Insurers move into banks' territory

Capital regulations influence investments

Source: Trends magazine (2 October 2014); Author: Ilse De Witte

The biggest insurer active in Belgium, AG Insurance, has 1.5 billion euro of mortgage loans in its portfolio. "Home mortgages fit into insurers' balance sheets better than banks' balance sheets," says Mathias Wambeke, who has carried out research at Vlerick, commissioned by Ageas. "The banks, however, still have the know-how and the network."

"We used to have four employees here and we also used a few external staff. Today, 35 people permanently monitor the risks in our investment portfolio," says the Ageas spokesman, as we pass the risk department. We are at the insurance holding's headquarters near the Cathedral of St. Michael and St. Gudula. The huge department illustrates just how much more complex the regulations for insurers have become. The new capital regulations (Solvency II) enter into force from 2016.

"There will be a lot more administration under the new Solvency II capital regulations for insurers," acknowledges Wim Vermeir. He is responsible for the investment strategy at the insurance subsidiary AG Insurance and for coordinating investments across the Group. "Solvency I didn't really look at the assets on insurers' balance sheets," explains Mathias Wambeke, researcher at Vlerick Business School. "It did look at insurers' liabilities and commitments, however." In preparation for Solvency II, most insurers have decreased their investments in shares over recent years. The percentage of shares in AG Insurance's portfolio has decreased from 9% in 2007 to 2.5% at the end of 2013, for example.

On behalf of Ageas, Wambeke researched how the capital regulations for banks (Basel III) and insurers (Solvency II) influence their investment policies and how they can offer each other a helping hand.

Insurers have to create capital buffers to absorb potential losses on their investments. How is the buffer required for various investments determined?

MATHIAS WAMBEKE. "There are various types of risks that influence the capital buffer for an investment portfolio: the market risk or spread is the most important and there are also counter-party, interest-rate and concentration risks. The yield-spread or risk premium is what investors pay on top of the risk-free interest rate. This premium can fluctuate depending on the market conditions. The larger the fluctuations, the more capital the insurer needs to set aside. For all government bonds issued by countries in the Eurozone and for most mortgage loans, Solvency II states that the market risk and counter-party risk are 0 percent. So an insurer does not need to create a buffer for this. For corporate bonds, the capital costs are already somewhat higher. Repackaged loans have become unaffordable.

The capital costs for government bonds and home mortgages can even become negative. When investments have the same term as liabilities, for example, the interest risk is reduced and the insurer does not need to hold as much capital. Mortgage loans in Belgium have an average term of 20 to 25 years. Longer terms are common in other countries. This can create a perfect match for insurance products, such as pension savings. If the investments also ensure additional spread within the portfolio, they can further reduce the total capital costs."

Is it not strange that the regulators are treating German and Greek government bonds the same way?

WIM VERMEIR. "It shows that the framework of Solvency II is not completely adjusted to reality. Insurers still have to do their own homework. Ageas does make a distinction between government bonds issued by core and periphery Eurozone countries. Aside from capital regulations, Solvency II also provides regulations relating to corporate governance, reporting, monitoring of investments etc.

Spain recently issued government bonds with a term of fifty years. If insurers were to unquestioningly pursue the standard model in Solvency II, this would be an ideal investment. We made a conscious decision not to invest in this kind of long-term Spanish bond, however. The longer the term, the higher the chance that the issuer's creditworthiness will have changed by the maturity date."

The European Central Bank will soon be purchasing repackaged loans, does it now have to fill the gap left by insurers?

WAMBEKE. “It has become nigh impossible for insurers to purchase repackaged loans. They have to reserve very high capital buffers for this. It's a reaction to accidents with some complex, structured products in the past."

VERMEIR. "This isn't a bad thing. Some of these products were much too sophisticated and based on theoretical models that didn't hold water in practice. In any case, we no longer invest in these. Now we only invest in products that are completely transparent and allow us to check for ourselves whether the counter party is creditworthy. We no longer rely solely on the judgements of credit-rating agencies. In principle, there is nothing wrong with the idea of dividing loans up and selling them in slices. But financial institutions then cannot offer loans to people who are unable to repay them.  And as an insurer, this is something you have no control over. Unless the bank keeps a portion the repackaged loan on its own balance sheet, the institution has no reason to thoroughly investigate the creditworthiness of the counter party."

Bazel III has made it more difficult for banks to keep mortgage loans on their balance sheets. Yet the mortgage market in Belgium is highly competitive.

WAMBEKE. "The situation at Belgian banks is different to foreign banks. In the Netherlands, for example, banks have a lot of mortgage loans on their balance sheets and too few savings deposits to finance them. Belgian banks, on the other hand, have a surplus of savings deposits. Belgian banks therefore have no problems at all with offering mortgage loans."

VERMEIR. "Of course, this is not structural. Today there is a huge amount of cash in the financial system. This is the result of all the ECB measures to stimulate the economy. The ECB will be scaling these measures back at some point."

The financing of infrastructure also seems to be an attractive target for long-term investors. The Belgian pension funds want to invest more in infrastructure, but they complain that the entry threshold is too high. Do investors experience the same problem?

VERMEIR.“AG Insurance has an investment portfolio of 60 billion euro. All Belgian pension funds put together have 20 billion euro to spend. For small insurers and pension funds it may be more difficult to invest in infrastructure. It's true that the financing of these projects is often not tailored to pension funds and insurers.

“Two years ago Ageas brokered a deal with the French bank Natixis. The bank had the know-how but no longer had space on its balance sheet. We are now investing side by side with Natixis. We focus on infrastructure projects in energy, transport and social infrastructure, such as schools and prisons. The deal with Natixis could grow to 2 billion.

"And with AG Real Estate, we also have the required in-house expertise to finance property-related infrastructural works, such as the school-building project Scholen van Morgen (Schools of Tomorrow). We have also taken over a claim against the European Community for the Belgian State relating to the Berlaymont building and a similar claim against Deutsche Telekom. For us, these are fixed-income alternatives to conventional bonds. We are looking for stable, defensive investments with regular cash flows, a very long-term perspective and an illiquidity premium."

Study on "Regulatory impact on banks' and insurers' investments"

The financial sector is operating in a rapidly changing environment with new regulations coming up and with a growing dependency on macro-economic developments. In this context, banks and insurers are both confronted with the, Basel III and Solvency II regulations that will soon be effective. To get a better insight in the consequences and opportunities of these new regulations for their investment behavior, Ageas has asked Vlerick to make a detailed study on "Regulatory impact on banks' and insurers' investments".

Vlerick Business School and Ageas and its Belgian operational company AG Insurance, promoters of the Vlerick Chair “Centre for Financial Services”, strongly belief that the exchange between the business community and the academic world is beneficial for both parties by increasing the mutual understanding of each other’s strategies, challenges, opportunities and needs.



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