the directive has already had a meaningful impact on bond markets and there could be a lot more to come over the next 24 months.

Let’s begin with a re-cap of our position on bonds, as that is very much part of the story. In the April 2010 Absolute Return Letter (see here) I argued the case for falling bond yields and concluded the following:

“All other things being equal, this puts a very effective lid on real rates and is one of the key reasons why I am gradually coming around to the realisation that long dated bonds could be one of the great surprises of the next few years.”

Still bullish on bonds

The only thing I regret about that statement is that I wrote “years” instead of “months”. Having said that, it hasn’t exactly been plain sailing these past six months. A constant bombardment from investors and commentators, high and low, why bond yields can only go up, has forced me to re-visit my bullish view at fairly regular intervals but, at least until now, I have seen no convincing reason to change tack.

So what drives our bullish stance? A combination of structural and cyclical factors:

• Ageing baby boomers’ rapidly growing appetite for income;
• Deflationary pressures driven by private sector de-leveraging;
• The global economic recovery losing momentum; and
• Central banks’ use of quantitative easing.

And, finally, the one that most investors ignore, and which is the focus of this month’s Absolute Return Letter:

• Asset/Liability re-allocations driven by Solvency II.

At a critical juncture Solvency II is at a critical juncture. The implementation is now just over two years away. Many insurers (and many of those pension funds which are impacted by the new rules) have already started preparing for life under Solvency II, but others are behind. Meanwhile, the European Union released a Green Paper only a couple of months ago, throwing a cat amongst the pigeons by re-opening the discussion whether Solvency II should also be applied to occupational pension schemes in countries such as the UK and the Netherlands. These schemes are currently outside the scope of Solvency II.

Why is all this important? Because the amounts of money that have already been shifted from equities to bonds are enormous, and there will be more to come if traditional pension schemes are subjected to the new rules as well.

Solvency II will govern capital adequacy standards in the European insurance and life insurance industry. It represents a complete overhaul of the existing rules (Solvency I), which date back to the 1970s. One of the pillars of the new directive is the introduction of a risk-based approach to reserving. Going forward, European insurers will have to be able to pass a 1-in-200 years’ event stress test, which has been designed to give the industry enough cushion to withstand even the most severe of bear markets without being forced to sell out in the darkest hour. Risky asset classes such as equities, commodities and other alternative investments will be assigned much higher reserve requirements than less risky asset classes such as bonds.

Solvency II is not without its teething problems, though. One such problem relates to who is and who isn’t subject to the new directive. The borderline between the European life insurance industry and pension industry is very blurred. In some countries (e.g. Denmark) pension funds are considered life insurance companies and regulated as such. In other countries (e.g. Germany) pension funds, the way we know them from the Anglo Saxon world, do not even exist, and pension products are provided by insurance companies. Then again, in countries such as the UK and the Netherlands, pension funds operate as a separate industry independently from the life insurance industry.