10 March 2023

Chart of the Week: Solvency capital charges, and what a cactus and CIO (should) have in common

As Charter of the Week each Friday, I feel well-placed to say data is the best lens for CIOs to understand their professional world. As one chief risk officer once told me: "I listen to words, but I act on figures."

But I'm a journalist from Monday to Thursday, so must also admit the English language can sometimes prove singularly poor at describing the landscape.

Consider, if you will, the humble cactus.

Spectacularly well adapted to hostile surrounds, it triangulates between spending its limited energies on roots/greenery for collecting precipitation, flowers for pollinating, and – in its case - stomata for photosynthesis.

Every plant needs water, sunlight and pollinators to extend its species. Only one of these elements is freely available to cacti, yet against tough odds they thrive.

This hardly exemplifies the English phrase to be 'cactus', meaning one's days are severely numbered. Quite the opposite, in fact.

CIOs' triangulation in tough climates

In Europe, whether CIOs are destined to become history's idiomatic 'cactus', or be a 'true cactus' by flourishing in sometimes tough surrounds, will depend largely on how well they triangulate three variables in their own world: prospective returns, volatility and Solvency II capital charges. Solvency II rules are under review in Brussels and London, so all three variables are in flux.

One could, of course, add variables such as 'an insurer's existing solvency buffer' and 'liquidity demands', but for today's exercise let's leave it at three.

Triangulate poorly, for too long, and your number's up.

This week's chart examines one of those three variables - capital charges, or more specifically the average charge that CIOs faced for investing GAs in 2020/2021, before diversification was accounted for.

This figure was analysed in a feature Insurance Asset Risk published earlier this year.

Average gross capital charges by GA size

The pre-diversified charge, for 244 standard formula users, is arrived at in simplest terms by multiplying an asset's volume in the general account by the applicable capital charge, and turning the results across the whole GA into a percentage. Allowances exist for risk-reducing hedging, and some other minutiae - but that is more or less 'it'.

The chart below shows what 'it' was, for CIOs of groups in 2021, as segmented by the size of their GAs.

Regardless of their GA size, CIOs faced a higher average gross capital charge in 2021 than in 2020. Groups with GAs of between €10bn and €50bn only faced a marginally higher average gross charge in 2021 - 10.9% versus 10.2% - but the pattern was otherwise uniform.

Fair enough. After all, CIOs' hunt for yield intensified, in what was still a relatively low-yield environment, and that hunt often involved asset classes that cost more in capital terms.

Moreover, CIOs buying shares faced an equity symmetric adjustment that rose from -0.49% to 6.88% during 2021, via a 5 November peak of 8.23%. CIOs added that to the relevant capital charge, making shareholdings listed in the EU/OECD markets cost 46% not 39%, and other shares cost 56% not 49%, by year's end. That adjustment aims to adjust the capital pressure on CIOs, and stop hasty trading based on past market moves. Sharemarkets had risen, and the ' regulatory price' for holding more shares, and applying the adjustment to them, was a higher capital bill. At Iceland's Vatryggingafelag Islands group, the adjustment caused about half the total increase in its equity SCR, in 2021.

Rising interest rates should mean, ceteris paribus, that core fixed income yields satisfy more CIOs more often, but Insurance Risk Data, the research and data arm of Insurance Asset Risk, does not expect CIOs to put planned adoption of capital-costlier asset classes entirely on hold, just for that reason.

Smaller GAs not necessarily less adventurous

Of further interest is, the average gross capital charge rose, each year, as the GAs got smaller - and markedly so. In 2021 the move was from 9.1% for GAs of over €100bn, to 15.7% for GAs with less than €5bn. In 2020, the corresponding change had been from 8% for the biggies to 15.3% - a near doubling in average charge.

We would still find this finding noteworthy, notwithstanding the significant caveat - that we are about to mention - in mind.

The finding belies the claim that, the smaller the GA, the more likely it is to be heavily stacked in low-capital-charge investments - think EU govvies, high-grade credit.

And the finding belies any claim linked to that, that a small-GA group has a CIO only more comfortable buying such stuff - assume this not.

CIOs of groups with large GAs can still, of course, invest heavily in classes with higher capital charges, but then temper that with a lot of sovereigns and investment-grade corporates, to create a lower gross cap charge.

Earlier this year CNP Assurances Group, for instance, won CIO of the Year - take a bow, Olivier Guigné - from Insurance Asset Risk, in part for deftly applying an eclectic investment taste.

Despite making a fair few high-charging investments in 2021 - see below - on average the group's pre-diversified capital charge was just 9.6%.

That ranked it sixth among 10 groups with GAs exceeding €100bn, below the likes of fellow French groups GACM (13.4%), BNP Paribas Cardif (13.3%) Aema (10.6%), and Sogecap (9.8%).

Or, among 240-odd standard formula-using groups of all GA sizes analysed by Insurance Asset Risk, Guigné's pre-diversified capital charge was below the 14.4% average, ranking CNP Assurances 150th

Guigné bought funds for debt for the group, Dutch mortgages, emerging countries particularly Asia, and in the US, using about €3bn.

He stoked 32 private equity funds in France, Europe and the US with €1bn, mainly benefitting SMEs and ETIs across various sectors, leaving the group with €5.2bn exposure. A health fund received €20m, infrastructure exposure was grown by €1.9bn in France and Europe, bringing total exposure to €4.3bn. (Then in 2022 a new infra unit-linked fund was launched in partnership with La Banque Postale, investments made in international equity funds, and two green bonds issued.)

In 2021, Guigné said: "We need to diversify more, to be more tactical as we need to adapt to the changes more rapidly than before, and also to invest in what we could call 'untested territories' as we see new technologies and sectors which are rising very quickly."

And diversify Guigné certainly did...which brings us to our significant caveat.

Guigné and others like him added some hefty capital charges to the GA in 2021, but their diversifying also brought a capital benefit upon their gross investment capital bill - and therefore the average charge they ultimately 'paid'.

Alas, CNP Assurances did not quantify its benefit, in its 2021 SFCR - but analysis of 56 groups using the standard formula found an average capital benefit that was worth 21.8% of those groups' gross investment capital bill, bestowed specifically by diversification.

What next?

In light of all these findings, and a degree of regulatory capital strain that could still be evident in some adventurous GAs, CIOs (and the asset managers helping them invest), might usefully ask themselves:

  • can the insurer's (or asset manager's) investment strategy generate similar Sharpe ratios, but in less capital-absorptive asset classes, or using less capital-intensive mixes of assets?
  • can different asset classes/approaches produce almost the same Sharpe ratio, but with significant capital savings?
  • how might the portfolio/strategy look, re-worked towards a Solvency II capital target first?
  • can the CIO or AM generate similar Sharpe ratios with a more diversified, or local-currency based focus – reducing any capital bill for concentration/FX risks?
  • what further knowledge about the insurer's approach to investment capital would help an AM do such modelling?
  • does the CIO face particular pressure to reduce any particular type of market risk and how could an AM help?
  • what strategies does the CIO say they employ internally, to manage/mitigate market risk?
  • does an AM's strategy generate a significant capital 'bill' for its client, in a risk class the client is trying to mitigate?
  • are there ways an AM can integrate its strategy more deeply into the GA, by using market intelligence about the insurer's investment risk capital profile?

Answering all these questions, and helping a CIO with them where possible, won't make tough market conditions go away.

But it may well help both a mandate's manager, and CIO, become the future's cactus, not history's 'cactus'.

Average pre-diversified Solvency II capital charge by size of GA, 2020-2021 (%)

Source for chart: Analysis of European groups' SFCRs by Insurance Risk Data. Note: Standard formula users only were examined. A sample of 244 groups (GA: €3.5trn) was used