Solvency II in focus – Considerations for building a diversified investment portfolio
In the fifth and final part of our serialisation of a Solvency II study, published recently by Clear Path Analysis, Charles Pears of Insight Investment discusses how insurers can build diversified investment portfolios with an eye on Solvency II restrictions, and what asset classes will provide challenges and opportunities.
The full report is available at https://www.clearpathanalysis.com/reports/solvency-ii-the-global-dimension-2012/
In the extract, below, Insight Investment’s Charles Pears says: “The return from a risk-free portfolio must be commensurate with the level of risk subsequently introduced, as well as the additional solvency capital required. Many investment managers have let down insurers in meeting these two principles, and this is a failing that Solvency II is likely to fully expose.”
Diversification is a valuable tool for any investor who wants to increase the probability of achieving their ultimate goal.
Spreading assets across a variety of investments reduces the overall impact of an unexpected shock rise or fall in one of those investments, in the same way that an insurer can underwrite a variety of uncorrelated risks to reduce the impact of a single event.
Solvency II rewards insurers for asset diversification by using a correlation-matrix approach to combine the different capital requirements for market risks, but complications arise as the correlation factors used to quantify the achievable benefits from diversification are typically more prudent than expected real-world correlations.
This complicates the argument for diversification, as insurers have to consider the marginal capital costs of investing in different asset classes alongside the impact on overall risk and potential returns.
Therefore, in approaching the question of diversification, insurers need to consider three factors. First, the purpose of diversification; second, how to incorporate capital considerations within diversification decisions; and finally, how positions can be managed over time.
The purpose of diversification
The starting point for an insurer is to look at matching their expected claims costs in as risk-free a manner as possible.
This ensures that the insurer can then make conscious decisions about acceptable market risk on the one hand, and any mismatch with their expected claims on the other.
For many insurers, this will lead to holding a portfolio of government bonds and similar low-risk instruments with a duration in line with that of their claims profile. However, they also need to factor in the real rate of return: in the current environment, short-term interest rates are low and inflation is high, and this supposedly safe portfolio would struggle to deliver a positive real return.