An EDHEC Financial Analysis and Accounting Research Centre Publication

The Impact of Solvency II on Bond Management
July 2012

Table of Contents
Executive Summary ................................................................................................5 Introduction .............................................................................................................9 I. Measuring Bond Risks under Solvency II ................................................... 13 II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment ...................................................... 23 III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility ............................................................35 IV. The Impact of Bond SCR on Insurers’ Asset Allocation – Solvency II Friendly Assets ...................................................................................................... 53 Conclusion ............................................................................................................. 73 References ............................................................................................................. 79 Appendices ............................................................................................................ 81 About EDHEC Financial Analysis and Accounting Research Centre .............. 93 About EDHEC Business School .......................................................................... 95

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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

The Impact of Solvency II on Bond Management - July 2012

Foreword
We are pleased to present this study, conducted by the EDHEC Financial Analysis and Accounting Research Centre, which, since its creation in 2006, has worked on issues relating to Solvency II and IFRS standards in the insurance sector. Solvency II, which will come into effect in 2014, will have a significant 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 to be incorporated into the analysis of insurers’ investment choices. This study analyses the impact of the new prudential regulation on bond management. We consider the appropriateness of the bond Solvency Capital Requirement (SCR) as a risk measure, the effects of this risk measure on bond management within a returnvolatility-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 for internal variances in ratings). Given the additional marginal cost that could be considered excessive in proportion to the return generated, bonds rated BBB or 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 their specificities, SCR does not fully reflect the 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 of SCR, could lead to a shortening of durations, given the calibration and current term structure of interest rates.

Philippe Foulquier PhD,
Director of the EDHEC Financial Analysis and Accounting Research Centre

An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

About the Authors
Liliana Arias is a Research Engineer at EDHEC Business School Financial Analysis and Accounting Research Centre. She has an MSc in Finance from EDHEC and an undergraduate degree in Economics from the University San Francisco de Quito in Ecuador. Prior to joining the research centre, Liliana worked as a risk analyst for the Corporate and Investment Banking division at Citigroup. Within the research centre, she actively participates in numerous studies on Solvency II and IFRS.

Philippe Foulquier PhD, is Professor of Finance and Accounting and Director of EDHEC Financial Analysis and Accounting Research Centre. After beginning his career within the scientific department of the French insurer UAP, Philippe spent 10 years as a financial analyst, specialising in the insurance sector. Prior to joining EDHEC in 2005, he was head of the Pan-European insurance sector at Exane BNP Paribas. He has been ranked top insurance sector financial analyst in the Extel/Thomson Financial and Agefi international surveys. His research primarily focuses on the impact of Solvency II and IFRS on the management of insurance companies and on corporate valuation issues (across all industries). He has authored a number of in-depth studies on the subject and has contributed to various consultations for European Insurance and Occupational Pensions Authority (EIOPA).He has published a number of articles in academic journals and his research has been cited in the Financial Times and The Economist. He sits on the Accounting and Financial Analysis committee of the SFAF (the French Financial Analysts’ Society). He has a PhD in Economics and an MSc in Finance, both from the University of Paris X Nanterre, and also holds an EFFAS certification. He is actively involved in consulting on issues relating to Solvency II, IFRS and corporate valuation (across all sectors).
Alexandre Le Maistre is an Associate Research Engineer at EDHEC Business School Financial Analysis and Accounting Research Centre. He holds an undergraduate degree in Mathematical Engineering from EISTI and joined EDHEC upon completion of his degree. In his position within the research centre, Alexandre participates in a number of research studies on the evaluation of market risks, particularly within the context of Solvency II.

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An EDHEC Financial Analysis and Accounting Research Centre Publication

Executive Summary

An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

Executive Summary

The insurance industry’s new prudential regulation will come into effect in 2014. By considering the majority of risks faced by insurance companies, Solvency II seeks to encourage insurers to better manage and control all risks they might face (underwriting risk, market risk, counterparty risk, operational risk). One of the major changes with Solvency II is the treatment of market risks. In exchange for complete liberty when choosing and allocating their assets, an intrinsic cost of capital is allocated to each asset (referred to as the Solvency Capital Requirement or SCR). This is likely to structurally change the way in which insurers’ assets are managed. This study analyses the impact of Solvency II on insurers’ bond management practices by attempting to answer four questions: (i) What are the defining bond characteristics of the SCR?; (ii) How adequate is SCR as a risk measure?; (iii) How could Solvency II change the traditional approach to bond management, using the three dimensions of return, volatility and VaR?; (iv) Will Solvency II give rise to a risk-return hierarchy and arbitrage opportunities between different types of fixed-rate bonds? Our study is based on a sample of 4,279 fixed-rate bonds, all sufficiently liquid, with fixed maturities and listed between 1999 and 2011 in 14 different countries. Which bond variables are regulatory capital requirements most sensitive to? Solvency II uses a delta-normal method to calculate the prudential capital requirement (SCR), which often leads to an underestimation of the real Value at Risk. This drawback pushed us to conduct an SCR sensitivity study on different bond
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characteristics (coupon frequency, coupon rate, spread, duration, residual maturity, rating, and the ratios of redemption value/ face value, clean price/redemption value and dirty price/redemption value). This study was carried out on a sample of 4,279 fixed-rate or zero coupon bonds, issued across 14 different countries (Europe, U.S., BRICS, PIIGS) over the period from 1999 to 2011. Our findings show that it is possible for bond managers to assess bond SCR using only two variables (rating and residual maturity), rather than the nine initially identified above. These two variables alone account for 89% of SCR. Moreover, real credit spread is not strongly correlated to the SCR level (32% using Spearman’s Rank Correlation). This is due to the flat-rate treatment of spread risk in the standard Solvency II formula, which assigns a single risk factor to each rating and does not account for internal variances within a rating. Finally, we show that, due to the construction of the standard Solvency II formula, long-term bonds, particularly those with ratings of BBB or lower could be neglected by investors who are subject to the new solvency standards, as a result of the additional marginal cost that could be considered excessive in proportion to the return generated. This would likely result in financing problems for companies issuing such bonds. Naturally, this raises many questions on the future financing of the economy by the insurance industry. Solvency II could therefore dry up a major source of corporate funding and thus counter the growth and financing objectives of the economy.

The Impact of Solvency II on Bond Management - July 2012

Executive Summary

Is the regulator’s chosen risk measure appropriate? An analysis over the 1999-2011 period shows that during crisis years, SCR had a tendency to underestimate (regulatory shock insufficient) high-risk bond losses (historical losses have exceeded the capital requirements set by the prudential regulator in more than 0.5% of the cases) and a tendency to overstate them in non-crisis periods. On the other hand, losses of low-risk bonds (rated A or above) are, in general, more accurately estimated. Elsewhere, an analysis of the relationship between historical volatility and bond SCR shows that these two risk measures are strongly correlated, as are bond SCR and historical VaR. This means that there is no need for Solvency II to add a fourth dimension to bond management, which would be based on the return-volatilityVaR triple factor. On the contrary, it would be possible to mange fixed-rate debt instruments using the bond SCR-return pair alone. On the whole, we therefore conclude that bond SCR is an appropriate risk measure for fixed-rate bonds, which is highly correlated to the two traditional asset management measures – VaR and volatility. What are the improvements suggested for the prudential bond risk measure? EIOPA should consider implementing an adjustment of bond SCR, which would incorporate the effects macroeconomic cycles, as the equity Dampener approach does. Moreover, a geographical analysis of the relationship between VaR and bond SCR produces highly heterogeneous results between the areas studied (Europe 1, PIIGS,

U.S. and BRICS). It could therefore also be useful for Solvency II to integrate these differences in geographical risk via an adjustment to SCR. Additionally, high-risk bonds – such as long maturity investment grade bonds and high yield bonds – generally meet insurers’ specific needs (with the hope that they will deliver additional performance and with their contribution to the ALM objective, respectively). Their valuation is highly sensitive to the estimation of loss given default and relatively unresponsive to movements of the term structure of interest rates. In order to address this problem, long-maturity investment grade bonds subject to ALM should be treated based on EIOPA’s chosen approach for equities backing ring-fenced pension liabilities. As for high yield bonds, they should be assessed using a model in which default risk is paramount. Are there any preferred fixed-rate bond instruments or opportunities for arbitrage within the new Solvency II environment? Analysing the efficiency of risk-taking, using the return/bond SCR ratio, shows that efficiency decreases with increasing bond duration. So, regardless of credit rating, maximum efficiency is achieved for short durations (less than or equal to three over the 1999-2011 period), and thus for low levels of risk (SCRs between 0% and 15%). When we classify all bonds in our sample according to their risk-taking efficiency, it appears that the standard Solvency II formula tends to favour short-duration and particularly high yield bonds, regardless of the shape of the interest rate term structure (except in cases of extreme steepening of
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The Impact of Solvency II on Bond Management - July 2012

Executive Summary

the curve).

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An EDHEC Financial Analysis and Accounting Research Centre Publication

Introduction

An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

Introduction

Solvency II, the new prudential regulation for the insurance sector which will come into effect in 2014, marks a significant change from its predecessor, Solvency I. The latter was founded on a flat-rate approach, mainly based on life technical provisions and non-life turnover figures. Solvency II, however, provides an approach which focuses on the majority of the risks faced by an insurance company. The main objective of this new regulation is to ensure the protection of policyholders and beneficiaries of insurance contracts (Article 27 of the 2009 Directive). To achieve this, the regulation seeks to encourage insurers to better manage and control all risks they face (underwriting risk, market risk, counterparty risk, operational risk). One of the major changes with Solvency II is the treatment of market risks. While under Solvency I, insurance companies’ asset choices were generally restricted by national insurance codes, this new European standard will offer insurers complete liberty when choosing and allocating their assets, in exchange for an intrinsic cost of capital allocated to each asset (referred to as the Solvency Capital Requirement or SCR). This is likely to structurally change the way in which insurers’ assets are managed. In this study, we will analyse the impact of Solvency II on insurers’ bond management practices. More specifically, we will look to answer four questions: (i) What are the defining bond characteristics of the SCR?; (ii) How adequate is SCR as a risk measure?; (iii) How could Solvency II change the traditional approach to bond management, using the three dimensions
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An EDHEC Financial Analysis and Accounting Research Centre Publication

of return, volatility and VaR?; (iv) Will Solvency II give rise to a risk-return hierarchy and arbitrage opportunities between different types of fixed-rate bonds? Our study is based on a sample of 4,279 fixed-rate bonds, all sufficiently liquid, with fixed maturities and listed between 1999 and 2011 in 14 different countries. In Part I, we first of all present the methodology for calculating bond SCR, so that we can analyse the sensitivity of prudential capital (SCR) to intrinsic bond characteristics (Part II). This analysis will show that bond SCR is strongly correlated to the residual maturity and rating of debt instruments and, to a lesser extent, to the coupon rate, credit spread and to zero-coupon characteristics. Part III tests the appropriateness of SCR bond risk measurement within the Solvency II environment against traditional risk measurement methods and shows the effects of macro-economic cycles on SCR. We carry out tests on the proportion of situations in which bond losses surpassed the regulatory capital requirement (SCR) as set by EIOPA and we also compare regulatory capital to 99.5% historical Value-at-Risk. We show that the capital overruns were most frequent during the financial crisis; that the SCR of high-risk bonds is overestimated in non-crisis periods and underestimated during crises; that the SCR of low-risk bonds is based on a reasonable estimate of historical losses. In order to incorporate the effects of macroeconomic cycles, these results call for a Dampener effect to be applied, just as with the equity dampener used by EIOPA. In conclusion, we note that

The Impact of Solvency II on Bond Management - July 2012

Introduction

bond SCR is strongly correlated to VaR and volatility and that, under Solvency II, the management of fixed-rate debt instruments could be reduced to a returnSCR analysis. In the last part of the paper (Part IV), we look at the behaviour of bond returnSCR pairs in our sample in order to assess whether Solvency II could lead to changes in bond preferences and provide arbitrage opportunities. The goal is to test the efficiency of holding bond risk by answering the following question: Does holding additional risk on certain debt instruments generate increased returns under Solvency II? We note that return increases with the level of risk, but only to a certain SCR level. Beyond this threshold, risk-taking is no longer rewarded. This is explained by interest rate curves, which, in recent years, inverse after a certain maturity level. A steepening of the interest rate curve (an increase in long-term rates all else being equal) would naturally lead to an increasing relation between returns and SCR levels, regardless of the current bond SCR level. To take different steepening scenarios into account, it could be useful for EIOPA to integrate a Dampener adjustment mechanism, such as that used by the EU regulator for equities. We will analyse the efficiency of such risk-taking by using the bond return/ SCR ratio. This indicator will show that efficiency diminishes with longer bond maturities and that maximum efficiency is often achieved with low levels of risk. The tests carried out on curves with different steepness conclude that, in all cases, the marginal increase in SCR relative to risk

is greater than the marginal increase in return. Thus, in terms of efficiency (return/ SCR), Solvency II favours short-term bonds – high-yield bonds in particular.

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The Impact of Solvency II on Bond Management - July 2012

Introduction

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I. Measuring Bond Risks under Solvency II

An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

I. Measuring Bond Risks under Solvency II
The EU regulator uses a risk-based capital and modular (see Appendix 1) approach when assessing risks faced by insurance companies. The benchmark risk measure chosen by the European Insurance and Occupational Pensions Authority (EIOPA) is value-at-risk (VaR). VaR is equal to a company’s maximum loss, taking into account the holding period and the α confidence level (one year and 99.5% for Solvency II, respectively): can have the same VaR, but with extremely different loss profiles. This may prove to be insufficiently informative when analysing rare events and the risk of default. The modular approach is based on seven risk modules: market risks; life, non-life and health underwriting risks; counterparty risks; intangible asset risks and operational risks. The market risks module measures risks brought about by volatility or variation in the pricing of financial market instruments (equities, interest rates, real estate and exchange rates). The capital requirements for each risk sub-module are based on an approach known as delta-NAV.1 In other words, it involves measuring the impact of a shock on a company’s Net Asset Value (NAV) – the variation in asset and liability levels following a shock. NAV does not take the risk margin of related liabilities into account. Calculations are therefore made only on a ‘best estimate’ basis. In actual fact, the measurement of the impact of shocks to NAV is done after accounting for the effects of hedging instruments and other risk mitigating techniques, and after considering changes in policyholder behaviour with regard to liability options, after the shock. The purpose of this section is to recall how prudential regulation measures bond risk, in order to identify the key variables that affect capital requirements (bond SCR) and to carry out sensitivity analyses (Part II) and validity testing on regulatory SCR measurement (Part III). These tests are essential when analysing the bond return-SCR pairs and when also looking at

1 - In reference to the Greek character which measures the sensitivity of an option relative to the fluctuations in the value of the underlying. Delta varies between 0 and 1 for a call option and between -1 and 0 for a put option.

While this concept might be easy to explain, it remains controversial as VaR is not aggregative – in other words, a company’s overall VaR is not necessarily less than or equal to the cumulative VaR of each of its constituents:

This indicates that the benefits of diversification are still not being taken into account. Moreover, in order to incorporate these benefits when aggregating the risk factors (life, non-life, market, etc.) that were initially separately measured, the regulator was obliged to define correlation matrices. In addition to the calibration of matrices (which is often seen as not adequate) comes the problem of correlation stability between different risk factors, particularly when confidence levels are high (a rare occurrence). Other sources of controversy include VaR not giving any indication on the severity of default (behaviour of tail distribution) and the assumption of a normality of events. It condenses a company’s risk profile to a single number (for example, an amount of loss in one currency) without providing any information on the thickness of the tail distribution. As such, two companies

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The Impact of Solvency II on Bond Management - July 2012

I. Measuring Bond Risks under Solvency II
arbitrage opportunities that are detailed in Part IV. Assessing bond risk is based on four of the seven market risk sub-modules (see Appendix 1): interest rate risk; spread risk; monetary risk (exchange rate risk) and concentration risk. The latter will be excluded from our analysis because our objective is to measure the sensitivity of a bond within a Solvency II environment and not that of a bond portfolio. Therefore, in this section, we treat the market risk submodules of interest rate, spread, exchange rate risk and the aggregation of the risk sub-modules according to the standard formula and we provide an example of a bond SCR calculation. These shocks are detailed in the following table:
Shocks3 applied to the risk-free curve Maturity t (years) 0.25 0.5 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 20 21 22 23 24 25 30 >30 Relative Variation sup (t) 70% 70% 70% 70% 64% 59% 55% 52% 49% 47% 44% 42% 39% 37% 35% 34% 33% 31% 30% 29% 26% 26% 26% 26% 26% 26% 25% 25% Relative Variation sdown (t) -75% -75% -75% -65% -56% -50% -46% -42% -39% -36% -33% -31% -30% -29% -28% -28% -27% -28% -28% -28% -29% -29% -30% -30% -30% -30% -30% -30%

2 - The capacity of technical provision to absorb losses derives from the company’s ability to reduce future discretionary profits from insurance contracts. 3 - Regarding shocks on the interest rate curve, two other conditions apply. For the downward scenario, the absolute value of interest rate variation must be at least 1%. Moreover, if the interest rate prior to the shock was below 1%, the ‘shocked’ rate in a downward scenario must equal 0%.

I.1. Measuring interest rate risk under to Solvency II: Using the Nelson Siegel Model
To measure interest rate risk, the regulator chose to measure the variation in net asset value following two distortions in the interest rate curve – an upward shock and a downward shock for each maturity of the risk-free curve. The capital required for interest rate risk is determined by the shock which calls for the highest level of capital to be deployed (after having incorporated the capacity of technical provision to absorb losses).2 However, when determining overall capital requirements for market risk, the two capital charges (for both the upward and downward scenarios) are separately incorporated to the other risk sub-modules (See Part I, Section 4).

Source: Quantitative Impact Study 5 (QIS 5)

Within the framework of our sensitivity analyses and studies on the appropriateness of SCR as a risk measure, which are carried out in subsequent sections, it should be noted that EIOPA is assessing interest rate risk based on the Nelson-Siegel model (1987), using a single convexity parameter. More precisely, in determining which shocks
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I. Measuring Bond Risks under Solvency II
to apply, EIOPA’s approach is a principal component analysis based on historical interest rate curves. The factors are the overall level, rotation, curvature and scale. In turn, these four factors allow the following to be modelled: short-term interest rate level; the difference between short- and long-term rates; interest rate volatility and the timescale of interest rate inversion. This Nelson-Siegel model expresses the zero-coupon rate as a function of maturity (the spot rate curve), using the following formula:

Source: EDHEC Business School

Where Rc (0, θ) is the zero-coupon rate with maturity θ β0 is the level factor (long-term rate) β1 is the rotation factor which models the divergence between the short and long term rate β2 is the curvature factor τ is the scale factor. With each of the four Nelson-Siegel factors being a source of risk, the term structure of interest rate risk can be subject to different distortions including shift, rotation or change in convexity, which are all illustrated in the following graphs:
Distortions in the term structure of interest rates

Having observed the behaviour of term structures at different dates, EIOPA defined a scenario with increased interest rates and another with a downward trend. The calibration of the Nelson-Siegel factors in an upward, downward or stable interest rate scenario (benchmark curve) provides us with the results shown in the table below.
Nelson Siegel Parameters deduced from EIOPA shocks NS-down Level Rotation Curvature Scale beta0 beta1 betat2 level1 -2.09% 1.83% 13.91% 1271.34% NS-spot 1.59% -0.76% 9.57% 995.77% NS-up 3.94% -2.59% 8.09% 558.14%

Source: EDHEC Business School

In the downward scenario (NS-down column in the table above), we observe: • a reduction in the level factor; • a clockwise rotation, indicating a contraction between short and long term rates; and • an increase in the curvature and scale factor.

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The Impact of Solvency II on Bond Management - July 2012

I. Measuring Bond Risks under Solvency II
As for the upward scenario (NS-up column in the table above), we observe an increase in the level factor, an anticlockwise rotation and a reduction in the curvature and scale factors. With these factors calibrated, it is possible to superimpose the interest rate curve derived from the four-factor model onto the interest rate curve derived from analysing 30 zero-coupon bonds (30 factors, one per maturity). The graph below shows is that this adjustment is reasonable, whatever maturity observed.
Spot rate curves based on the Nelson Siegel Model
4 - If the bond in question in unrated, the issuer’s credit rating can be factored into the spread risk – on the condition that the bond’s features do not negatively affect the credit quality (subordination). 5 - For variable interest rate bonds, the modified duration used to calculate spread risk should be equal to that of a fixed-rate bond with a coupon rate equal to the forward interest rate.

offsetting mechanisms are reversed. The underestimation is linked to EIOPA’s view on a shift-rotation combination, while, in fact, the portfolio’s sensitivity only depends on a shift in interest rates. Nevertheless, as this study focuses solely on fixed-rate bonds, we can retain EIOPA’s approach for analysing interest rate shocks in the sensitivity studies we carry out in Part II.

Source: EDHEC Business School

The different tests we carried out to validate the interest rate risk modelling approach based on the Nelson-Siegel model adopted by EIOPA shows that the EIOPA’s approach can be called into question when it comes to certain financial instruments. For instance, a portfolio composed of a fixed-rate bond and a constant maturity swap (CMS) would have an underestimated level of risk. In the upward scenario, the loss on a fixed-rate bond is offset by swap gains. In the downward scenario, these

I.2. Measuring spread risk under Solvency II based on duration and rating
Spread risk is measured by assessing the variation in net asset value following a shock rise in credit spreads. Spread risk capital requirements are dependent on the rating4 and modified duration5 of the bonds. Based on these two characteristics, a spread risk factor (FUp) is then defined in accordance with a 99.5% VaR over one year.

An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

I. Measuring Bond Risks under Solvency II
Spread Risk Factors F AAA AA A BBB BB B or < Unrated
up

Floor Duration 1 1 1 1 1 1 1

Cap Duration 36 29 23 13 10 8 12

0.9% 1.1% 1.4% 2.5% 4.5% 7.5% 3.0%

I.3. Exchange rate risk under Solvency II
Exchange rate risk is measured by the variation in net assets following a shock (a 25% increase or decrease) in foreign currency value relative to local currency (the currency in which the financial statements are published). Given our research objectives, we have chosen not to bias comparisons between different geographic areas studied and our view is that foreign exchange risks are covered at negligible costs (using currency futures, for instance)6. Moreover, this seems to be in line with foreign exchange risk management, as practised by insurance companies.

Source: Quantitative Impact Study 5

6 - Indeed, with a series of pre-determined bond flows (set dates and amounts), exchange risk can be hedged via currency futures at a negligible cost.

In addition, according to EIOPA, some bonds do not need to retain capital reserves for spread risk. These would include: bonds issued or guaranteed by European Economic Area (EEA) governments and issued in local currency; bonds issued by multilateral and development banks or international organisations (Annex IV, Section 1, Points 4 and 5 of Directive 2006/48/EC); or bonds issued by the European Central Bank (ECB). Lastly, mortgage covered bonds, public sector covered bonds, as well as those issued by non-EEA countries or central banks are subject to the following specific conditions: • for mortgage covered bonds, the risk factor is set at 0.6% with a modified duration limit of 53; • for sovereign and non-EEA bonds, the parameters depend on the ratings listed in the table below:
Spread Risk Factors for non-EEA Sovereign or Central Bank Bonds F up AAA AA A BBB BB B or < Unrated 0.9% 0.0% 1.1% 1.4% 2.5% 4.5% 3.0% Floor Duration 1 1 1 1 1 Cap Duration 29 23 13 10 12

I.4. A highly controversial aggregation of market risks due to the characteristics of Solvency II’s chosen risk measure
Based on the different capital requirement calculations for each risk sub-module, it is possible to determine the capital required for overall market risk (SCRmkt) by combining the individual capital requirements according to a correlation matrix. As previously mentioned, the regulator’s chosen risk measure (VaR) is not aggregative, thus meaning that EIOPA has to resort to correlation matrix, whose coefficients are always called into question (Foulquier, Lemaistre 2012). The overall market risk capital requirement corresponds to the highest capital charge between an upward and downward interest rate scenario (see Part I, Section 1), after it has been added to the capital charges of the other risk sub-modules.

Source: Quantitative Impact Study 5

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I. Measuring Bond Risks under Solvency II
Thus, the overall market risk capital requirement (SCRmkt) is given by the following: (which is considered to be hedged so as not to bias the analysis) nor concentration risk (individual bond evaluation as opposed to a bond portfolio). Therefore, our study only looks at interest rate risk (Part I, Section 1) and spread risk (Part II, Section 2).

where Mktup,r and Mktup,c represent the market risk capital requirements in an upward interest rate scenario and Mktdown,r and Mktdown,c correspond to the capital requirements in a downward interest rate scenario. The correlation matrices used for aggregation (CorrMktUpr,c and CorrMktDownr,c) are shown below.

I.5. The bond SCR calculation illustrated
As previously justified, our study looks at the impact of Solvency II on fixed-rate bond selection and for this reason, there is no need to account for exchange rate risk
Market Risk Correlation Matrices
CorrMkt Down Interest Rate Equities Real Estate Spread FX Rate Concentration Illiquidity CorrMkt Up
Interest Rate Equities Real Estate Spread FX Rate Concentration Illiquidity

Interest Rate 1 0.5 0.5 0.5 0.25 0 0 Interest Rate
1 0 0 0 0.25 0 0

Equities

Real Estate

Spread

FX Rate

Concentration

Illiquidity

1 0.75 0.75 0.25 0 0 Equities
1 0.75 0.75 0.25 0 0 1 0.5 0.25 0 0 1 0.25 0.5 -0.5 1 0 0 1 0 1

1 0.5 0.25 0 0 Real Estate 1 0.25 0.5 -0.5 Spread 1 0 0 FX Rate 1 0 Concentration 1 Illiquidity

Source: Quantitative Impact Study 5 An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

I. Measuring Bond Risks under Solvency II
For illustrative purposes, we look at two bonds: • the BB+ rated bond issued by Lafarge in November 2005, with an annual coupon of 4.25%; and • the AA rated bond issued by Total in January 2007, with an annual coupon rate of 5.50%. The characteristics of these two bonds are detailed in the table below:
Characteristics of the Lafarge SA and Total Capital SA bonds ISIN Company CFI Code Country Face Value Redemption Value Coupon Rate Issuance Date Maturity Date First coupon detachment date Number of annual coupon payments Calculation Date Spread Clean price Dirty price Rating Source: Bloomberg Interest rate sensitivity and Required Capital (as % of the bond’s dirty price) Company Sensitivity to interest rates NAV Variation with upward interest rates NAV Variation with downward interest rates Equity SCR Real Estate SCR Spread Risk SCR NAV Variation with upward FX rate NAV Variation with downward FX rates SCR market up SCR market down SCR market final Source: EDHEC Business School LAFARGE SA 4.71 4.87% -4.28% 0.00% 0.00% 21.18% 0.00% 0.00% 21.73% 21.18% 21.73% TOTAL CAPITAL SA 2.15 2.13% -2.00% 0.00% 0.00% 2.37% 0.00% 0.00% 3.20% 2.40% 3.20% XS0235605853 LAFARGE SA DTFXFB FR 1 000.00 € 1 000.00 € 4.25% 2005-11-23 2016-03-23 2006-11-23 1 2010-09-29 2.19% 1 003.67 € 1 025.79 € BB+ XS0284605036 TOTAL CAPITAL SA DTFXFB FR 1 000.00 € 1 000.00 € 5.50% 2007-01-29 2013-01-29 2008-01-29 1 2010-09-29 0.10% 1 089.22 € 1 125.84 € AA

Using the data from these two bonds, we calculated the interest rate sensitivity, spread and the capital requirements for each of the risk sub-modules as at 29 September 2010. Given the results presented in the table above, we established that the Lafarge bond required a prudential capital charge of 21.73%, based on its dirty price. Before aggregating both risks, the capital requirements for spread risk and interest

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The Impact of Solvency II on Bond Management - July 2012

I. Measuring Bond Risks under Solvency II
rate risk were 21.18%7 and 4.87%, respectively. In Part I, Section 2, we note that the 4.5% risk factor for a BB+ rated sovereign bond is one of the highest. On the other hand, the Total bond required a 3.20% market risk capital charge, based on its dirty price. Compared to the Lafarge bond, this relatively weak capital requirement is due to the better rating (AA versus BB+) and to a lower level of interest rate sensitivity (2.15% versus 4.71%). The aim of this section was to revisit the key principles of risk measurement and calibration used by the prudential European regulator within bond management. In contrast to equity or real estate risk, bond capital requirements are not direct – for instance, it lies at 30% for OECD and EEA member countries, at 40% for private equity firms and hedge funds, and at 25% for real estate (according to QIS5). This reminder also highlighted the key characteristics of bonds, which are a pre-requisite for carrying out sensitivity studies and capital requirement analyses.

7 - Spread risk capital requirement is calculated in the following manner: (risk factor * sensitivity to interest rate * dirty price) / dirty price = (4.5%*4.71*1.025.79)/1.025.79 = 21.18%.

An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

I. Measuring Bond Risks under Solvency II

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An EDHEC Financial Analysis and Accounting Research Centre Publication

II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment

An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment
In this section, we will observe bond behaviours within a Solvency II environment, by conducting a sensitivity study on Solvency II prudential capital requirements (bond SCR). To achieve this, we used a sample of 4,279 bonds and analysed the SCR sensitivity of each, looking at their intrinsic characteristics (maturity, rating, price, nominal to redemption value ratio, coupon rate, zero coupon characteristics) and analysing them over time (intertemporal approach). We will show that bond SCR is highly sensitive to two variables – residual maturity and rating. After having presented the methodology used to construct and compose our sample, we will analyse the sensitivity of bond SCR by looking at different bond characteristics – coupon frequency, coupon rate, spread, duration, residual maturity, rating, redemption value/face value, clean price/redemption value, dirty price/redemption value. • have a sufficient level of data (for robustness of results); • fully take economic cycles into account (particularly the 2000 Internet bubble, the 2007-2008 banking crisis that was linked to private sector debt and the sovereign debt crisis of 2010-2011). Bloomberg was our source for all data on fixed maturity bonds (i.e. non-perpetual and non-extendible bonds), which are sufficiently liquid8 and listed between January 1999 and mid-October 2011. We thus created this sample of 4,279 fixedrate9 or zero coupon bonds issued across 14 different countries, with a combined outstanding face value of roughly €20,000bn in 2011. It is important to note that bonds that matured or that were cancelled following the issuer’s default are not listed on Bloomberg. Therefore, on one hand it is impossible to analyse short maturity bonds using relatively old dates, and bonds which suffered heavy losses following the issuer’s default on the other hand. This would likely lead to underestimating the frequency of extreme losses. On the other hand, in our sample we include bonds that suffered heavy losses following a company going in to receivership (ongoing receivership or companies that have been bought out). This table indicates that our sample is principally composed of bonds issued by countries in the ‘Europe 1’ zone (45.9%) – which includes the so-called leading nations (France, Germany, United Kingdom) – and issued in the United Stated (32.8%). Bonds issued by the PIIGS (Portugal, Ireland, Italy, Greece and Spain)

8 - Liquidity is based on the volume of significant daily trades as determined by Bloomberg. For each bond in our sample, we have taken into account the available data on closing prices over the period in question. Moreover, unavailable price data were deduced using cubic spline interpolation. This provided daily closing prices for the entire period. The data source only provides information of bonds have not yet matured. If a longer sample period had been chosen (maturities greater than 13 years), the entire sample would have been biased, particularly from a rating perspective. 9 - Convertible bonds do not feature in this study given their equity composition which would significantly bias the comparison with non-convertible fixed-rate bonds.

II.1. A sample of 4,279 bonds across 14 countries
Our goal is to analyse the sensitivity of the prudential capital requirement, SCR, in order to determine if it is an adequate risk measure that makes it possible to make strategic asset allocation choices based on a bond return-SCR pair. We also want to determine if it is a measure that will shed light on an insurer’s decision-making criteria when making bond investments within the new Solvency II environment. To achieve this, our bond sample must: • be a sufficiently consistent and varied sample so that it is representative of the entire bond market;

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II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment
Cross-section of the sample by country and by outstanding face value10 in 2011 # of Bonds U.S. Germany France U.K. Italy Spain Russia Brazil Portugal Ireland Greece South Africa China India Sample
10 - Bond outstanding par value varies over time due to recalls and re-issuances of fungible bonds. 11 - For each bond, an average S&P rating is given according to data acquired from Bloomberg. Bloomberg’s calculation is based on a collection of data from the different ratings agencies – Moody’s, S&P, Fitch and DBRS. Additionally, as Bloomberg does not provide access to the historical ratings database, we have to assume that the rating provided by Bloomberg remained constant over the time period.

As % of the entire sample 32.8% 19.2% 14.0% 12.8% 6.9% 6.6% 1.8% 1.7% 1.3% 1.1% 0.9% 0.5% 0.3% 0.1% 100.0% 45.9% 32.8% 16.8% 4.4% 100.0%

Face Value (€bn) 3 528 11 219 1 625 1 286 1 017 677 165 130 136 121 216 516 8 3 20 647 14 130 3 528 2 167 822 20 647

1404 822 598 546 295 284 75 74 56 47 39 21 12 6 4279 1966 1404 721 188 4279

Europe 1 Zone U.S. PIIGS BRICS Sample Source: EDHEC Business School

and the BRICS (Brazil, Russia, India, China and South Africa) constitute 21.2% of the sample (16.8% and 4.4%, respectively). The low weighting of the latter geographic zone is due to the low number of issuances and/or difficulty in obtaining information from illiquid markets (Brazil, Russia, and India). As mentioned in the previous section, rating is an important factor in determining Solvency II prudential capital requirements. For reference, we therefore express our sample according to bond ratings as shown in the following table.11 Given the number of sovereign bonds (from the likes of France, Germany, the UK and the United States), our sample

includes a high percentage (61.81%) of AAA, AA and A-rated bonds. BBB-rated bonds constitute 16.3% of the sample and principally emanate from the BRICS and PIIGS countries. Bonds with lower credit ratings (from BB to CC) make up 8% of the sample. Lastly, 14% of the bonds in our sample are unrated. As shown in the following table, 6.8% of the bonds are zero-coupon bonds. Moreover, if we add government-backed private sector bonds to our sovereign bonds sample, 25% of our sample is made up of government bonds, with a high concentration from Spain, Greece, Germany and Ireland.

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II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment
Make-up of our sample: ratings as a percentage of bonds per country
AAA U.S. Germany France U.K. Italy Spain Russia Brazil Portugal Ireland Greece South Africa China India Sample Europe 1 Zone U.S. PIIGS BRICS Sample 15.0% 36.4% 41.6% 23.1% 0.7% 4.2% 0.0% 0.0% 0.0% 8.5% 0.0% 0.0% 0.0% 0.0% 21.1% 34.3% 15.0% 2.5% 0.0% 21.1% AA 14.9% 16.7% 10.7% 5.9% 1.0% 21.8% 0.0% 0.0% 1.8% 27.7% 0.0% 0.0% 8.3% 0.0% 12.2% 11.9% 14.9% 11.0% 0.5% 12.2% A 38.3% 15.7% 20.1% 31.3% 40.0% 39.1% 0.0% 0.0% 14.3% 6.4% 7.7% 47.6% 66.7% 0.0% 28.5% 21.4% 38.3% 33.7% 9.6% 28.5% BBB 12.5% 9.1% 11.2% 26.2% 11.9% 13.4% 61.3% 50.0% 73.2% 40.4% 2.6% 42.9% 25.0% 100.0% 16.3% 14.5% 12.5% 18.6% 53.7% 16.3% BB 5.8% 1.9% 3.5% 8.2% 2.4% 1.1% 24.0% 16.2% 7.1% 4.3% 89.7% 0.0% 0.0% 0.0% 5.7% 4.2% 5.8% 7.1% 16.0% 5.7% B 4.4% 0.1% 0.2% 0.7% 0.0% 0.4% 10.7% 4.1% 0.0% 4.3% 0.0% 0.0% 0.0% 0.0% 1.9% 0.3% 4.4% 0.4% 5.9% 1.9% CCC 0.1% 0.2% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.1% 0.1% 0.1% 0.0% 0.0% 0.1% CC 0.6% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 4.3% 0.0% 0.0% 0.0% 0.0% 0.3% 0.0% 0.6% 0.3% 0.0% 0.3% NR 8.3% 19.8% 12.7% 4.6% 44.1% 20.1% 4.0% 29.7% 3.6% 4.3% 0.0% 9.5% 0.0% 0.0% 14.0% 13.4% 8.3% 26.5% 14.4% 14.0% TOTAL 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Source: EDHEC Business School Zero coupon and government bonds as a percentage of total bonds per country
Zero-Coupon Bonds U.S. Germany France U.K. Italy Spain Russia Brazil Portugal Ireland Greece South Africa China India Sample Europe 1 Zone U.S. PIIGS BRICS Sample 7.7% 4.5% 1.0% 0.2% 40.7% 6.0% 0.0% 1.4% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 6.8% 2.2% 7.7% 19.0% 0.5% 6.8% Sovereign Bonds 17.0% 43.9% 20.4% 11.5% 3.1% 69.0% 8.0% 29.7% 23.2% 36.2% 43.6% 4.8% 16.7% 0.0% 25.0% 27.8% 17.0% 35.0% 16.5% 25.0%

Source: EDHEC Business School

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The Impact of Solvency II on Bond Management - July 2012

II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment

Another key factor when analysing bond management is maturity – the table below highlighting this within the context of our sample. Most bonds (81%) have a maturity of less than 10 years. The maturity breakdown across the different countries was largely similar, except for the UK and South Africa (15.6% for 10-15 year maturities and 10.8% for 20-30 years in the UK; 19% for 10-15 year maturities in South Africa). Based on the features described in this sample, we will analyse bond SCR sensitivity based on different characteristics of fixed-rate bonds.

II.2. SCR sensitivity study of different bond characteristics: Solvency II cannot be neutral on the steepening of the interest rate curve
As analysed in Section 1, the calculation of the Solvency II prudential capital requirement is based on a VaR of 99.5% over a one-year horizon, using a deltanormal approach (Henrard 2005). This approach assumes that variations in the value of a financial instrument can be explained by a linear combination of a limited number of risk factors, following normal distribution. While the upside of this approach is its simple application (simply based on the calculation of a covariance matrix, a linear combination coefficient and a multiplication matrix), it does however

Bond maturities as a percentage of bonds per country
0 to 3 yrs U.S. Germany France U.K. Italy Spain Russia Brazil Portugal Ireland Greece South Africa China India Sample Europe 1 Zone U.S. PIIGS BRICS Sample 24.6% 33.6% 27.3% 18.1% 11.5% 22.5% 40.0% 21.6% 26.8% 17.0% 30.8% 9.5% 8.3% 33.3% 24.9% 27.4% 24.6% 18.4% 27.1% 24.9% 3 to 5 yrs 24.2% 29.9% 27.4% 17.6% 19.3% 31.0% 33.3% 18.9% 25.0% 17.0% 28.2% 28.6% 50.0% 33.3% 25.0% 25.7% 24.2% 23.4% 28.2% 25.0% 5 to 10 yrs 33.7% 27.9% 30.8% 29.1% 30.8% 31.3% 24.0% 43.2% 35.7% 42.6% 23.1% 33.3% 33.3% 33.3% 31.2% 29.1% 33.7% 31.8% 33.5% 31.2% 10 to 15 yrs 4.1% 3.6% 8.4% 15.6% 15.6% 8.1% 2.7% 6.8% 8.9% 8.5% 5.1% 19.0% 0.0% 0.0% 7.3% 8.4% 4.1% 11.1% 5.9% 7.3% 15 to 20 yrs 5.8% 1.9% 2.2% 5.3% 10.8% 4.6% 0.0% 4.1% 1.8% 2.1% 5.1% 4.8% 0.0% 0.0% 4.5% 3.0% 5.8% 6.8% 2.1% 4.5% 20 to 30 yrs 6.8% 2.9% 3.2% 10.8% 13.6% 1.8% 0.0% 5.4% 1.8% 12.8% 5.1% 4.8% 8.3% 0.0% 6.0% 5.2% 6.8% 7.5% 3.2% 6.0% 30yrs+ 0.9% 0.1% 0.8% 3.5% 1.4% 0.7% 0.0% 0.0% 0.0% 0.0% 2.6% 0.0% 0.0% 0.0% 0.0% 1.3% 0.9% 1.0% 0.0% 1.0% TOTAL 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Source: EDHEC Business School An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment
lead to an underestimation of real VaR, given the underestimation of rare events (thick-tailed distributions). Due to this drawback of the Solvency II delta-normal method, we analysed the sensitivity of SCR based on the characteristics of different bond instruments and based on its evolution over time. II.2.1. Prudential capital requirements based on bond maturities and ratings: An atemporal study We will assess the sensitivity of the bond SCR capital requirement across all bond characteristics in our sample from 1999 to 2011. In terms of the calculations required to determine the correlation coefficients of for all the calculated SCRs (6,226,067 bond SCRs for 4,279 bonds), we randomly constructed a sub-sample made up of 1 million observations. The correlation analysis was carried out using two methods: • Pearson’s correlation • Spearman’s rank correlation 1) Pearson’s correlation For each (x,y) pair, we calculate the correlation coefficient using the following: Spearman’s rank correlation, once we verified the monotony of the links (see Appendix 4). 2) Spearman’s rank correlation Spearman’s rank correlation allows us to analyse the monotonous relationship between two variables without assuming a functional form of the link. It involves finding a correlation coefficient that does not fall between the values of the two variables, but between the ranks of these values. The calculation is then identical to that of Pearson’s correlation:

12 - Duration expressed in the following manner:

The variables analysed are the following: bond SCR, coupon frequency, coupon rate, spread, duration, residual maturity, rating (redemption value/face value), (clean price/redemption value), (dirty price/redemption value). We obtain the correlation matrices shown on the following page. We often witnessed high correlation levels between the bond SCRs and analysed variables shown in these matrices. As such, bond SCR is highly correlated with duration12 – 74% with Pearson’s correlation coefficient (PCC) and 83% with Spearman’s Rank Correlation Coefficient (SRCC). Moreover, it should be noted that duration contains information already found in other variables – specifically residual maturity (84% PCC; 98% SRCC), clean price/redemption value (-52%PCC; -18% SRCC), dirty price/redemption value (-52%PCC; -18% SRCC), coupon rate (-33% PCC; -5% SRCC) and coupon frequency (-32% PCC;

where Cov(x, y), Var(x) and Var(y) respectively indicate the covariance between the variables x and y, the variance of variable x and that of variable y. However, this indicator rests on the assumption of a functional relationship between the variables. To avoid using an overly complex functional form, we opted for a linear relationship between the variables, which we completed, using
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The Impact of Solvency II on Bond Management - July 2012

II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment
-19% SRCC). Duration will therefore serve as the principal variable in the simplified SCR calculation. Nevertheless, duration
Pearson correlation matrix Clean Price / Redemption Value Redemption Value / Face Value Dirty Price / Redemption Value Coupon Frequency

is a non-observable bond characteristic and calculating it requires the use of a valuation mechanism.

Residual Maturity

Coupon Rate

Bond SCR

Duration

Spread

Bond SCR Coupon Frequency Coupon Rate Spread Duration Redemption Value / Face Value Clean Price / Redemption Value Dirty Price / Redemption Value Residual Maturity Rating

100.0% -26.0% -18.6% 6.6% 74.2% 8.0% -51.0% -50.6% 65.9% 56.2%

-26.1% 100.0% 63.4% 31.6% -31.5% 5.2% 50.8% 49.7% -5.2% -9.3%

-18.6% 63.4% 100.0% 46.3% -33.1% -5.7% 68.3% 69.7% -0.2% 3.1%

6.7% 31.6% 46.3% 100.0% -16.2% -10.9% -12.8% -11.3% 1.1% 35.7%

74.2% -31.5% -33.1% -16.2% 100.0% 22.6% -51.7% -51.6% 83.9% 10.0%

8.1% 5.2% -5.7% -10.9% 22.6% 100.0% 1.8% 1.3% 12.1% -5.8%

-51.0% 50.8% 68.3% -12.8% -51.7% 1.8% 100.0% 99.7% -23.3% -29.7%

-50.7% 49.7% 69.7% -11.3% -51.6% 1.3% 99.7% 100.0% -22.9% -29.1%

66.0% -5.2% -0.2% 1.1% 83.9% 12.1% -23.3% -22.9% 100.0% 6.8%

56.2% -9.3% 3.1% 35.7% 10.0% -5.8% -29.7% -29.1% 6.8% 100.0%

Source: EDHEC Business School Spearman correlation matrix Clean Price / Redemption Value Redemption Value / Face Value Dirty Price / Redemption Value Coupon Frequency

Residual Maturity

Coupon Rate

Bond SCR

Duration

Spread

Bond SCR Coupon Frequency Coupon Rate Spread Duration Redemption Value / Face Value Clean Price / Redemption Value Dirty Price / Redemption Value Residual Maturity Rating

100.0% -18.4% 2.3% 7.5% 83.2% 3.9% -30.0% -29.1% 83.1% 53.2%

-18.5% 100.0% 56.5% 39.7% -19.3% 0.9% 32.2% 29.2% -7.3% -11.7%

2.4% 56.5% 100.0% 59.2% -5.0% -15.2% 52.4% 54.5% 10.9% 8.7%

7.6% 39.7% 59.2% 100.0% -4.4% -16.6% -8.7% -6.6% 7.9% 31.9%

83.3% -19.3% -5.0% -4.4% 100.0% 7.2% -18.0% -17.9% 97.8% 9.3%

3.9% 0.9% -15.2% -16.6% 7.2% 100.0% 1.2% -0.3% 4.3% -10.1%

-30.1% 32.2% 52.4% -8.7% -18.0% 1.2% 100.0% 98.7% -12.6% -25.7%

-29.2% 29.2% 54.5% -6.6% -17.9% -0.3% 98.7% 100.0% -12.0% -24.5%

83.2% -7.3% 10.9% 7.9% 97.8% 4.3% -12.6% -12.0% 100.0% 10.2%

53.3% -11.7% 8.7% 31.9% 9.3% -10.1% -25.7% -24.5% 10.2% 100.0%

Source: EDHEC Business School

Rating

Rating

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II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment
Residual maturity is the second most correlated variable with bond SCR (66% PCC; 83% SRCC) and it also has a relative strong correlation with duration (84% PCC; 98% SRCC). While it does not include as much information as duration (it has low correlation with most other variables, see the preceding table), residual maturity posses the advantage of being directly observable. It can be easily illustrated in a nomograph, thus providing an indication of the bond risk levels for different categories of fixed-rate bonds. Bond SCR is equally sensitive to ratings. Whatever method used, there is always a correlation of more than 50%. It is weakly correlated with residual maturity (correlation less than or equal to 10%). We observe that real credit spread has little effect on SCR levels. This is due to the flat-rate treatment of spread risk in the standard Solvency II formula, which assigns a single risk factor to each rating and does not account for internal variances in ratings. All the same, we note that the Spearman’s rank correlation between rating and spread to be 32%. Based on the two most significant variables (residual maturity and rating),
Bond SCR as a function of maturity and rating

it is possible to graphically illustrate SCR behaviour. These curves represent the average SCR level for a maturity segment and for a given rating. By using fewer characteristics (residual maturity and rating) to determine bond SCR, it is possible to derive the ratingmaturity combination that will require the same prudential capital charge. For instance, by simply observing the graph on the next page, it is possible to identify the rating-maturity pair that would correspond to a 15% capital charge (B – 2.5 yrs; BB – 4 yrs; BBB – 7 yrs; A – 10 yrs; AA – 12 yrs; AAA – 12yrs). We observe that at a given maturity, AAA, AA and A-rated bonds consume significantly less capital that bonds with lower ratings (for instance, a BB-rated bond consumes 2.5 times more capital than a AAA-rated bond). Due to the construction of the standard Solvency II formula, bonds rated BBB or lower could be neglected by investors who are subject to the new solvency standards, as a result of the additional marginal cost that could be considered excessive. This would likely bring about financing problems for companies issuing such bonds.

Source: EDHEC Business School

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II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment
Bond SCR as a function of maturity and rating

Source: EDHEC Business School

Results from the regression model AAA c1(Rating) c2(Rating) c3(Rating) R² 1.958E-02 -5.784E-04 6.490E-06 83.1% AA 2.216E-02 -8.327E-04 1.096E-05 85.7% A 2.020E-02 -5.075E-04 3.511E-06 88.0% BBB 2.728E-02 -6.890E-04 4.738E-06 97.9% BB 4.468E-02 -1.285E-03 9.630E-06 95.3% B 7.274E-02 -2.896E-03 3.578E-05 80.2% NR 3.690E-02 -8.176E-04 2.061E-06 90.1% CCC or < 7.254E-02 -3.100E-03 4.261E-05 67.2% Sample 89.1%

Source: EDHEC Business School

Additionally, this graph shows that SCR curves rise with maturity – in other words, the longer the maturity, the higher the capital requirements, and the same applies to the credit ratings. Solvency II could therefore encourage an increase in long-term rates, triggered by weak demand for long-maturity bonds. We have also analysed the regression model expressed below, where the coefficient values are determined by the rating:

These results show that for all bonds, except those rated CCC or below, the coefficient of determination is high (above 80%) and the overall coefficient of determination for the model is 89.1%. To confirm our results regarding the influence of maturity on bond SCR, the next section presents an intertemporal study of prudential capital requirements (bond SCR).

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The Impact of Solvency II on Bond Management - July 2012

II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment
II.2.2. Prudential capital requirements in relation to bond maturities: An intertemporal study The objective of this section is to analyse prudential capital requirements (SCR) over recent years. In addition to observing the intertemporal behaviour of SCR, this analysis will help us validate maturity weights. So, for each bond in our sample, we carried out a linear regression for which the causal variable was time and the dependent variable was the bond SCR capital requirement. All the regressions carried out over time confirm that bond maturity is the main causal variable in the variation of the prudential capital requirement – the average coefficient of determination is 90%. On average, bond SCR is reduced by 233.5 basis points per annum. Additionally, we also observe that for 68.8% of the bonds in our sample, the time variable is responsible for more than 85% of bond SCR variations (see the following table).
Cumulative percentage of bonds by level of the coefficient of determination R² Interval [95%.100%] [90%.100%[ [85%.100%[ [80%.100%[ [75%.100%[ [70%.100%[ [65%.100%[ [60%.100%[ [55%.100%[ [50%.100%[ [0%.100%[ Source: EDHEC Business School Cumulative percentage of bonds 29.0% 52.4% 68.8% 76.2% 81.9% 85.6% 89.0% 91.3% 92.8% 93.7% 100.0%

13 - The graph’s legend indicates the name of the issuer, the year of maturity, the coupon rate and the bond rating. For instance, GIE PSA TRESORERIE * 2011 * 5.875% * BB+ refers to a bond whose issuer is GIE PSA TRESORERIE, it matures in 2011, the coupon rate is 5.875% and it has a BB+ rating.

To illustrate, the following graph shows the evolution of bond SCR as a function of time for three separate bonds (a French, an American and a German bond), each producing different levels of risk.

Illustration of the evolution of bond SCR versus time for three bonds in our sample13

Source: EDHEC Business School

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The Impact of Solvency II on Bond Management - July 2012

II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment
We can see that the prudential capital requirements (SCR) decrease in linear fashion in relation to time for all three bonds. The spikes in bond SCR shown at different points in time coincide with coupons detachments. In fact, at each of these dates, the bonds become more sensitive to both interest rate and spread risk. We also note that on these coupon detachment dates, bond duration increases (see Appendix 5). Exchange rate risk and spread risk are also positively impacted – this is reflected in the overall bond SCR level. AAA, AA or A and 81% have a maturity of less than 10 years. The SCR sensitivity study over the period of 1999 to 2011 was conducted using the following variables – coupon frequency, coupon rate, spread, duration, residual maturity, rating, and the ratios of redemption value/par value, clean price/redemption value and dirty price/redemption value. Sensitivities were calculated using two methods – Pearson’s Correlation Coefficient (PCC) and Spearman’s Rank Correlation Coefficient (SRCC). The results show that the variables that are most correlated to bond SCR are duration, residual maturity and rating. Correlation between bond SCR and duration is the highest (74% PCC; 83% SRCC). Duration is also highly correlated to residual maturity (84% PCC; 98% SRCC) and is not directly observable. Residual maturity is the variable with the second highest level of correlation with bond SCR (66% PCC; 83% SRCC). Although it does not comprise as much data as duration, residual maturity offers the benefit of being directly observable. Therefore it can be easily expressed using a nomograph, which provides an indication of bond risk levels for different categories of fixed-rate bonds. Rating has a correlation of over 50% with bond SCR (regardless of the correlation method used) and is weakly correlated with residual maturity (correlation is less than or equal to 10%). Lastly, we note that real credit spread has little influence on the SCR level, which is due to the flat-rate treatment of spread risk in the standard Solvency II formula which does not take it into account.
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II.3 Summary of the sensitivity analysis of prudential capital requirements for different bond characteristics
The objective of this section is to observe SCR sensitivity against different bond characteristics in order to determine if bond SCR is an adequate risk measure and also to define an insurer’s decision-making criteria when making bond investments within the new Solvency II framework. To conduct this sensitivity analysis, we created a sample of 4,279 fixed-rate or zero-coupon bonds, issued across 14 different countries. The sample is predominantly made up of bonds issued in the Europe 1 zone (45.9%) – which includes the so-called leading nations (France, Germany, United Kingdom) – and those issued in the United Stated (32.8%). Bonds issued by the PIIGS (Portugal, Ireland, Italy, Greece and Spain) and the BRICS (Brazil, Russia, India, China and South Africa) countries constitute 21.2% of the sample. As for the sample composition by rating and maturity, 61.8% of the bonds are rated

An EDHEC Financial Analysis and Accounting Research Centre Publication

The Impact of Solvency II on Bond Management - July 2012

II. Sensitivity Analysis of Solvency II Prudential Capital Requirements within a Bond Management Environment
A detailed analysis of bond SCR based on residual maturity shows that: • the longer a bond’s maturity, the higher the capital requirements (SCR), regardless of the rating; • for a given maturity, AAA, AA and A-rated bonds require significantly less capital than bonds with lower credit ratings. Due to excessive marginal costs, bonds rated BBB or lower could end up being avoided by investors subject to the new solvency standards. This could cause financing difficulties for the issuing companies of such bonds. Additionally, weak demand for long-maturity bonds, which are also penalised by Solvency II, could affect the interest rate curve (with a rise in long-term rates). This raises many questions on the future financing of the economy by the insurance industry. Solvency II could therefore dry up a major source of corporate funding and thus counter the growth and financing objectives of the economy. Finally, we showed that residual maturity and rating accounted for 89.1% of bond SCRs. This finding should be of relevance to bond managers as it offers an acute insight into bond SCR by using only two variables (residual maturity and rating), rather than the nine initially identified (Part II, Section 2). This new bond SCR calculation can be used in a nomograph to identify the ratingmaturity combinations that would produce the same capital charge. Furthermore, our intertemporal study sheds light on the fact that for 68.8% of the bonds in our sample, the time variable explains more than 85% of bond SCR variations. This supports the results of the atemporal study and confirms that bond maturity is
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An EDHEC Financial Analysis and Accounting Research Centre Publication

the main causal variable when it comes to variation in bond capital requirements. These results also revealed a linear decrease in prudential SCR capital requirements of 233.5 basis points per annum. The findings in this section encourage us to deepen our analysis of regulatory capital requirements, particularly with a study on bond SCR as a relevant and adequate risk measure.

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility

An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
Today, bond managers make strategic choices based on three factors: return, volatility and VaR.14 With Solvency II coming into effect, a new constraint is imposed on bond management – that of regulatory capital (SCR). Bond managers thus have more complex investment decisions to make, as they must now take four variables into account when making their asset allocation decisions. We therefore consider it important to evaluate the risk measure chosen by the regulator in relation to VaR and volatility. Lastly, if these two traditional risk measures could be expressed as a function of SCR, it would be possible to substitute them for one measure alone – SCR. In such a case, bond selection would not depend on four factors, but rather on two – the bond return-SCR pair. In order to assess EIOPA’s chosen risk measure for bond risk, in this section we will look at the capacity of bond SCR to absorb historical bond losses, based on a 99.5% VaR. This involves analysing the number of situations during which historical losses from our sample of 4,279 fixed-rate bonds exceeded the capital requirements set by EIOPA. This analysis was conducted over the 1999-2011 period, by geographical area, rating and maturity, which led us to identify 6,226,067 rolling annual returns. To validate our findings, we also compared bond SCR to historical bond VaR, as well as to historical return volatility. To perform these studies, it is necessary to first of all define the measurement of historical losses.

III.1. Measuring historical losses
In order to measure historical losses and then compare them to bond SCR within the context of testing EIOPA’s chosen risk measure, it is necessary to calculate the annual return of each of the 4,279 bonds. Two calculation methods exist – internal rate of return (IRR), which is the rate of return required by the market), and historical returns (returns realised ex-post). While IRR has the benefit of being widely accepted by market participants, and (based on efficient market hypothesis) integrates all available information, it still produces expected returns (ex-ante). Moreover, we prefer to adopt an empirical approach by measuring historical returns ex-post. We calculated rolling annual returns (RT) for the periods of TN and TN+1, on a daily basis over the entire period in question, based on historical prices and capitalised cash flows:

14 - The drawback of volatility relates to the problem of mean distribution and that of VaR relates to extreme risks. In fact, it is possible for two risk distributions to have the same VaR, but very different volatilities.

where : market value at time TN : market value at time TN+1 : capitalised value of cash flows between TN and TN+1 where where : capitalised value of cash flows between TN and TN+1 : cash flows as at date t : forward interest rate TN for the period t, TN+1 It is assumed that intermediate cash flows received at time t are deposited in an interest-bearing account using a forward

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An EDHEC Financial Analysis and Accounting Research Centre Publication

The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
rate (the cash flow capitalisation rate was set at the beginning of the period TN). Therefore, at date TN+1, the portfolio value (cash and bond) is the bond value added to that of capitalised cash flows on this account during TN+1. The calculation of these bond returns allows us to compare bond SCR to historical VaR – the central topic of Part III, Section 3. set by the prudential regulator. If bond SCR is seen to be an appropriate risk measure, the frequency of capital requirement overruns should, by definition, be roughly 0.5% (99.5% VaR). The following table shows the frequency of capital overruns by geographic area and time period. Firstly, for all bonds regardless of their geographic area, rating and maturity, we can see (bottom line of the table above) that between January 1999 and October 2011, 1.23% of the 6,226,067 rolling annual returns exceed the bond SCR capital requirements – a figure which is 2.5 times the target level set by the regulator (0.5%). This corresponds to a VaR of 98.77% rather than 99.5%. During the financial crisis – January 2007 to January 2009 – capital

III.2. Bond SCR regulatory capital versus historical VaR for the entire sample
In order to verify the quality of EIOPA bond risk measure, over the 1999-2011 period we calculated the rolling annual returns of the 4,279 bonds in our sample, and we then determined how often historical losses exceeded the bond SCR capital requirements

15 - See Appendix 2 for more detail on the number of observations per country, region, maturity, rating and number of times capital requirements were exceeded.

Frequency of historical losses exceeding prudential SCR capital requirements (Capital overruns by time period and by area)15 RT < -SCR Country / Period France Germany U.K. Portugal Italy Ireland Greece Spain Brazil Russia India China South Africa U.S. Europe 1 Zone PIIGS BRICS Sample 1.jan.1999 1.jan.2001 0.006% 0.003% 0.000% 0.861% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.002% 0.203% 0.000% 0.069% 2.jan.2001 1.jan.2003 0.853% 0.000% 0.170% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 2.385% 0.275% 0.000% 0.000% 0.402% 2.jan.2003 1.jan.2005 0.802% 0.194% 0.016% 0.000% 0.003% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.307% 0.316% 0.002% 0.000% 0.236% 2.jan.2005 1 jan.2007 0.373% 0.502% 0.220% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.544% 0.391% 0.000% 0.000% 0.351% 2.jan.2007 1.jan.2009 0.782% 0.907% 1.719% 0.361% 0.424% 3.741% 0.000% 0.000% 3.139% 17.107% 0.000% 0.000% 3.296% 6.959% 1.072% 0.562% 10.619% 3.113% 2.jan.2009 1.oct.2011 0.531% 0.195% 0.126% 0.218% 0.302% 8.003% 15.470% 13.070% 0.037% 0.000% 0.000% 0.000% 0.833% 0.219% 0.280% 2.526% 0.070% 0.651% 1.jan.1999 1.oct.2011 0.605% 0.436% 0.533% 0.213% 0.188% 4.508% 7.332% 4.702% 0.750% 5.859% 0.000% 0.000% 1.224% 2.346% 0.513% 1.007% 3.091% 1.228%

Source: EDHEC Business School An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
requirement overruns were significantly higher (3.11% - six times the regulator’s target level). In order to better understand the link between bond SCR and historical bond VaR, in the subsequent sections, we analyse the frequency of capital overruns by geographic area, country, rating and maturity.
Sovereign bond ratings for the PIIGS zone Portugal Ireland Italy Greece Spain Source: Fitch Ratings 07-Apr-11 14-Apr-11 05-Nov-10 13-Jul-11 04-Mar-11 BBBBBB+ AACCC AA+

III.3. Bond SCR regulatory capital versus historical VaR based on geographic area and country
The aim of this section is to analyse bond risk capital requirement overruns by geographic area and by country. For the Europe 1 zone (France, Germany, United Kingdom), the back testing of the bond SCR measure produced satisfactory results (see the table above). On average, the SCR threshold is exceeded only 0.51% of the time, between the 1999-2011 period. A more detailed analysis by country and by period corroborates the back testing of this measure except for the 2007-2009 period where the crisis produced substantial losses (capital overruns of 1.1% for the Europe 1 zone, and notably 1.7% for the UK). However, it is interesting to note that SCR is a reliable measure for the 2009-2011 period, despite the sovereign debt crisis. For the PIIGS zone, the average overrun for the 1999-2011 period was twice that of the Europe 1 zone (1.007% versus 0.513%). Nevertheless, an analysis by period shows that the threshold was exceeded only during the 2009-2011 period (2.526%) and only once for each of the three most affected countries (Greece, Ireland and Spain).

This is an important point because it suggests that, for debt instruments with average credit ratings (between B and BBB), the Solvency II measure is highly satisfactory in the absence of a severe crisis. As highlighted in Section 1, regulatory capital requirements are increasingly sensitive to lower ratings. Bond SCR could offer a better coverage for weakly-rated bonds, due to likely overestimations of capital requirements. We develop this notion in the next section. For the United States, the level of capital requirement overruns was nearly five times that of the Europe 1 zone (2.346% versus 0.513%) and the regulatory SCR level during the 1999-2011 period. Bond SCR overruns were observed during the crisis periods of 2001-2003 and 2007-2009. For the BRICS countries, the average capital overrun level was six times more than that of the Europe 1 zone (3.091% versus 0.513%) and the regulatory SCR level during the 1999-2011 period. Nevertheless, an analysis by period shows that the threshold was exceeded only during the 2009-2011 period (10.619%), as we observed with the PIIGS countries. The three most affected countries are Russia (17.11%), South Africa (3.30%) and Brazil (3.14%). On the other hand, for other periods the overrun level was close to 0%, indicating that regulatory bond capital requirements overestimated the real capital needs of BBB-rated bonds.

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An EDHEC Financial Analysis and Accounting Research Centre Publication

The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
Sovereign bond ratings for the BRICS zone Brazil Russia India China South Africa Source: Fitch Ratings 25-Oct-11 28-Oct-11 21-Jun-11 12-May-11 17-Jan-11 BBB BBB BBBA+ BBB+

To support this analysis, we decided to calculate historical VaR (ex-post) and make a comparison with prudential bond capital requirements. To achieve this, we observed bond SCR at 21 different intervals using a 2.5% increment in order to calculate historical VaR and compare it with the average SCR at each particular interval. The following graph shows the SCR-VaR combinations for all the bonds in the sample. If SCR is a quality risk measure, we should see SCR-VaR combinations around the bisecting line. Linear correlation between VaR and SCR comes out at 87.5%. However, this graph shows most SCR-VaR combinations lying above the bisecting line, meaning

that SCR tends to underestimate real risk as measured by VaR. This corroborates our earlier analysis on frequency of regulatory capital overruns in relation to the SCR threshold. We recall that 1.23% of our observations (returns) exceeded the prudential capital requirements, while EIOPA retained a target of 0.5% (a target that would correspond to a 99.5% VaR, while from a historical point of view SCR corresponded to a 98.77% VaR). More specifically, when we look at the overall period, it would seem that for bonds with low risk profiles (SCR less than 10%), the standard Solvency II formula tended to overestimate the capital needs in contrast to other risk profiles which had been underestimated. Nevertheless, as we showed in the previous table highlighting the SCR threshold overruns, it would appear that there are severe disparities between the periods studied. We also decided to compare VaR and bond SCR during non-crisis periods (1997 to 2007).

Comparison of historical Value at Risk to bond SCR for the entire sample (from 1999 to 2011)

Source: EDHEC Business School

An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
Comparison of historical Value at Risk to prudential bond SCR capital requirements for the entire sample (from 1999 to 2007)

Source: EDHEC Business School

This graph highlights the bias of the bond crisis period when comparing historical VaR to SCR. Once we remove the effects of the crisis from our analysis, the trend reverses – the SCRs of low-risk bonds are underestimated while those of high-risk bonds are overestimated. From the comparison of historical VaR to bond SCR, we see that depending on the period: • Bonds with a high risk profile (high SCR) exhibited overestimations of regulatory capital requirements during non-crisis periods and underestimations during the bond crisis (2007-2011); • Bonds with a weak risk profile (low SCR) exhibited more accurately estimated capital requirements. Some slight under- and overestimations were present in non-crisis and crisis periods, respectively. The underestimation of capital requirements for bonds with an SCR higher than 10% could therefore reflect an average of
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An EDHEC Financial Analysis and Accounting Research Centre Publication

two opposing findings – a significant underestimation during crisis periods and an overestimation during non-crisis periods. To refine the analysis on historical bond losses exceeding capital requirement thresholds by country, we compared bond SCR and historical VaR by grouping together all the bonds in our sample by geographic area. For Europe 1 zone bonds (France, Germany, UK), the linear correlation is relatively high (with a coefficient of determination R2 of 77.9%). As shown in the graph below, we do not note any significant differences between the risk levels observed in the previous graphs, which capture the entire period. Once we exclude the crisis years (2007-2011), we see that from 11%, SCR overestimates historical VaR, and the Europe 1 zone confirms the previously described trend. Meanwhile, the coefficient of determination for the linear regression decreases to 0.41% for the 1997-2007 period.

The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
Comparison of historical Value at Risk and SCR for the Europe 1 zone

Source: EDHEC Business School

For the United States, the linear correlation between historical VaR and SCR is slightly higher than for the Europe 1 zone – the coefficient of determination R2 is 81%. The following graph confirms the remarks made regarding the frequency of bond losses exceeding capital requirements (the overrun rate of 2.34% is nearly five times that targeted by the European regulator) – the standard Solvency II formula tends to

underestimate American real risk (compared to our back testing), except for American bonds with a weak risk profile (bond SCR levels of below 10%). Once data relating to crisis years are excluded from the sample, the regression coefficient of determination decreases significantly (to 16.31%) and the trend reverses – SCR overestimates losses for most American bonds even if some lie above the bisecting line.
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An EDHEC Financial Analysis and Accounting Research Centre Publication

The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
Comparison of historical Value at Risk and SCR for the United States

Source: EDHEC Business School

For the PIIGS and BRICS zones, the linear relationship between historical VaR and prudential capital requirements over the entire period analysed is weaker than for the Europe 1 zone and the United States (39.17% for the PIIGS and -0.33% for the BRICS). For the BRICS in particular, the SCR-VaR combinations are highly dispersed. For PIIGS bonds, we observe that across the entire period studied, SCR underestimates historical losses for average risk levels, while
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An EDHEC Financial Analysis and Accounting Research Centre Publication

for high risk levels, it overestimates them (from an SCR level of 30%). If we only look at the 1999 to 2007 period, we note that SCR systematically overestimates these bond losses. For the BRICS zone, we observe that bond SCR tends to underestimate real losses throughout the period, while between 1997 and 2007 (a non-crisis period), historical losses were overestimated.

The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
Comparison of historical Value at Risk and prudential SCR capital requirements for the PIIGS and BRICS zones

An EDHEC Financial Analysis and Accounting Research Centre Publication

43

The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility

Source : EDHEC Business School

Based on these analyses of regulatory capital overruns and on the comparison of historical VaR to SCR, it is interesting to note that a Dampener formula such as the equity Dampener could be studied. The aim would be to integrate the effects of economic cycles and thus to proceed to adjust the calibration of shocks. In conclusion, the overall analysis shows that: • Bonds with a high risk profile (high SCR) exhibited overestimations of regulatory capital requirements during non-crisis periods and underestimations during the bond crisis (2007-2011); • Bonds with a weak risk profile (low SCR) exhibited more accurately estimated capital requirements. Some slight under- and overestimations were present in non-crisis and crisis periods, respectively. The underestimation of capital requirements for bonds with an SCR of less than 10% could therefore reflect an average of two opposing findings – a significant underestimation during crisis periods and an overestimation during non-crisis periods.
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An EDHEC Financial Analysis and Accounting Research Centre Publication

Lastly, it could be useful for Solvency II to integrate these differences in geographical risk via an adjustment to SCR. To broaden these analyses, in the next section we carry out a study on the capital overrun thresholds and compare bond SCR and historical VaR across a sample of 4,279 bonds classified according to their respective ratings.

III.4. Bond SCR regulatory capital versus historical VaR based on rating
The findings from the previous section led us to refine our analysis on overruns of prudential capital requirements in relation to bond ratings, as it appeared that there was an overestimation of capital requirements in the B-BBB tranche and an underestimation for AAA-AA credit ratings. As with the previous section, in order to assess the quality of EIOPA’s bond risk measure, we calculated over the period in question (1999-2011) the frequency with which historical bond losses exceeded

The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
(rolling) regulatory bond SCRs as set by the prudential regulator – however, in the current section we do so according to rating. If SCR as defined by the European regulator is deemed an adequate measure, the frequency of capital overruns based on the rating criterion should roughly be 0.5% (with a 99.5% VaR). The table below highlights the frequency of capital requirement overruns by rating and by period. To complete this analysis of historical bond losses exceeding regulatory capital thresholds, we compared bond SCR and historical VaR by grouping together bonds in our sample according to their rating. Analysing the frequency of capital overruns by rating according to VaR and bond SCR shows, at first sight, that on average over the 1999-2011 period, the capital overruns increase with ratings downgrades (from 0.510% for AAA to 6.185% for CCC and below). SCR therefore underestimates real risk as measured by historical VaR. Throughout this period, only the capital requirements of AAA–rated bonds satisfied a 99.5% VaR, with others being significantly higher (99% VaR for AA and A, 98.2% for BBB, 95% VaR for B and 93.8% VaR for CCC and below). Nevertheless, once we analyse by period, we find the same results as before. During non-crisis periods, regulatory capital requirements for weakly rated bonds appear to be overestimated (notably ratings between BBB and CCC for which overrun rates are often close to 0% compared to AA ratings for which the thresholds are significantly higher). On the other hand, during a crisis, the weakest ratings have insufficient capital requirements. So, during these periods, bond SCR does not reflect real risk. For example, between 2007 and 2009, the frequency of overruns by weakly-rated bonds was very high (from 4.603% for a BBB-rated bond to 14.351% for CCC-rated bonds or lower). The estimation error of real risk for high yield bonds is explained by the regulator’s common approach for all bond types, which does not take into account the specificities of high yield bonds. In fact, their high probability of default greatly increases the

Frequency of historical bond losses exceeding prudential SCR capital requirements within the context of bond risk (Overruns by period and by rating) RT < -SCR Rating / Period AAA AA A BBB BB B CCC or below NR Sample 1.jan.1999 1.jan.2001 0.007% 0.000% 0.000% 0.000% 0.000% 0.000% 0.162% 0.069% 2.jan.2001 1.jan.2003 0.284% 3.677% 0.080% 0.092% 0.000% 0.000% 0.000% 0.402% 2.jan.2003 1.jan.2005 0.910% 0.484% 0.025% 0.036% 0.654% 0.000% 0.000% 0.002% 0.236% 2.jan.2005 1.jan.2007 0.491% 0.811% 0.268% 0.094% 0.253% 0.307% 0.000% 0.316% 0.351% 2.jan.2007 1.jan.2009 0.796% 1.664% 3.162% 4.603% 7.849% 15.779% 14.351% 1.290% 3.113% 2.jan.2009 1.oct.2011 0.295% 0.397% 0.489% 1.176% 2.640% 0.677% 2.844% 0.268% 0.651% 1.jan.1999 1.oct.2011 0.510% 0.962% 1.145% 1.786% 3.487% 5.037% 6.185% 0.468% 1.228%

Source: EDHEC Business School

An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
Comparison of historical Value at Risk and SCR based on ratings

Source: EDHEC Business School

sensitivity of their value to the estimate of default probability and recovery rates. In addition to this, there is a very strong dependence on the economic environment that leads to non-negligible cyclical effects. If we only consider the interest rate spread risk modules, the Solvency II standard model produces an erroneous estimation of risk for this bond category – SCR does not entirely reflect real bond risk (measured here by historical VaR). These bonds should
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An EDHEC Financial Analysis and Accounting Research Centre Publication

be subject to specific treatment using a model in which default risk is paramount. We further analysed the frequency of bond SCR overruns by also analysing them depending on the maturity of the instruments.

The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
III.5. Bond SCR regulatory capital versus historical VaR based on maturity
The aim of this section is to analyse the frequency of capital requirement overruns by bond maturity and over different periods. The trend observed over the entire period studied is a reduction in the frequency of overruns with increasing maturity – bonds with maturities between 0 and 5 years have a rate of 1.394%, while those with 35 to 50 year maturities have a rate of 0.548%. This overrun trend is explained by two factors: • long maturity tranches consist mainly of strongly rated bonds (for maturities of 25 years and upwards, the concentration of AAA, AA and A ratings is greater than 60%, see table in Appendix 2) whose bond SCRs estimate losses rather accurately; • a concentration of BBB and unrated bonds of more than 30% for maturities between 5 and 30 years. The SCR of these bonds appear to overstate the losses, which results in a low occurrence of bond losses exceeding the regulatory threshold.

Frequency of historical losses exceeding prudential capital requirements (Capital overruns by time period and maturity) RT < -SCR Maturity / Period [0yrs,5yrs] [5yrs,10yrs] [10yrs,15yrs] [15yrs,20yrs] [20yrs,25yrs] [25yrs,30yrs] [30yrs,35yrs] [35yrs,50yrs] + 50yrs Sample 1.jan.1999 1.jan.2001 0.002% 0.000% 0.287% 0.004% 0.000% 0.069% 2.jan.2001 1.jan.2003 0.060% 1.011% 0.070% 0.252% 0.000% 0.000% 0.000% 0.000% 0.402% 2.jan.2003 1.jan.2005 0.442% 0.197% 0.026% 0.006% 0.003% 0.000% 0.000% 0.000% 0.236% 2.jan.2005 1.jan.2007 0.677% 0.407% 0.474% 0.025% 0.308% 0.000% 0.000% 0.000% 0.000% 0.351% 2.jan.2007 1.jan.2009 3.386% 3.374% 2.503% 2.577% 2.793% 1.980% 0.947% 1.584% 11.701% 3.113% 2.jan.2009 1.oct.2011 0.627% 1.005% 0.337% 0.087% 0.084% 0.033% 0.000% 0.000% 0.000% 0.651% 1.jan.1999 1.oct.2011 1.394% 1.547% 0.907% 0.671% 0.759% 0.438% 0.249% 0.548% 3.094% 1.228%

Source: EDHEC Business School Overrun rate (%) based on maturity during the 1999-2011 period

Source: EDHEC Business School An EDHEC Financial Analysis and Accounting Research Centre Publication

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The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
When we observe these overruns by period, we note that in a non-crisis period (1999 to 2007), they are below the 0.5% threshold regardless of maturity. For the 2007 to 2009 period, the overruns are high, which indicates an underestimation of losses for the highest risk profiles, with BBB and unrated bonds. Lastly, we highlight that the highest overrun rates are concentrated in bonds that have maturities longer than 50 years. However, this category only contains 10 bonds. It would only require one bond which significantly exceeds the threshold to raise the average overrun rate by a substantial amount. When the level of bond losses that exceed the regulatory capital requirements is analysed based on the risk level (the higher the SCR, the higher the bond risk), we corroborate previous findings (see table above). During non-crisis periods, bonds with the most risk tend to have a regulatory capital requirement that is rather overestimated by the European regulator, while that of bonds with the lowest risk levels tends to be underestimated. However, in times of crisis, the regulator tends to underestimate the need for capital, particularly for bonds with a high risk profile.

III.6. Bond SCR regulatory capital versus historical VaR based on the level of risk as measured by SCR
The results from the previous section, which incorporates bond ratings and maturities. The results of the previous section lead us to refine the analysis of SCR capital requirement overruns, compared to the level of risk as measured by SCR, which incorporated the rating and maturity of the bonds.

III.7. Bond SCR regulatory capital requirements versus the volatility of historical returns
To complete the study on the adequacy of measuring bond risk using the standard formula, in this section we analyse the correlation between bond SCR and the volatility of historical returns. Volatility is strongly linked to bond SCR bond as the two-degree polynomial model has a coefficient of determination (R2) of 98.4%.
RT < -SCR

Frequency of historical losses exceeding prudential capital requirements (Capital overruns by time period and by SCR risk level) SCR / Period [0%,5%] [5%,10%] [10%,15%] [15%,20%] [20%,25%] [25%,30%] [30%,35%] [30%,50%] + 50% Sample 1.jan.1999 1.jan.2001 0.000% 0.373% 0.155% 0.000% 0.000% 0.000% 0.000% 0.151% 0.000% 0.069% 2.jan.2001 1.jan.2003 0.000% 1.058% 0.898% 0.503% 0.039% 0.461% 0.000% 0.000% 0.402% 2.jan.2003 1.jan.2005 0.000% 0.593% 0.255% 0.008% 0.013% 0.411% 0.003% 0.000% 0.236% 2.jan.2005 1 jan.2007 0.816% 0.365% 0.350% 0.578% 0.185% 0.519% 0.198% 0.107% 0.000% 0.351% 2.jan.2007 1.jan.2009 0.953% 1.047% 2.480% 3.265% 5.058% 4.560% 4.893% 2.002% 8.271% 3.113% 2.jan.2009 1.oct.2011 0.248% 0.582% 0.961% 1.006% 0.797% 0.509% 0.219% 0.408% 0.000% 0.651% 1.jan.1999 1.oct.2011 0.256% 0.681% 1.347% 1.574% 1.855% 1.609% 1.493% 0.516% 2.264% 1.228%

Source: EDHEC Business School

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III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
Evolution of SCR volatility based on the entire sample

Source: EDHEC Business School

Based on this graph, the bond risk measure applied in the Solvency II standard formula appropriately incorporates the volatility of returns, although it would appear that for bonds with very high risk profiles (SCR greater than 40%), the quality of the estimation deteriorates. So, bond SCR is highly correlated to both traditional asset management measures – VaR and volatility. As it stands today, Solvency II cannot add an additional dimension to bond management, which is based on the return-volatility-VaR triple factor. On the contrary, it might be possible to manage the fixed-rate debt instruments only using the bond return-SCR pair.

looking at the sample in its entirety, we observe that SCR underestimates historical bond losses. The overall capital overrun rate for the period was 1.23%, while the regulator’s target stood at 0.5%. However, as we were still interested in capital overruns by geographic area, we observed that bond SCR for the Europe 1 zone was satisfactory, as the rate was only 0.51% between 1999 and 2011. It was during the 2007-2009 period that substantial losses became apparent for this area (1.1%) and particularly for the United Kingdom (1.7%). The PIIGS zone suffered significant losses with an average capital overrun rate of 1% over the period. However, the majority of these losses are attributable to the 2009-2011 period, which indicates that SCR overestimates risk for B and BBB ratings in the absence of a severe crisis. The BRICS zone exhibits similar behaviour. The capital overrun rate is six times higher than that of the Europe 1 zone, but the threshold was only breached during the 2009-2011 period

III.8. Summary of the quality of the bond risk measure using the Solvency II standard formula
Based on the rolling annual returns of the bonds in our sample, we calculated the frequency with which historical bond losses exceeded regulatory capital requirements over the period studied (1999-2011). When

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III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
(10.619%), particularly in Russia (17.107%), South Africa (3.296%) and Brazil (3.139%). During other periods, the rate was close to 0%, suggesting that capital requirements were overestimated for BBB-rated bonds. The United States capital overrun rate is five times higher than that of the Europe 1 zone, with notable high concentration during the periods of 2001-2003 and 2007-2009. Furthermore, a comparison between historical VaR and the regulatory measure (bond SCR) was conducted for the entire period. This comparison showed a strong correlation between these two measures (87.5%) as well as a tendency of VaR being underestimated. This is particularly true for bonds with average and high risk profiles, while for those with low risk profiles (SCR below 10%), losses are slightly overstated. Given that significant disparities do exist depending on the period in question, we were keen to see the effects of the crisis on bond losses. So, we observed that in severe crisis periods, SCR underestimates losses for high-risk bonds while in non-crisis periods they are overestimated. For low risk bonds, losses are underestimated in non-crisis periods and the opposite is true for crisis periods. An analysis by geographical area confirmed these trends. For the three zones – Europe 1, The United States and the PIIGS – we noted that during a crisis, high risk bond losses were underestimated and low risk bond losses were overestimated. The degree of over- and underestimation is certainly dependent on the zone in question. For the BRICS, there is little difference between high and low risk bonds. Generally speaking, during a crisis, we see an
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overstatement of losses, while in the absence of a crisis, we see an understatement of losses. Analysing capital requirement overruns and the comparison of historical VaR to bond SCR by rating shows that, on average, bond losses increasingly exceeded the limits, the lower the credit quality (0.510% for a AAA rating and 6.185% for a rating of CCC of below). Once again, the general trend is confirmed – SCR underestimates bond losses. Moreover, the analysis by time period showed that in the absence of a crisis, losses of the most weakly rated bonds were overestimated but in a severe crisis, the capital requirements were insufficient to cover losses. The analysis of capital requirement overruns based on maturity shows that as maturity increases, these capital overruns become less frequent. This effect is linked to bond ratings – the longer the maturity, the higher the concentration of good quality bonds for which SCR is more accurately estimated and BBB and unrated bonds, for which SCR is overstated. We also find that in the absence of a severe crisis, capital overruns are low (from below 0.5% to 0%) while during a crisis they become more significant for all maturity levels. Elsewhere, the high correlation of bond SCR to VaR and volatility shows that there is no need for Solvency II to add a fourth dimension to bond management, which would be based on the return-volatilityVaR triple factor. On the contrary, it would be possible to manage fixed-rate debt instruments using only the bond returnSCR pair.

The Impact of Solvency II on Bond Management - July 2012

III. Is Solvency II’s chosen Risk Measure for Bond Risk Adequate? SCR versus Historical VaR and Volatility
Following this section’s focus on the quality of EIOPA’s chosen risk measure, which has shown that SCR is as relevant and adequate a measure as its traditional counterparts (VaR and volatility), we will now analyse the impact of this risk measure on insurers’ asset allocation.

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IV. The Impact of Bond SCR on Insurers’ Asset Allocation – Solvency II Friendly Assets

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IV. The Impact of Bond SCR on Insurers’ Asset Allocation – Solvency II Friendly Assets

We have already analysed the adequacy of the bond risk measure within the prudential framework of Solvency II, notably by comparing historical VaR over the 1999-2011 period to regulatory capital requirements measured by bond SCR. Within this new regulatory framework, insurance companies should be encouraged to define their strategic bond allocation according to risk compensation, particularly in relation to the bond return-SCR pair. The aim of this section is to determine if Solvency II will lead to changes in bond preferences and provide arbitrage opportunities. The goal is to test the efficiency of holding bond risk by answering the following question: Does holding additional risk on certain debt instruments generate increased returns under Solvency II? To achieve this, we will study, as with all issues relating to asset allocation, the behaviour of the return-risk pair – which, within the framework of our study, refers to the bond return-SCR pair (see Part III) First of all, it is necessary to analyse the returns of the 4,279 bonds in our sample (standard deviation, skewness, kurtosis, VaR, Sharpe ratio, etc.), over time, by geographical area and by rating (investment grade, below investment grade, unrated).

Return-risk profiles naturally depend on the geographical area and rating. Bonds issued in the Europe 1 zone exhibit low risk for low return (average of 6.29%, VaR99.5% of 21.28%, and volatility of 14.71%). American bonds are riskier (VaR99.5% of 49.65%, volatility of 24.54%) but more rewarding (average return of 8.68%). BRICS bonds offer a similar level of risk (VaR99.5% of 36.86%, volatility of 24.08%) but with a higher return (average of 14.29%). Lastly, given the recent sovereign debt crisis, the PIIGS are inefficient compared to the other areas – returns are low and risk is high (average of 4.35%, VaR99.5% of 27.75%, volatility of 9.88%). It is also interesting to note the significant difference between losses at the 95% VaR level and those at the 99.5% level, for all categories. Indeed the passage from a 5% to a 0.5% confidence interval enables us to focus on losses that are extremely rare, but of significant value. In general, these losses are the result of a credit event rather than due to interest rate or spread movements. Given the confidence interval considered,16 another approach might be to use models that focus on the end of the distribution, such as those that model defaults, loss given defaults or the contagion effects of a default. The use of such models would be more appropriate than the parametric VaR method used by the European prudential regulator. The parametric method is indeed not very accurate when used to study the extreme end of the distribution, particularly because of the normality assumption required for the aggregation of risk factors.

16 - The methodology enabling the choice of a risk model dependent on the confidence interval considered is described in detail by Christoffersen (2001).

IV.1. An intertemporal study of bond returns based on their characteristics
In this section, as background to an analysis of the bond return-SCR pair, we evaluate the performance of the 4,279 bonds in our sample over time and based on their characteristics (geographical area and rating).
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Statistical indicators of bond returns Avg. Return Avg. Std. Deviation Skewness VaR99.5% Kurtosis VaR95% Zone Sample IG* BIG** NR*** U.S. IG* BIG** NR*** Europe1Zone IG* BIG** NR*** PIIGS IG* BIG** NR*** BRICS IG* BIG** NR*** Sample Size 6 226 067 3 886 561 490 242 1 021 059 1 844 799 1 321 396 265 477 32 054 2 963 947 1 998 989 108 427 462 091 1 240 743 530 273 81 509 494 650 176 578 35 903 34 829 32 264 Sharpe Ratio 0.38 0.43 0.29 0.43 0.35 0.49 0.31 0.30 0.43 0.40 0.50 0.42 0.44 0.51 0.02 0.52 0.59 0.75 0.52 0.72 Rating

6.84% 6.22% 11.19% 6.38% 8.68% 7.26% 15.27% 10.62% 6.29% 6.05% 8.30% 6.42% 4.35% 3.65% 0.33% 5.69% 14.29% 15.33% 14.50% 12.15%

17.92% 14.40% 38.91% 14.67% 24.54% 14.85% 49.61% 35.10% 14.71% 15.24% 16.75% 15.39% 9.88% 7.22% 14.14% 10.98% 24.08% 20.37% 27.76% 16.96%

20.61 38.80 5.44 28.37 9.90 16.71 4.53 12.88 47.66 53.00 2.21 42.38 2.71 9.45 0.07 1.77 3.88 1.90 2.46 2.76

1183.76 3351.96 53.51 2573.97 233.19 1011.15 35.55 347.26 4323.77 4586.34 17.91 4018.97 121.47 855.55 9.63 21.14 38.55 6.18 14.02 19.98

6.70% 4.28% 27.95% 6.99% 11.50% 6.58% 34.03% 13.70% 3.15% 2.55% 14.67% 3.66% 8.72% 6.10% 26.82% 8.34% 9.60% -0.34% 22.27% 4.09%

33.85% 23.21% 59.53% 26.45% 49.65% 29.97% 63.68% 57.52% 21.28% 16.43% 39.23% 25.09% 27.75% 19.67% 45.78% 24.51% 36.86% 24.08% 45.16% 37.41%

*IG : investment grade ; ** BIG : below investment grade, *** NR Unrated Source: EDHEC Business School

Analysis of skewness (asymmetry coefficient) shows that the return distributions of the Europe 1 zone and the BRICS country group have the highest values (1.44% and 0.75%, respectively) – in other words, their distributions are spread more to the right for than distributions of the PIIGS countries and the United States (0.65% and 0.75%, respectively). Kurtosis indicates that the tails of return distributions are thick for all zones. The Europe 1 zone has the thickest tails (kurtosis 20.46), ahead of the United States (11.44), the PIIGS (10.36) and then the BRICS (7.27). The Sharpe ratio enables us to compare risk-adjusted returns of the four geographical areas. The Europe 1 zone, with

a Sharpe ratio of 0.71, has the highest return of all four areas. The BRICS have a lower risk-adjusted return (0.67), while the Sharpe ratios of the United States and the PIIGS are similar (0.48 and 0.45, respectively).

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IV. The Impact of Bond SCR on Insurers’ Asset Allocation – Solvency II Friendly Assets

To complete the analysis of bond returns in our sample, we conducted an intertemporal study of returns over the 1999-2010 period. We observe that the United States and the BRICS recorded strong fluctuations over the period, with particularly high sensitivity during the 2007-2010 crisis (especially in 2008). As for the PIIGS zone, it was very sensitive to the sovereign debt crisis (2009-2010). The table below examines the correlation between the different areas in our sample. It appears that bond returns for the Europe 1 zone are highly correlated to those of the PIIGS countries (with a correlation coefficient of 92.5%) and to a lesser extent to those of the United States (with a correlation coefficient of 72.7%). However, a weak linear correlation was noted between the United States and the PIIGS countries (correlation coefficient of 58.3%). The most significant diversification effects were seen between the BRICS and

Europe 1, the PIIGS and the United States (41.4%, 42.4% and 53.4%, respectively). In other words, the choice of a European or American insurer to invest in BRICS bonds is an effective diversification strategy.
Return correlation between different geographical areas PIIGS PIIGS USA EUROPE 1 BRICS 100.0% 58.3% 92.5% 42.4% 100.0% 72.7% 53.4% 100.0% 41.4% 100.0% USA EUROPE 1 BRICS

Source: EDHEC Business School

With the bond return characteristics of the sample analysed, in the next section we study the behaviour of bond return-SCR pairs in order to determine the impact of Solvency II on bond asset allocation.

IV.2. Analysis of the bond return-SCR pair – Do arbitrage opportunities exist?
Assessing the risk-return pair is essential in asset allocation. With the adoption of

Evolution of returns over the period from December 1999 to November 2010

Source: EDHEC Business School

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IV. The Impact of Bond SCR on Insurers’ Asset Allocation – Solvency II Friendly Assets

Solvency II, investors must now think in terms of the bond return-SCR dimension as we demonstrated in Part III. In this section, we will analyse this combination using different approaches, in order to determine if the SCR measure used by the regulator will lead to changes in bond preferences and provide arbitrage opportunities. In order to do so, the graph below illustrates the bond return-SCR relationship according to bond ratings. This graph shows that the bond return curves expressed in terms of bond SCR are quasi-concave. With such a shape, for low levels of risk (bond SCR between 0% and 10%), bond returns tend to increase with risk (measured here by the regulatory capital requirement – SCR). In other words, risk-taking is rewarded. When bond SCR exceeds 10%, returns have stagnated or even decreased as risk increases. Therefore, bond risk-taking is no longer rewarded beyond a certain level of SCR risk.

This trend is due to the inversion of interest rate term structures. In fact, over the period studied there is an inversion value beyond which the return no longer increases (and even decreases) with maturity while SCR is still on the rise. Over the period studied, the curves that represent the return against the SCR therefore reach maximum levels. In addition, an analysis based on bond ratings allows us to observe significant differences in curve shapes, particularly in relation to maximum return. So, for AAA or AA-rated bonds, maximum return is achieved for a bond SCR of 7.5% versus 8.5% for A-rated bonds and over 11% for bonds with a BBB rating or lower. This means that the weaker the bond rating, the more the risk taken needs to be significant in order to achieve the maximum return.

Bond return-SCR pairs based on ratings (1999-2011)

Source: EDHEC Business School

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To enhance this analysis, we will present the bond return-SCR pairs for each risk bucket. Traditionally, an investor wishing to increase the level of risk on a bond instrument would likely choose either a long duration bond, or one with a low credit rating. The chart above accounts for both of these strategies. We observe that for low levels of risk (bond SCR between 2% and 8%), A-rated bonds have slightly higher returns than AAA and AA bonds. So, an investor whose risk budget (bond SCR) would have been between 2% to 8%, would have been able to adjust his or her level of risk taking with duration on bonds with relatively high ratings. However, beyond a risk level of 8%, it would have been preferable to increase risk taking by holding bonds with lower credit ratings, such as BB-rated bonds with SCRs between 8% and 10% and B-rated bonds with SCRs of 10% and upwards. This is explained by the inversion of the term structure of
Bond return-SCR pairs by rating (0% to 14% SCR) (1999-2011)

interest rates from a certain maturity. A steepening of the term structure of interest rates (all else being equal) would result in an increased correlation between bond returns and SCR. EIOPA could take different term structure of interest rates steepening scenarios into account by incorporating a Dampener-type adjustment mechanism such as that used for equities. For a fixed exposure to risk (that is to say, for a given prudential capital requirement) between 10% and 14%, higher returns can be achieved by choosing bonds with low ratings and short maturities. That said, such a strategy is difficult to implement for insurance companies whose asset-liability management (ALM) strategy is to align the maturities of their liabilities with those of their assets. Lastly, it should be noted that for low SCRs, unrated bonds have performed poorly compared to rated bonds. For example, a difference in return of 3.40% compared to

Source: EDHEC Business School

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IV. The Impact of Bond SCR on Insurers’ Asset Allocation – Solvency II Friendly Assets

A-rated bonds is observed for an SCR of 6.5%. Beyond an SCR of 11%, we observe that these bonds perform increasingly better, up to the point they outperform even AAA and AA-rated bonds. These findings show that Solvency II does not model the unrated bonds appropriately. The spread risk factor (Part I, Section 2) is 3% and lies between a BBB bond (risk factor of 2.5%) and BB bond (risk factor of 4.5%). The chart above shows that the spread risk factor required by Solvency II for unrated bonds is not in line with the risk premium that has been used over the last ten years. When the level of risk is increased (bond SCR between 14% and 25%), the optimal investment strategies seem to significantly differ from those previously highlighted (with bond SCRs between 0% and 14%). We can see that once we take a higher risk level into account (bond SCR between 14% and 25%), no additional returns are generated. Returns are stable and even
Bond return-SCR pairs by rating (14% to 25% SCR) (1999-2011)

decrease in the case of a BB rating. The Solvency II environment, therefore, does not provide incentives to hold bonds with maturities that exceed a certain threshold – a threshold that decreases the lower the rating. For these types of bonds, capital requirements are high relative to the additional return. Long-term ALM activities could thus be penalised in terms of the cost of capital. The image below shows that beyond a 25% SCR, return and SCR have little dependence on each other. This level of risk is found in investment grade bonds with long maturities and in high yield bonds with maturities of more than seven years. Investment grade bonds with very long maturities are selected by insurers within the context of ALM, with the aim of aligning the maturity of their assets and liabilities. This generates significant demand for such bonds, resulting in a reduction in returns (and thus maturity), even though the SCR continues to rise.

Source: EDHEC Business School

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IV. The Impact of Bond SCR on Insurers’ Asset Allocation – Solvency II Friendly Assets

High yield bonds are selected in the hope that they will deliver additional performance. They are sensitive to risk factors different to those of other bonds. In fact, as they have a high probability of default, their valuation is highly sensitive to the estimation of loss given default (LGD) and not sensitive to movements of the term structure of interest rates. By only considering only the interest rate spread module, the standard formula produces an inaccurate risk assessment of this bond category. The regulator has adopted a common approach to bond categories, without taking their specific characteristics into consideration (probability of default for high yield bonds and the ALM objective underlying investment grade long-term bonds). As such, for high risk levels, SCR does not fully reflect real bond risk (measured here by historical VaR) and therefore cannot be an explanatory variable of performance. Both bond types should
Bond return-SCR pairs by rating (SCR above 25%) (1999-2011)

have specific treatments. High yield bonds could be assessed using a model in which default risk is paramount. Long-maturity investment grade bonds dedicated to ALM could be treated based on EIOPA’s chosen approach for equities backing ring-fenced pension liabilities. To enhance our analysis, we also studied bond return-SCR pairs based on ratings over the period from 1999 to 2007 – that is to say, in non-crisis periods (see the graph below). We must first of all point out that over this time period, as there were very few bonds with SCR risk levels below 9% (20 in total) they are not shown on the graph. This would not have allowed us to construct a sample that was representative of this risk bucket and these bonds were therefore excluded from the analysis. The graph shows that in terms of ratings, returns increase for bond SCRs between

Source: EDHEC Business School

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IV. The Impact of Bond SCR on Insurers’ Asset Allocation – Solvency II Friendly Assets

9% and 25% – in other words, risk-taking is rewarded. We note that this risk compensation is observed for higher SCR levels than those observed during crisis periods (1999-2011), where risk taking rewarded only up to a 15% SCR level. From 25% bond SCR and beyond, bond return behaviour becomes unpredictable, as was the case for the 1999-2011 period.

If we look more closely, highly-rated bonds (AAA, AA, A) generated the highest return for risk levels of up to 25%, in contrast with the 1999-2011 period, where the turning point was roughly around 8%. We recall that at this risk level, the highest returns were generated by BB and B-rated bonds. Over the 1999-2007 period, for an SCR between 9% and 11%, we note that A-rated bonds produced the highest returns.

Bond return-SCR pairs by rating (1999-2007)

Source: EDHEC Business School Bond return-SCR pairs by rating (0% to 25% SCR) (1999-2007)

Source: EDHEC Business School An EDHEC Financial Analysis and Accounting Research Centre Publication

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Bond return-SCR pairs by rating (SCR above 25%) (1999-2007)

Source: EDHEC Business School

In summary, during the crisis, the growth of returns with respect to bond SCRs were abruptly interrupted and maximum returns were achieved with low SCRs, linked to shorter maturity bonds. This is consistent with the inversion of the term structure of interest rates which coincided with maturities that were much shorter than those observed in a non-crisis environment. In the next section, we complete the bond return-SCR pair analysis with a study on return distribution functions, based on the bond SCR level.

Based on these graphs, it appears that the deformation of the density function is consistent with an increased level of risk (bond SCR): an increased risk level produces higher returns in exchange for a more dispersed distribution. Once again, these distribution functions show that beyond a certain level, any additional risk taking does not produce additional returns. As an illustration, we observe that for a bond SCR of between 5% and 10%, the average maximum return is 7.16%. Beyond 10%, the average return decreases. In a more general sense, the analysis of the return distribution function shows that: • standard deviations increase in relation to bond SCR; • the skewness of the return distribution is a decreasing function of bond SCR, which means that the tail distribution spreads out more and more to the left of the distribution (i.e. towards the losses); • kurtosis, measuring the thickness of the distribution tails, is a decreasing function of bond SCR.

IV.3. Analysis of return distribution functions, based on bond SCR levels
To conduct the abovementioned analysis, it will be beneficial to study return distribution functions by bond SCR level, in order to establish gain, loss and dispersion profiles. To do this, we grouped together returns based on their associated bond SCR level, thus obtaining six SCR intervals: 0%-5%; 5%-10%; 10%-15%; 15%-20%; 20%-25% and 25%-30%.

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IV. The Impact of Bond SCR on Insurers’ Asset Allocation – Solvency II Friendly Assets

Return distribution functions by bond SCR risk intervals

Source: EDHEC Business School

For each of the distributions, we calculated historical VaR at 99.5% and compared it to SCR level of the interval in question. We note that from a risk level of between 5% and 10%, bond SCR underestimates VaR. Historical VaR calculations always exceed the upper bound of the bond SCR interval studied; for example, the 99.5% VaR over a bond SCR range of 10% to 15% is 22.60%, indicating that historical VaR does not match the SCR level in question. This explains the high capital overrun levels observed in Part II, Section 4.

IV.4. Sharpe ratio analysis based on the bond SCR level
In this section, we analyse the Sharpe ratio, often used in asset allocation, as a function of bond SCR. Establishing a relationship between the two indicators allows us to identify the links between asset management with or without the Solvency II constraint. Thus, a bond manager who manages his allocation using the Sharpe ratio could also manage it using bond SCR. By establishing this link, investors will be able to calculate the magnitude of their Sharpe ratios using their bond SCRs.

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The chart below shows Sharpe ratiobond SCR combinations and third-order polynomial regression.
Sharpe ratio as a function of bond SCR level (entire sample)

Source: EDHEC Business School

Sharpe Ratio = 7.661 SCR3 + 0.1821SCR2 3.3831 SCR + 1.3 R² = 0.8845 Additionally, we observe that the general trend with the Sharpe ratio is that it decreases as bond SCR rises, until it gets to a point
Sharpe ratio as a function of bond SCR

of stagnation. This means that increased volatility was not offset by increased returns (see the graph below).

Source: EDHEC Business School

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IV. The Impact of Bond SCR on Insurers’ Asset Allocation – Solvency II Friendly Assets

So, given the calibration of the standard formula used by the European regulator, increasing the level of portfolio risk does not maintain the same Sharpe ratio. This leads to research on risk-taking other than by the duration or rating deterioration. The next section discusses the efficiency of risk-taking (return/bond SCR) and will present the strategies that should achieve maximum efficiency for all levels of SCR risk.

classified bonds in our sample by credit rating and by SCR risk buckets. For each bucket, we calculated the average bond SCR, return and duration. For each credit rating level, we observe that maximum returns are generally achieved at SCR risk levels of between 0% and 15%, with the exception of AAA-rated bonds for which the level is 22%. Therefore, in order to maximise AAA bond returns, one must invest in long maturities – typically 25 years. However, analysing maximum return without comparing it to the assumed risk is meaningless. We therefore analysed the efficiency of risk-taking under Solvency II using a return/bond SCR ratio. This efficiency was measured for all bonds in the sample (see the table below).

IV.5 Analysing the efficiency of risk-taking
In this section, we analyse the efficiency of risk-taking. In other words, we ask the question: Does holding additional risk on certain debt instruments generate increased returns under Solvency II? To do this, we
Ranking of bond instruments by return and maximum efficiency
Rating AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AA AA AA AA AA AA A A A A A Minimum SCR 1.15% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 45.00% 50.00% 1.27% 5.00% 10.00% 15.00% 20.00% 25.00% 1.55% 5.00% 10.00% 15.00% 20.00% Maximum SCR 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 39.99% 45.00% 50.00% 55.00% 5.00% 10.00% 15.00% 20.00% 25.00% 27.15% 5.00% 10.00% 15.00% 20.00% 25.00% Average SCR 3.25% 7.78% 12.45% 17.24% 22.03% 27.03% 32.47% 37.57% 42.55% 47.88% 52.62% 3.49% 7.64% 12.40% 17.11% 21.84% 25.65% 3.63% 7.59% 12.57% 17.19% 22.11%

Average Duration 2.4 4.8 8.1 14.9 25.4 29.2 26.1 29.5 36.3 42.4 48.4 2.4 4.5 7.4 13.9 25.0 30.9 2.2 4.3 7.2 12.5 22.6

Average Return 2.80% 5.78% 5.38% 5.71% 6.31% 3.36% 5.63% 4.77% 3.05% -0.03% 1.96% 3.35% 6.37% 5.02% 5.45% 3.32% 4.32% 3.61% 7.09% 5.94% 5.43% 5.09%

Return Std. Deviation 2.81% 4.39% 5.48% 6.14% 6.71% 7.35% 7.81% 8.10% 7.62% 8.42% 9.43% 3.01% 5.09% 6.04% 7.87% 9.55% 7.34% 3.40% 6.09% 7.22% 7.98% 8.63%

Sample Size 186692 233781 375687 221794 96542 24219 10433 6565 2246 1670 1025 95066 166155 296364 152057 45043 2847 139938 317477 543694 402123 221498

RT/SCR 86.34% 74.25% 43.24% 33.10% 28.65% 12.42% 17.34% 12.69% 7.17% -0.06% 3.73% 95.87% 83.42% 40.47% 31.84% 15.18% 16.83% 99.47% 93.47% 47.25% 31.59% 23.04%

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A A A A A BBB BBB BBB BBB BBB BBB BBB BBB BB BB BB BB BB BB BB BB BB BB BB B B B B B B B B B B NR NR NR NR NR NR NR NR NR NR CCC ou < CCC ou < CCC ou <

25.00% 30.00% 35.00% 40.00% 45.00% 2.59% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 4.54% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 45.00% 50.00% 7.53% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 45.00% 50.00% 3.08% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 45.00% 7.53% 10.02% 15.00%

30.00% 35.00% 40.00% 45.00% 49.55% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 39.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 45.00% 50.00% 50.66% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 45.00% 50.00% 55.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 45.00% 49.99% 10.00% 14.99% 20.00%

26.57% 32.35% 38.12% 41.91% 46.39% 4.03% 7.76% 12.69% 17.50% 22.26% 27.35% 32.34% 36.20% 4.69% 7.85% 12.66% 17.47% 22.53% 27.49% 32.40% 37.27% 42.48% 47.16% 50.20% 8.67% 12.41% 17.72% 22.47% 27.50% 32.69% 37.47% 42.63% 47.36% 52.44% 4.16% 7.63% 12.70% 17.54% 22.53% 27.18% 32.37% 38.42% 41.94% 46.66% 8.68% 12.25% 17.85%

30.0 24.0 24.8 27.0 29.3 1.6 3.1 5.0 7.6 10.9 17.2 24.6 30.1 1.1 1.9 3.1 4.4 5.9 8.0 9.6 12.4 16.9 22.8 22.7 1.3 1.9 2.8 3.7 4.5 5.5 6.7 8.2 9.7 12.2 1.4 2.5 4.1 5.9 8.0 9.6 11.7 14.7 19.4 26.5 1.3 1.9 2.9

3.84% 0.31% 4.58% 4.80% 15.21% 3.23% 6.50% 6.93% 6.10% 5.17% 5.44% 4.66% 2.27% 5.38% 7.89% 7.75% 3.49% 4.23% 5.48% 3.15% 5.14% 4.19% 0.58% -6.25% 8.03% 11.64% 13.21% 7.54% 2.87% 2.13% 6.21% 4.37% 5.35% 4.06% 2.38% 3.79% 6.02% 5.28% 4.87% 4.73% 5.53% 3.87% 5.87% 10.94% 8.57% 18.40% 15.55%

8.66% 12.65% 13.70% 11.06% 9.92% 2.70% 6.08% 7.99% 8.47% 9.09% 9.70% 9.58% 9.17% 3.35% 7.14% 11.30% 12.28% 10.59% 10.45% 9.46% 10.22% 11.40% 11.06% 6.89% 3.64% 8.40% 9.37% 15.06% 13.91% 13.52% 11.89% 11.14% 13.13% 12.76% 2.72% 4.00% 5.58% 6.19% 7.01% 6.33% 6.81% 8.82% 10.43% 10.00% 3.08% 4.55% 9.00%

58472 5377 5496 5053 1635 25264 111629 177509 237735 182347 119988 78889 27217 1357 20425 26525 39242 42170 47980 38807 22183 16687 30456 232 2342 4959 4916 5170 6568 6728 7903 9347 7697 7970 11870 64520 99965 130668 139181 100544 64792 99400 243501 37766 200 277 931

14.45% 0.94% 12.02% 11.45% 32.78% 80.13% 83.73% 54.56% 34.86% 23.21% 19.88% 14.40% 6.27% 114.57% 100.49% 61.24% 19.96% 18.78% 19.92% 9.71% 13.78% 9.85% 1.22% -12.45% 92.66% 93.81% 74.56% 33.56% 10.43% 6.53% 16.57% 10.24% 11.29% 7.73% 57.22% 49.63% 47.39% 30.08% 21.60% 17.39% 17.09% 10.08% 13.99% 23.45% 98.69% 150.24% 87.11%

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CCC ou < CCC ou < CCC ou < CCC ou < CCC ou < CCC ou < CCC ou <

20.00% 25.05% 30.02% 35.00% 40.00% 45.00% 50.00%

24.98% 30.00% 35.00% 40.00% 45.00% 49.99% 55.00%

21.98% 28.01% 32.68% 37.82% 42.37% 47.39% 52.69%

3.6 4.8 5.9 6.8 8.4 10.6 11.2

11.82% -1.17% -1.09% 1.50% 4.30% 1.75% -8.26%

11.42% 12.94% 14.18% 11.06% 10.41% 12.79% 10.82%

1145 1191 1925 2920 3046 1768 1090

53.76% -4.17% -3.33% 3.97% 10.14% 3.69% -15.68%

Maximum Return/SCR by rating Maximum Return by rating Source: EDHEC Business School

In general, we observe that efficiency decreases with increasing bond duration. The maximum efficiency is usually achieved on low risk levels (between 0% and 15%). It also includes a quasi-concave shape previously noted on the return-SCR combination curves. If we analyse the efficiency of risk-taking based on credit ratings, we note that for bonds with high ratings (AAA, AA, A), maximum efficiency is generated by instruments with low duration, which are thus less risky (SCR between 0% and 5%). So, for AAA-rated bonds, the maximum efficiency (86.34%) is achieved for an average duration of 2.4 and an average SCR of 3.5%. Unrated (NR) and BB-rated bonds behave in the same way as bonds with at least an A rating. Their maximum efficiency (57.22% for NR and 114.57% for BB) is reached on low risk levels (between 3% and 5% SCR), but with even lower durations than the bonds with at least an A rating – 1.4 for NR and 1.1 for BB bonds. BBB-rated bonds have an average duration of 3.1 and an average SCR of 7.76%, which generates a maximum efficiency of 83.73%. Finally, bonds rated B or CCC at best produce their maximum efficiency on a medium risk level of 12% and have an average duration of 1.9. When we analysed the efficiency of

risk-taking across the whole sample (all ratings combined), we observed that the highest efficiency (first 10 rows in the table below) was generated on bonds with SCRs between 5% and 20% and durations of less than 5. It is important to underline that while here, maximum return is achieved on SCR risk levels between 0% and 15%, this is linked to the inversion of the interest rate curve which has been observed over a number of years. However, in terms of an efficient analysis of SCR risk-taking, the standard Solvency II formula tends to favour short-duration and particularly high yield bonds, regardless of the shape of the term structure of interest rates (except in cases of extreme steepening – spreads of above 18% between short and long-term interest rates). To explain the efficiency of risk-taking more clearly, we analysed a basket of Euro zone AAA-rated bonds (Source: European Central Bank) to create a graphical representation of the interest rate and bond SCR curves over time (see graph next page). The reduction in efficiency coupled with longer duration is due to the difference in slope between the interest rate curve and that of bond SCR. In fact, the largest gap between the long-term rate (15-year rate) and the short-term rate (3-month rate) since 2004 occurred in July 2009 –

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the value was 4.03%,17 which corresponds to a slope of 27 basis points per year. On the other hand, the minimum slope of the bond SCR curve for AAA-rated bonds was much higher than the term structure of interest rates – 124 basis points per year. So, as the difference between long-term and short-term rates is below 18%,18 an increase in SCR will not be offset by higher interest rates of the same proportion. Since the efficiency of risk-taking decreases with duration, the optimal risk-taking should involve selecting lower-rated bonds rather than choosing instruments with longer maturities. However, this strategy is not suited to the needs of an insurer wishing to maximise his portfolio's rating within return restrictions.
Interest rate and SCR curves according to maturity

17 - Calculation made based on the ECB risk-free rate, calculated on a daily basis since 2004 from a basket of AAA-rated Euro zone bonds. 18 - Gap required for the slope of the interest rate curve to be equal to 124 bps per year.

Seeking performance at the expense of efficient risk compensation leads to choosing longer duration bonds. However, the inversion of the current interest rate term structure will cap the maturity-rating pair at a certain maturity level, and beyond this point, performance seeking will lead to choosing weaker ratings. To illustrate, in the interest rate environment shown in the graph below, where bond returns depend on maturity and credit rating, the strategy of maximising one’s portfolio rating under a return constraint leads to making maturityrating choices that lie on the black curve. At each maturity level, when the interest rate term structure inverts, one has to pick a bond with which, when downgraded, will still retain the same SCR. Mechanically, it would also produce a lower maturity level.

Source: EDHEC Business School Seeking bond performance within the constraints of ratings maximisation

Source: EDHEC Business School and ECB

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Ranking of bond instruments by maximum efficiency
Average SCR Sample Size Return Std. Deviation Maximum SCR Minimum SCR Average Duration Average Return RT/SCR Rating Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42

CCC or < BB BB A CCC or < AA B A B CCC or < AAA BBB AA BBB B AAA BB NR BBB CCC or < NR NR A AAA AA BBB B AAA A AA A NR AAA NR BBB A NR BB BB BBB BB NR

10.0% 4.5% 5.0% 1.5% 7.5% 1.3% 10.0% 5.0% 7.5% 15.0% 1.1% 5.0% 5.0% 2.6% 15.0% 5.0% 10.0% 3.1% 10.0% 20.0% 5.0% 10.0% 10.0% 10.0% 10.0% 15.0% 20.0% 15.0% 45.0% 15.0% 15.0% 15.0% 20.0% 45.0% 20.0% 20.0% 20.0% 15.0% 25.0% 25.0% 20.0% 25.0%

15.0% 5.0% 10.0% 5.0% 10.0% 5.0% 15.0% 10.0% 10.0% 20.0% 5.0% 10.0% 10.0% 5.0% 20.0% 10.0% 15.0% 5.0% 15.0% 25.0% 10.0% 15.0% 15.0% 15.0% 15.0% 20.0% 25.0% 20.0% 49.5% 20.0% 20.0% 20.0% 25.0% 50.0% 25.0% 25.0% 25.0% 20.0% 30.0% 30.0% 25.0% 30.0%

12.2% 4.7% 7.9% 3.6% 8.7% 3.5% 12.4% 7.6% 8.7% 17.8% 3.2% 7.8% 7.6% 4.0% 17.7% 7.8% 12.7% 4.2% 12.7% 22.0% 7.6% 12.7% 12.6% 12.4% 12.4% 17.5% 22.5% 17.2% 46.4% 17.1% 17.2% 17.5% 22.0% 46.7% 22.3% 22.1% 22.5% 17.5% 27.5% 27.3% 22.5% 27.2%

1.9 1.1 1.9 2.2 1.3 2.4 1.9 4.3 1.3 2.9 2.4 3.1 4.5 1.6 2.8 4.8 3.1 1.4 5.0 3.6 2.5 4.1 7.2 8.1 7.4 7.6 3.7 14.9 29.3 13.9 12.5 5.9 25.4 26.5 10.9 22.6 8.0 4.4 8.0 17.2 5.9 9.6

18.4% 5.4% 7.9% 3.6% 8.6% 3.4% 11.6% 7.1% 8.0% 15.5% 2.8% 6.5% 6.4% 3.2% 13.2% 5.8% 7.8% 2.4% 6.9% 11.8% 3.8% 6.0% 5.9% 5.4% 5.0% 6.1% 7.5% 5.7% 15.2% 5.4% 5.4% 5.3% 6.3% 10.9% 5.2% 5.1% 4.9% 3.5% 5.5% 5.4% 4.2% 4.7%

4.5% 3.3% 7.1% 3.4% 3.1% 3.0% 8.4% 6.1% 3.6% 9.0% 2.8% 6.1% 5.1% 2.7% 9.4% 4.4% 11.3% 2.7% 8.0% 11.4% 4.0% 5.6% 7.2% 5.5% 6.0% 8.5% 15.1% 6.1% 9.9% 7.9% 8.0% 6.2% 6.7% 10.0% 9.1% 8.6% 7.0% 12.3% 10.4% 9.7% 10.6% 6.3%

277 1357 20425 139938 200 95066 4959 317477 2342 931 186692 111629 166155 25264 4916 233781 26525 11870 177509 1145 64520 99965 543694 375687 296364 237735 5170 221794 1635 152057 402123 130668 96542 37766 182347 221498 139181 39242 47980 119988 42170 100544

150.2% 114.6% 100.5% 99.5% 98.7% 95.9% 93.8% 93.5% 92.7% 87.1% 86.3% 83.7% 83.4% 80.1% 74.6% 74.2% 61.2% 57.2% 54.6% 53.8% 49.6% 47.4% 47.2% 43.2% 40.5% 34.9% 33.6% 33.1% 32.8% 31.8% 31.6% 30.1% 28.6% 23.4% 23.2% 23.0% 21.6% 20.0% 19.9% 19.9% 18.8% 17.4%

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AAA NR AA B AA A BBB NR BB AAA AAA A A B B B CCC or < NR BB BB B AAA B BBB CCC or < AAA CCC or < BB A AAA CCC or < CCC or < BB CCC or <

30.0% 30.0% 25.0% 35.0% 20.0% 25.0% 30.0% 40.0% 35.0% 35.0% 25.0% 35.0% 40.0% 45.0% 25.0% 40.0% 40.0% 35.0% 40.0% 30.0% 50.0% 40.0% 30.0% 35.0% 35.0% 50.0% 45.0% 45.0% 30.0% 45.0% 30.0% 25.1% 50.0% 50.0%

35.0% 35.0% 27.1% 40.0% 25.0% 30.0% 35.0% 45.0% 40.0% 40.0% 30.0% 40.0% 45.0% 50.0% 30.0% 45.0% 45.0% 40.0% 45.0% 35.0% 55.0% 45.0% 35.0% 39.0% 40.0% 55.0% 50.0% 50.0% 35.0% 50.0% 35.0% 30.0% 50.7% 55.0%

32.5% 32.4% 25.6% 37.5% 21.8% 26.6% 32.3% 41.9% 37.3% 37.6% 27.0% 38.1% 41.9% 47.4% 27.5% 42.6% 42.4% 38.4% 42.5% 32.4% 52.4% 42.6% 32.7% 36.2% 37.8% 52.6% 47.4% 47.2% 32.3% 47.9% 32.7% 28.0% 50.2% 52.7%

26.1 11.7 30.9 6.7 25.0 30.0 24.6 19.4 12.4 29.5 29.2 24.8 27.0 9.7 4.5 8.2 8.4 14.7 16.9 9.6 12.2 36.3 5.5 30.1 6.8 48.4 10.6 22.8 24.0 42.4 5.9 4.8 22.7 11.2

5.6% 5.5% 4.3% 6.2% 3.3% 3.8% 4.7% 5.9% 5.1% 4.8% 3.4% 4.6% 4.8% 5.3% 2.9% 4.4% 4.3% 3.9% 4.2% 3.1% 4.1% 3.0% 2.1% 2.3% 1.5% 2.0% 1.7% 0.6% 0.3% 0.0% -1.1% -1.2% -6.2% -8.3%

7.8% 6.8% 7.3% 11.9% 9.5% 8.7% 9.6% 10.4% 10.2% 8.1% 7.4% 13.7% 11.1% 13.1% 13.9% 11.1% 10.4% 8.8% 11.4% 9.5% 12.8% 7.6% 13.5% 9.2% 11.1% 9.4% 12.8% 11.1% 12.7% 8.4% 14.2% 12.9% 6.9% 10.8%

10433 64792 2847 7903 45043 58472 78889 243501 22183 6565 24219 5496 5053 7697 6568 9347 3046 99400 16687 38807 7970 2246 6728 27217 2920 1025 1768 30456 5377 1670 1925 1191 232 1090

17.3% 17.1% 16.8% 16.6% 15.2% 14.5% 14.4% 14.0% 13.8% 12.7% 12.4% 12.0% 11.4% 11.3% 10.4% 10.2% 10.1% 10.1% 9.9% 9.7% 7.7% 7.2% 6.5% 6.3% 4.0% 3.7% 3.7% 1.2% 0.9% -0.1% -3.3% -4.2% -12.4% -15.7%

43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76

Source: EDHEC Business School

IV. 6 Summary of the impact of bond SCR on insurers’ asset allocation
Here in Part IV, we studied the behaviour of the return-risk pairs of fixed income instruments – in other words, bond return-SCR pair – in order to determine whether Solvency II led to changes in bond preferences and provided arbitrage opportunities

To do this, we first of all analysed the bond returns in our sample using traditional statistical management indicators – average return, standard deviation, VaR, skewness, kurtosis. These indicators allowed us to present the bond profiles studied according to their characteristics (geographical area and rating), and over time. Based on these returns, we

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incorporated bond SCR, so that we could study the behaviour of different riskreturn profiles – the central focus within asset allocation. Return curves expressed in terms of bond SCR have a quasi-concave shape, regardless of rating. For low levels of risk (bond SCR between 0% and 10%), bond returns tend to increase with the risk, indicating that risk-taking is rewarded. Beyond 10% SCR, bond returns stagnate or even decline. So, beyond a certain SCR level, bond risktaking no longer rewarded. This behaviour is due to the inversion of interest rate term structures. In fact, over the period studied there is an inversion value beyond which the return no longer increases (and even decreases) with maturity while SCR is still on the rise. Over the period studied, the curves that represent the return against the SCR therefore reach maximum levels. This maximum return was achieved at different SCR levels depending on the bond rating being considered. For AAA or AA-rated bonds, the maximum return is achieved for a bond SCR of 7.5% versus 8.5% for A-rated bonds and more than 11% bonds rated BBB or lower. This means that the weaker the bond rating, the more the maximum return is achieved on high SCR levels. Using return-SCR pairs, it was possible to establish general trends of investment choices within the constraints of Solvency II. Risk-taking through an increase in duration was rewarded for SCR levels below a certain threshold, depending on the maturity and the inversion of the interest

rate term structure. Beyond this threshold, only a ratings downgrade provided any reward for risk. Lastly, beyond a certain very high risk threshold (20% for our sample), no risk-taking is rewarded under bond SCR. The calibration of the Solvency II standard formula for high risk bonds produces an SCR risk measure. This is the case for long maturity investment grade and high yield bonds. The regulator has defined a common method for the treatment of bonds regardless of the specificities some of them possess, including the ALM objective underlying investment grade bonds and the relatively high probability of default for high yield bonds. Bond SCR cannot fully reflect the real risk (historical VaR) of these instruments, nor can it serve as explanatory variable of returns for high levels of risk. Solvency II regulation, thus penalises holding bonds with low ratings and, particularly long duration bonds, because capital requirements are high and returns do not compensate for additional risk taking. On this last point, ALM could thus be penalised in terms of cost of capital. The trends have led us to investigate the impact of the crisis could have had on our results. We therefore analysed return-SCR pairs over the 1999-2007 period and found that returns increase according to rating for bond SCRs of between 9% and 25% (versus 15% over the 1999-2011 period). Beyond a 25% SCR, bond return behaviour is highly unpredictable over the 19992007 period, similar to trend we witnessed over 1999-2011. A more detailed analysis of bond return-SCR pairs by rating shows that the highly-rated bonds (AAA, AA, A) produced the highest returns for risk
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levels up to 25% (versus 8% for 19992011). During the crisis, the growth of returns relative to maturity was abruptly interrupted and maximum returns were achieved with shorter maturities. This is consistent with the inversion of the interest rate term structure which coincided with maturities that were much shorter than those observed in a noncrisis environment. In addition, we also observed the return distribution functions for each SCR level. It appears that the deformation of the density function is consistent with the increased level of risk (bond SCR) – increasing the level of risk produces higher return at the cost of a more dispersed distribution. However, beyond a certain threshold, any additional risk-taking does not generate additional returns. For a bond SCR between 5% and 10%, the average maximum return is 7.18%. Beyond a 10% SCR, the average return decreases. When we compare the 99.5% VaR of historical returns to the SCR bond level, we find that from an average risk level of 5%, bond SCR underestimates the VaR. This explains the high capital overrun levels observed in Part II. We are also interested in the relationship between the Sharpe ratio and bond SCR so that we can identify the links between asset management with or without the Solvency II constraint. This link will enable asset managers to use their bond SCRs to determine the magnitude of their Sharpe ratios. We observe that the general trend of the Sharpe ratio is to decrease with and increasing bond SCR, till it reaches a point of stagnation (third order polynomial function). This means that
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the increase in volatility is not offset by higher returns. To further analyse investment choice trends, we looked at the efficiency of risktaking instruments using the bond return/ SCR ratio. The objective is to analyse whether risk taking is systematically rewarded. We observed that, in terms of analysing the efficiency of SCR risk-taking, Solvency II favours low duration bonds. These findings show that efficiency decreases with increasing bond duration and that maximum efficiency is most often reached for low risk levels (SCR between 0% and 15%). Bonds with high ratings (AAA, AA, A) reach maximum efficiency on small durations (2.3 on average). Unrated bonds (NR) and BB-rated bonds behave similarly to bonds with at least an A rating and reach their maximum efficiency with even lower durations (1.4 for unrated bonds and 1.1 for BB-rated bonds). BBB-rated bonds produce their maximum efficiency with an average duration of 3.1. Lastly, bonds with a B rating or CCC and below produce their maximum efficiency with an average duration of 1.9. So, whatever the credit rating, the efficiency (return / bond SCR) is reached on durations less than or equal to three.

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Conclusion

Faced with the new Solvency II regulation, insurers are obliged to rethink their investment strategies and to consider which asset classes are the most efficient in terms of return-risk, the latter factor as of now being measured by the Solvency Capital Requirement (SCR). In response to discussions on bond management under Solvency II, this study analysed: the most influential variables on bond SCR; the appropriateness of bond SCR as a risk measure, its impact on traditional asset management which today is based on three dimensions (return-volatility-VaR); and finally, our study showed that the new prudential regulation could lead to changes in fixed-rate bond choices and offer arbitrage opportunities between different types of fixed rate bonds. To do this, we studied the rolling returns and SCRs of 4,279 fixed-rate bonds listed between 1999 and 2011 and issued in 14 different countries. First, a sensitivity study of bond SCR based on different intrinsic characteristics of fixed-rate bonds showed that residual maturity and rating accounted for 89.1% of bond SCRs (through analysis of Pearson and Spearman correlations). However, real spread has little influence on the SCR level as the standard Solvency II formula addresses spread risk on a flat-rate basis and does not reflect actual spread. This is a very interesting finding for bond managers, because they can get a rather accurate insight into bond SCR, using only two variables – residual maturity and rating (instead of the initially identified nine variables, see Part II Section 2.1). This new bond SCR calculation can be used in a nomograph to identify the rating-maturity
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combinations that would produce the same capital charge. The analysis of the behaviour of bond SCR using residual maturity and rating showed that for a given maturity, the higherrated bonds (AAA, AA and A) consume significantly less capital than those with lower ratings. For example, a BBB-rated bond uses 2.5 times more capital than an AAA-rated bond (see chart in Part II, Section 2.1). A major consequence could be that the bonds with ratings less than or equal to BBB are neglected by investors subject to the new solvency standards. Moreover, it is clear from our various tests that the longer the maturity, the greater the capital requirements are, regardless of the rating. Solvency II could therefore result in an increase in long-term rates driven by weaker demand for long maturity bonds. Then, the intertemporal study of bond SCR confirms that bond maturity is still the causal variable in the variation of the prudential capital requirement (it decreases linearly with time). Secondly, we analysed the adequacy of bond SCR as a risk measure, to determine whether bond management based on the return-volatility-VaR triple factor would now, under Solvency II, include a fourth dimension which would be regulatory capital SCR. This analysis is conducted by studying the capacity of bond SCR to absorb bond losses based on a 99.5% VaR, by comparing the bond SCR prudential capital requirements to historical VaR at 99.5% and analysing the volatility of historical returns as a function of bond SCR.

The Impact of Solvency II on Bond Management - July 2012

Conclusion

The results showed that bond SCR, as defined by the EIOPA, underestimates the historical VaR of bonds over the 1999-2011 period (sample of 4,279 fixed-rate bonds) and therefore potentially the real risk. The capital overrun rate was 1.23%, while the regulator’s target rate was 0.5%. The comparison of historical VaR and regulatory capital requirements shows a strong correlation between VaR and the bond SCR (87.5%), and a tendency of SCR underestimating VaR. This effect is visible, particularly for bonds with medium and high risk profiles (bond SCR exceeding 10%) while for bonds with a lower risk profile, it seems that the SCR slightly overestimates the losses. However, a period analysis shows that during the crisis years, bond SCR tends to underestimate losses of high-risk bonds, while in the absence of a crisis, they are overestimated. In contrast, losses for low-risk bonds are, in general, accurately estimated. On the whole, SCR is an appropriate measure of risk, although during periods of crisis, it has tended to underestimate historical VaR at 99.5%. This suggests that EIOPA could consider implementing an adjustment of bond SCR, which incorporates macroeconomic cycles, as the equity Dampener approach does. Moreover, the geographic analysis of capital requirement overruns and the relationship between VaR and SCR, shows very heterogeneous results between areas studied (Europe 1, PIIGS, United States., and BRICS). It could also be useful for Solvency II to integrate these differences in geographical risk via an adjustment to SCR. Additionally, the study of the relationship between volatility and SCR shows that these two risk measures are closely related.

Bond SCR accounts for 98.4% of changes in historical volatility. The analyses conducted in this section therefore concluded that SCR is an appropriate bond risk measure, which is highly correlated to the two traditional asset management measures – VaR and volatility. This means that there is no need for Solvency II to add a new dimension to bond management, which today is based on the return-volatility-VaR triple factor. Instead, the management of fixed-rate debt instruments should be possible using the return-SCR pair alone. Thirdly, we studied the bond return-SCR pairs, as insurance companies should be encouraged to define their strategic bond allocation according to risk compensation, particularly in relation to the bond returnSCR pair. Over the 1999-2011 period, we observe that the bond return increases with duration up to a certain level of maturity corresponding to the inversion of interest rate term structures. Beyond this threshold (SCR of 8% for our sample), the additional risk of longer duration is no longer rewarded, while bond SCR continues to grow. Only the risk linked to rating is still rewarded up to a certain SCR level (20% for our sample). It is important to highlight the fact that bond return – which when expressed as a function of SCR reaches a maximum for relatively low SCRs – is totally linked to the shape of the interest rate curve (a structure with interest rate inversion). In absence of this inversion, returns would be an increasing function of SCR, regardless of the level. Studies on return density functions corroborate all of these findings.
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Conclusion

EIOPA could take different interest rate term structure steepening scenarios into account by incorporating a Dampener-type adjustment mechanism such as that used for equities. Tests carried out on curves with different steepness conclude that, in all cases, bond SCR is growing faster than bond returns. The marginal increase in bond SCR relative to risk is greater than that of bond returns. On the other hand, regardless of the inversion of interest rate term structure, the calibration of the standard Solvency II formula for very high risk bonds produces an irrelevant risk measure. This concerns long maturity investment grade bonds and high yield bonds with relatively long maturities (seven years for our sample). The regulator adopts a common approach to all bond classes, without taking their specificities into account. Long maturity investment grade bonds are generally selected by insurers with an ALM objective (aligning the maturities of their assets to those of their liabilities). High yield bonds, however, are rather selected in the hope that they will deliver additional performance. In fact, as they have a high probability of default, their valuation is highly sensitive to the estimation of loss given default and not very sensitive to movements of the interest rate term structure. These two bond categories have sensitivities to risk factors different to those of other bonds. By considering only the interest rate spread modules, the standard formula produces an inaccurate risk assessment of these two bond categories – SCR does not fully reflect real bond risk (measured here by historical VaR) and therefore cannot be an explanatory variable of performance for high-risk bonds. Both bond types should
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have specific treatments. High yield bonds could be assessed using a model in which default risk is paramount. Long-maturity investment grade bonds subject to ALM could be treated based on EIOPA’s chosen approach for equities backing ring-fenced pension liabilities. Finally, we note that the Solvency II standard formula is also limited when it comes to unrated bonds. Their spread risk factor is 3% and lies between a BBB-rated bond (risk factor of 2.5%) and a BB-rated bond (risk factor of 4.5%). We showed that the spread risk factor required by Solvency II for unrated bonds is not in line with the risk premium that has been used over the last ten years. We completed our study with a Sharpe ratio analysis. Different tests show that (taking into account the calibration of the standard formula used by the European regulator) increasing the level of portfolio risk does not maintain the same Sharpe ratio. The latter decreases with an increasing bond SCR, until it reaches a stagnation point. This means that an increase in volatility is not offset by higher returns. The last part of this study analyses the efficiency of risk-taking on debt instruments, measured by the bond return/SCR ratio. The results show that efficiency decreases with increasing bond duration. So, regardless of credit rating, maximum efficiency is achieved for short durations (less than or equal to three over the 1999-2011 period) and thus for low levels of risk (SCRs between 0% and 15%). When we classify all bonds in our sample according to their risk-taking efficiency, it appears that the standard Solvency II

The Impact of Solvency II on Bond Management - July 2012

Conclusion

formula tends to favour short-duration and particularly low ratings (high yield bonds), regardless of the shape of the interest rate term structure (except in cases of extreme steepening – spreads of above 18% between short and long-term interest rates). In conclusion, bond SCR – as defined by the standard Solvency II formula – is, overall, an appropriate measure of risk. However, given their specificities, SCR does not fully reflect the 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 European regulator’s standard formula favours low duration bonds, particularly high yield bonds. This management, within the constraints of SCR, could lead to a shortening of durations, given the calibration and current term structure of interest rates.

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Conclusion

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References

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References

• Christoffersen, P., Hahnb, J., Inouec, A. 2001. Testing and comparing Value-at-Risk measures, Journal of Empirical Finance 8 (3) : 325–342. • Committee of European Insurance and Occupational Pensions Supervisors. 2010. QIS 5 Calibration Paper. Avril. • European Commission. Financial Institutions (insurance and pensions). 2010. QIS5 Technical Specifications, Juillet. • Foulquier, P., Lemaistre A. 2012. Les dix péchés capitaux de la Value at Risk. Banque et Stratégie 303: 21-23 • Henrard, M. 2005. Value-at-Risk: The Delta-normal Approach, Risk and Insurance, Working Paper. • Journal officiel de l’Union Européenne. 2009. Directive du Parlement Européen et du Conseil sur l’accès aux activités de l’assurance et de la réassurance et leur exercice (solvabilité II). Décembre. • Korn, O., Koziol, C. 2006. Bond portfolio optimisation: risk-return approach. Journal of Fixed Income 15(4) : 48-60. • Martellini, L., Priaulet, P., Priaulet S. 2003. Fixed Income Securities: Valuation, risk management, and portfolio strategies. Wiley. • Nelson, C., Siegel A.F. 1987. Parsimonious Modeling of Yield Curves. Journal of Business University of Chicago Press 60(4) : 473-89. • Official Journal of the European Union. 2009. Directive 2009/138/EC of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II). December. • Portait, R., Poncet P. 2009. Finance de marché instruments de base, produits dérivés, portefeuille et risques. Editions Dalloz.

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Appendices

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Appendices

Appendix 1: Risk modular structure of Solvency II
Modular Structure of SCR

Source: Quantitative Impact Study 5, CEIOPS 2010

Appendix 2: Frequency of historical bond losses exceeding prudential capital requirements
Number of occurrences in which SCR was exceeded (by time period and area) RT < -SCR Country/ Period France Germany U.K. Portugal Italy Ireland Greece Spain Brazil Russia India China South Africa U.S. Europe 1 Zone PIIGS BRICS Sample 1.jan.1999 - 1.jan.2001 1 1 93 2 93 95 2.jan.2001 - 1.jan.2003 329 85 601 414 1 015 2.jan.2003 - 1.jan.2005 688 237 14 3 538 939 3 1 480 2.jan.2005 1 jan.2007 565 1 097 279 1 922 1 941 3 863 2.jan.2007 - 1.jan.2009 1 950 3 298 3 516 446 656 764 422 4 853 122 38 611 8 764 1 866 5 397 54 638 2.jan.2009 - 1.oct.2011 1 842 923 376 355 530 2 132 4 660 2 856 13 48 1 600 3 141 10 533 61 15 335 1.jan.1999 - 1.oct.2011 5 375 5 556 4 270 894 1 189 2 896 4 660 2 856 435 4 853 170 43 272 15 201 12 495 5 458 76 426

Source: EDHEC Business School

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Appendices

Number of observations taken from our sample (by time period and by area) RT < -SCR Country / Period France Germany U.K. Portugal Italy Ireland Greece Spain Brazil Russia India China South Africa U.S. Europe 1 Zone PIIGS BRICS Sample 1.jan.1999 - 1.jan.2001 16 283 33 808 30 647 10 804 31 237 1 327 729 1 803 2 054 305 1 485 6 576 80 738 45 900 3 844 137 058 2.jan.2001 - 1.jan.2003 38 550 61 911 49 905 17 149 46 714 1 795 2 450 3 492 762 2 190 730 588 785 25 197 150 366 71 600 5 055 252 218 2.jan.2003 - 1.jan.2005 85 808 121 995 89 593 34 150 96 985 3 790 4 085 6 782 1 863 3 240 731 1 913 847 175 408 297 396 145 792 8 594 627 190 2.jan.2005 1 jan.2007 151 478 218 600 126 973 70 924 127 676 10 272 9 448 10 400 6 731 9 286 1 035 2 190 1 314 353 458 497 051 228 720 20 556 1 099 785 2.jan.2007 - 1.jan.2009 249 444 363 642 204 574 123 668 154 544 20 422 16 725 16 408 13 444 28 369 1 462 3 848 3 702 554 807 817 660 331 767 50 825 1 755 059 2.jan.2009 - 1.oct.2011 347 196 473 995 299 545 163 119 175 231 26 640 30 122 21 852 35 189 37 692 2 411 6 651 5 761 729 353 1 120 736 416 964 87 704 2 354 757 1.jan.1999 - 1.oct.2011 888 759 1 273 951 801 237 419 814 632 387 64 246 63 559 60 737 57 989 82 831 6 674 15 190 13 894 1 844 799 2 963 947 1 240 743 176 578 6 226 067

Source: EDHEC Business School Number of occurrences in which SCR was exceeded (by rating and by time period) RT < -SCR Rating / Period AAA AA A BBB BB B CCC or below NR Sample 1.jan.1999 - 1.jan.2001 2 93 95 2.jan.2001 - 1.jan.2003 163 784 40 28 1 015 2.jan.2003 - 1.jan.2005 925 296 47 36 173 3 1 480 2.jan.2005 - 1.jan.2007 919 1 123 794 178 150 109 590 3 863 2.jan.2007 - 1.jan.2009 2 579 4 037 15 761 13 298 7 454 7 082 1 162 3 265 54 638 2.jan.2009 - 1.oct.2011 1 389 1 195 3 435 4 613 3 343 311 222 827 15 335 1.jan.1999 - 1.oct.2011 5 977 7 435 20 077 18 153 11 120 7 502 1 384 4 778 76 426

Source EDHEC Business School

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Appendices

Number of observations taken from our sample (by rating and by time period) RT < -SCR Rating / Period AAA AA A BBB BB B CCC or below NR Sample 1.jan.1999 - 1.jan.2001 30 728 8 331 20 383 14 232 3 070 2 911 57 403 137 058 2.jan.2001 - 1.jan.2003 57 322 21 324 50 219 30 423 8 453 4 386 80 091 252 218 2.jan.2003 - 1.jan.2005 101 596 61 209 185 499 101 100 26 456 15 265 697 135 368 627 190 2.jan.2005 - 1.jan.2007 187 323 138 509 296 568 189 709 59 360 35 544 5 778 186 994 1 099 785 2.jan.2007 - 1.jan.2009 323 995 242 624 498 405 288 925 94 968 44 883 8 097 253 162 1 755 059 2.jan.2009 - 1.oct.2011 470 722 301 044 702 354 392 222 126 629 45 940 7 805 308 041 2 354 757 1.jan.1999 - 1.oct.2011 1 171 686 773 041 1 753 428 1 016 611 318 936 148 929 22 377 1 021 059 6 226 067

Source: EDHEC Business School Number of occurrences in which SCR was exceeded (by SCR tranche and by time period) RT < -SCR SCR / Period [0%,5%] [5%,10%] [10%,15%] [15%,20%] [20%,25%] [25%,30%] [30%,35%] [30%,50%] + 50% Sample 1.jan.1999 - 1.jan.2001 1 1 93 95 2.jan.2001 - 1.jan.2003 45 593 281 11 85 1 015 2.jan.2003 - 1.jan.2005 107 739 441 9 8 173 3 1 480 2.jan.2005 1 jan.2007 5 129 1 261 1 457 305 475 104 127 3 863 2.jan.2007 - 1.jan.2009 45 2 043 14 274 13 971 12 345 5 236 2 809 2 327 1 588 54 638 2.jan.2009 - 1.oct.2011 1 153 4 135 4 923 3 066 1 253 360 80 365 15 335 1.jan.1999 - 1.oct.2011 1 203 6 415 21 243 19 528 14 193 6 090 3 251 2 915 1 588 76 426

Source: EDHEC Business School Number of observations taken from our sample (by SCR tranche and by time period) RT < -SCR SCR / Period [0%,5%] [5%,10%] [10%,15%] [15%,20%] [20%,25%] [25%,30%] [30%,35%] [30%,50%] + 50% Sample 1.jan.1999 - 1.jan.2001 783 268 647 16 863 29 735 13 349 10 684 61 772 2 957 137 058 2.jan.2001 - 1.jan.2003 55 4 254 66 052 55 878 28 245 18 455 75 559 3 720 252 218 2.jan.2003 - 1.jan.2005 119 362 124 585 173 252 113 122 59 839 42 113 103 068 10 730 627 190 2.jan.2005 1 jan.2007 613 35 310 360 400 251 953 164 985 91 541 52 454 118 544 23 985 1 099 785 2.jan.2007 - 1.jan.2009 4 721 195 052 575 600 427 950 244 083 114 827 57 413 116 213 19 200 1 755 059 2.jan.2009 - 1.oct.2011 464 045 710 335 512 084 304 751 157 298 70 732 36 603 89 359 9 550 2 354 757 1.jan.1999 - 1.oct.2011 470 336 941 327 1 577 570 1 240 821 765 101 378 533 217 722 564 515 70 142 6 226 067

Source: EDHEC Business School

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Appendices

Number of occurrences in which SCR was exceeded (by maturity and by time period) RT < -SCR Maturity / Period [0yrs,5yrs] [5yrs,10yrs] [10yrs,15yrs] [15yrs,20yrs] [20yrs,25yrs] [25yrs,30yrs] [30yrs,35yrs] [35yrs,50yrs] + 50yrs Sample 1.jan.1999 - 1.jan.2001 0 0 1 0 93 1 0 0 0 95 2.jan.2001 - 1.jan.2003 0 25 873 32 85 0 0 0 0 1 015 2.jan.2003 - 1.jan.2005 0 1 175 279 20 4 2 0 0 0 1 480 2.jan.2005 - 1.jan.2007 179 2 495 880 24 285 0 0 0 0 3 863 2.jan.2007 - 1.jan.2009 15 525 26 724 4 915 3 082 2 415 1 476 123 206 172 54 638 2.jan.2009 - 1.oct.2011 7 312 7 233 603 99 63 25 0 0 0 15 335 1.jan.1999 - 1.oct.2011 23 016 37 652 7 551 3 257 2 945 1 504 123 206 172 76 426

Source: EDHEC Business School Number of observations taken from our sample (by maturity and time period) RT < -SCR Maturity / Period [0yrs,5yrs] [5yrs,10yrs] [10yrs,15yrs] [15yrs,20yrs] [20yrs,25yrs] [25yrs,30yrs] [30yrs,35yrs] [35yrs,50yrs] + 50yrs Sample 1.jan.1999 - 1.jan.2001 0 0 43 033 32 488 32 420 25 918 3 199 0 0 137 058 2.jan.2001 - 1.jan.2003 0 41 857 86 374 45 663 33 710 37 285 6 513 804 12 252 218 2.jan.2003 - 1.jan.2005 0 265 980 141 782 77 018 68 378 64 474 6 146 2 651 761 627 190 2.jan.2005 - 1.jan.2007 26 428 613 299 185 736 96 614 92 506 65 765 8 988 8 635 1 814 1 099 785 2.jan.2007 - 1.jan.2009 458 479 792 106 196 385 119 598 86 481 74 543 12 994 13 003 1 470 1 755 059 2.jan.2009 - 1.oct.2011 1 166 231 720 044 179 166 113 713 74 743 75 302 11 575 12 480 1 503 2 354 757 1.jan.1999 - 1.oct.2011 1 651 138 2 433 286 832 476 485 094 388 238 343 287 49 415 37 573 5 560 6 226 067

Source: EDHEC Business School Composition of the sample by rating and bond maturities Maturity / Rating [0yrs,5yrs] [5yrs,10yrs] [10yrs,15yrs] [15yrs,20yrs] [20yrs,25yrs] [25yrs,30yrs] [30yrs,35yrs] [35yrs,50yrs] + 50yrs Sample AAA 21.9% 17.8% 17.9% 15.0% 15.1% 16.8% 39.0% 47.1% 8.2% 18.8% AA 15.1% 13.9% 11.6% 5.5% 5.2% 10.5% 8.4% 5.2% 0.0% 12.4% A 27.8% 28.9% 25.6% 26.3% 27.6% 33.1% 34.9% 21.2% 50.0% 28.2% BBB 14.7% 17.2% 17.3% 17.9% 15.5% 15.6% 6.9% 11.2% 39.3% 16.3% BB 6.2% 5.3% 4.5% 4.8% 3.6% 2.9% 4.9% 0.0% 2.5% 5.1% B 2.2% 1.6% 1.8% 4.2% 6.3% 1.8% 1.7% 15.3% 0.0% 2.4% CCC 0.2% 0.1% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.1% CC 0.1% 0.4% 0.2% 0.3% 0.2% 0.0% 0.0% 0.0% 0.0% 0.3% NR 11.7% 14.6% 21.0% 26.2% 26.4% 19.3% 4.2% 0.0% 0.0% 16.4% Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Source: EDHEC Business School

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Appendices

Maturity / Rating [0yrs,5yrs] [5yrs,10yrs] [10yrs,15yrs] [15yrs,20yrs] [20yrs,25yrs] [25yrs,30yrs] [30yrs,35yrs] [35yrs,50yrs] + 50yrs Sample

AAA
362 285 434 049 148 961 72 567 58 741 57 676 19 254 17 695 458 1 171 686

AA
249 098 338 624 96 246 26 504 20 379 36 055 4 164 1 971 0 773 041

A
459 817 704 384 212 956 127 454 107 076 113 759 17 238 7 965 2 779 1 753 428

BBB
243 462 419 050 143 914 86 730 60 144 53 504 3 422 4 201 2 184 1 016 611

BB
101 650 130 085 37 377 23 315 14 055 9 880 2 435 0 139 318 936

B
36 487 40 033 14 930 20 339 24 479 6 094 826 5 741 0 148 929

CCC
2 483 2 557 1 112 0 0 0 0 0 0 6 152

CC
2 357 9 775 1 906 1 318 869 0 0 0 0 16 225

NR
193 499 354 729 175 074 126 867 102 495 66 319 2 076 0 0 1 021 059

Total
1 651 138 2 433 286 832 476 485 094 388 238 343 287 49 415 37 573 5 560 6 226 067

Source: EDHEC Business School

Appendix 3: Return distribution functions by geographic area and by bond SCR interval
Return distribution functions of the Europe 1 zone by bond SCR interval

Source: EDHEC Business School

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Appendices

Return distribution functions of the U.S. by bond SCR interval

Source: EDHEC Business School

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Appendices

Return distribution functions of the PIIGS zone by bond SCR interval

Source: EDHEC Business School

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Appendices

Return distribution functions of the BRICS zone by bond SCR interval

Source: EDHEC Business School

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Appendices

Appendix 4: Bond SCR as a function of all the variables analysed in the study

Source: EDHEC Business School

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Appendices

Appendix 5: Effect of coupon detachment on duration and thus bond SCR

We denote NPV - as the value of the bond before the detachment of a coupon of amount c and NPV + represents value just after the coupon detachment. The relationship between NPV - and NPV + is as follows: NPV + = NPV - —c Duration d is expressed by the following:

After the coupon detachment, duration d + is expressed by:

As

We have

Therefore
_

Therefore d + > d

This confirms that the detachment of a coupon leads to an increase in duration.

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Appendices

Appendix 6: Comparison of historical Value at Risk and bond SCR across the entire sample by time period

Source: EDHEC Business School

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About EDHEC Financial Analysis and Accounting Research Centre

An EDHEC Financial Analysis and Accounting Research Centre Publication

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About EDHEC Financial Analysis and Accounting Research Centre
The EDHEC Financial Analysis and Accounting Research Centre was created in 2006 around the themes of company valuation and management; featuring prominently in the context of the creation of the Centre were new accounting (IFRS, US GAAP) and new prudential rules (Solvency II and Basel III). Today, cultural and technological changes allow multiple dynamic analyses in several areas, the cornerstone of which is the discount rate: risk is the essential element. A profound change has been underway for a decade now; the aim of the change is to improve stakeholders' views of the risks actually taken by companies. Faced with increasingly complex risks, accounting and prudential standards (IFRS, US GAAP, Solvency II, and Basel III) are undergoing a complete revision. These reforms have an impact on the management of financial or non-financial firms (enterprise risk management, economic capital models, management control, internal control, and so on). There may be a large body of research into the determination of the discount rate in general and on risk more particularly, but the gap between academe and the business world seems to be growing wider by the day. In practice, those who do the valuations often oversimplify, invalidating their reasoning; they may even ignore theory and transform the discount rate into a black box to hide the absence of objective and academic foundations for the determination of the risk premium and of beta. The aim of the EDHEC Financial Analysis and Accounting Research Centre is to shed new light on risk integration (the impact on management, strategy and financial communication, valuation, and discount rates)
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and to recommend new practical solutions of management in general as well as methods suited to the frameworks for accounting and prudential standards. The great diversity of backgrounds is one of the advantages of the research centre (specialists in financial analysis, in corporate finance, in accounting on one hand and from academe or from business on the other), and it allows the centre to take a multi-disciplinary approach to company valuation and management: the impact of IFRS on risk valuation and risk pricing; the impact of IFRS and Solvency II on insurance company management; bankinsurance and optimal capital allocation; the financial structure of family firms and cost of capital; optimisation of steering tools (internal control, management control, enterprise risk management, market-consistent embedded value, asset/liability management, economic capital). The EDHEC Financial Analysis and Accounting Research Centre is working on five research programmes: • 1. Determination of the cost of capital • 2. Impact of IFRS on company valuation • 3. Family firms, financing structure and governance • 4. Enterprise risk management, economic capital, management control, and internal control within the new accounting and prudential frames of reference • 5. Bankruptcy modelling and company valuation The mission of the EDHEC Financial Analysis and Accounting Research Centre is also to accompany businesses in a tailor-made implementation of the Centre's research results and thus to offer consulting and financial engineering services.

About EDHEC Business School

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About EDHEC Business School

EDHEC Business School equips students and executives with the skills required to manage projects and lead people in a multicultural environment. The School offers a variety of education and training courses covering the full spectrum of business needs. A broad range of international degree programmes attracts students the world over. Close to 6,000 students and 10,000 executives currently participate in EDHEC seminars and education programmes on the five sites in Lille, Nice, Paris, London and Singapore. EDHEC Business School’s international strategy comprises an innovative business-focused research policy organised around specialist research centres. EDHEC holds AACSB, AMBA and EQUIS accreditations and is regularly ranked among Europe’s leading business schools. More information is available on the EDHEC website: www.edhec.edu

EDHEC BUSINESS SCHOOL 393 promenade des Anglais 06202 Nice Cedex 3 Tel. : +33 (0)4 93 18 32 53 Fax : +33 (0)4 93 18 78 40 Web : www.edhec.com

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Notes

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The Impact of Solvency II on Bond Management - July 2012

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An EDHEC Financial Analysis and Accounting Research Centre Publication

EDHEC Financial Analysis and Accounting Research Centre 16-18 rue du 4 septembre 75002 Paris - France E-mail: philippe.foulquier@edhec.edu Web : www.edhec.com/edhec-valuation

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