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Fitch: Solvency II Set to Reshape Asset Allocation and Capital Markets

Fitch Ratings says in a newly-published report that Solvency II, the new regulatory regime for European insurers from 1 January 2013, is poised to transform how insurers allocate their assets, leading to shifts in demand and pricing for several asset classes.

The report, entitled “Solvency II Set to Reshape Asset Allocation and Capital Markets”, highlights that the new rules will require insurers to value asset and liabilities at market value in determining their solvency position.

“Solvency II will force insurers to set aside explicit capital to reflect short-term volatility in the market value of the assets they hold,” says Clara Hughes, Director in Fitch’s Insurance team. “Insurers’ asset allocations will be heavily influenced by these capital charges, which vary significantly by asset class, quality and duration. This is a fundamental change from current asset allocations, which are driven by expected long-term investment returns.”

The main impacts would be a shift from long-term to shorter-term debt; an increase in the attractiveness of higher-rated corporate debt and government bonds; diversification of large asset holdings; an increase in the attractiveness of covered bonds; a preference for assets based on the long-term swap rate and a shift from short-dated paper to deposits.

European insurers are the largest investors in the European financial markets, holding EUR6.7trn of assets including more than EUR3trn of government and corporate debt.

Fitch expects to see better duration matching with derivatives such as swaps and floors and an increase in downside protection to mitigate the impact of the new capital charges. Fitch also anticipates an increase in financial engineering to create Solvency II-friendly assets such as reverse repos and structured notes, which can optimise return on capital

However, Fitch considers it unlikely that large-scale reallocations will happen in the short term as transitional arrangements are likely to phase in implementation of Solvency II over several years.

Insurers will also have the option to calculate their capital position using an internal model rather than the proposed standard formula. This could offset the impact of any capital requirements in the standard formula that do not accurately reflect the risk in insurers’ portfolios.

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