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EDHEC Position Paper Solvency II ENG

EDHEC Position Paper Solvency II ENG

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Published by pensiontalk
EDHEC Position Paper Solvency II ENG
EDHEC Position Paper Solvency II ENG

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Published by: pensiontalk on Jul 27, 2012
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The Impact of Solvency IIon Bond Management
July 2012
An EDHEC Financial Analysis and Accounting Research Centre Publication
 
2
Printed in France, July 2012. Copyright© EDHEC 2012.The opinions expressed in this study are those of the author and do not necessarily reflect those of EDHEC Business School.The author can be contacted at research@edhec-risk.com
Executive Summary ................................................................................................5Introduction .............................................................................................................9I. Measuring Bond Risks under Solvency II ...................................................13
 
II. Sensitivity Analysis of Solvency II Prudential Capital Requirementswithin a Bond Management Environment ......................................................23III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate?SCR versus Historical VaR and Volatility ............................................................35IV. The Impact of Bond SCR on Insurers’ Asset Allocation – Solvency IIFriendly Assets ......................................................................................................53Conclusion .............................................................................................................73References .............................................................................................................79Appendices ............................................................................................................81About EDHEC Financial Analysis and Accounting Research Centre ..............93About EDHEC Business School ..........................................................................95
Table of Contents
 
3
An EDHEC Financial Analysis and Accounting Research Centre Publication
The Impact of Solvency II on Bond Management - July 2012
We are pleased to present this study,
conducted by the EDHEC Financial Analysis
and Accounting Research Centre, which,
since its creation in 2006, has workedon issues relating to Solvency II andIFRS standards in the insurance sector.
Solvency II, which will come into effect
in 2014, will have a signiicant impact on
the way insurance companies, as well as
financial markets, perceive risk. One of 
the major changes with Solvency II is the
treatment of market risks, which represent
an additional capital cost that now needs tobe incorporated into the analysis of insurers’
investment choices.This study analyses the impact o the new
prudential regulation on bond management.We consider the appropriateness of the bondSolvency Capital Requirement (SCR) as a risk
measure, the effects of this risk measure
on bond management within a return-
volatility-Value-at-Risk-SCR universe, and
whether Solvency II will give rise to a new
bond hierarchy and arbitrage opportunities.
This study demonstrates that an investor
is able to evaluate bond SCR by using
only two variables, residual maturity and
rating, rather than the nine initially tested.
Moreover, the correlation between real
credit spread and SCR is not high. This is
due to the flat-rate treatment of spread risk
under Solvency II (which assigns a single
risk factor to each rating and does not
account or internal variances in ratings).
Given the additional marginal cost that
could be considered excessive in proportion
to the return generated, bonds rated BBBor lower could end up being neglected by
investors, potentially resulting in significant
implications for the financing needs of the
economy.
We show that SCR – as defined by the
standard formula – is, overall, an appropriate
measure of risk. However, given theirspecificities, SCR does not fully reflectthe risk associated with long-maturity
investment grade bonds, high yield and
unrated bonds. Due to the features of bond
SCR (high correlation with volatility and
historical VaR), bond management currently
based on the return-VaR-volatility triple
factor should evolve under Solvency II,more towards a management approach
based solely on the bond return-SCR pair.
Finally, an analysis of the efficiency of 
risk-taking measured by the bond return/
SCR ratio shows that the standard formula
favours low duration bonds, particularly
high yield bonds. This management,
within the constraints o SCR, could lead
to a shortening of durations, given the
calibration and current term structure o interest rates.
Philippe Foulquier PhD,
Director of the EDHEC Financial Analysis and Accounting
Research Centre
Foreword

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