- The 25% capital charge for property investments, required by EIOPA using the British property market as a reference, is overestimated. We show that the capital charge is only 9% when using a Euro zone index and 14% when using a French index.
- Diversification gains between property and financial assets appear to be systematically underestimated by EIOPA. The analysis shows that the correlation between real estate and equities is close to zero and that correlation with spreads is negative.
- The European insurance sector currently has €10 trillion worth of outstanding investments, of which €0.4 trillion are invested in real estate assets. According to many insurance companies, the excessive calibration of Solvency II could prevent their return to the property market.
In a position paper entitled “The Impact of Solvency II Prudential Regulation on Property Financing in the Insurance Industry”, the Financial Analysis and Accounting Research Centre and the Economics Research Centre at EDHEC Business School conduct a critical analysis of the calibration of property risk under Solvency II prudential regulation.
This study, conducted in partnership with the French Ministry for Housing, tests the robustness of the calculations for two key elements within the Solvency II calibration – the size of the property shock (Value-at-Risk) and the correlation of real estate with other asset classes.
The challenge of this analysis is sizeable given that the European insurance sector currently has €10 trillion worth of outstanding investments. Real estate has historically played an important role in the asset-liability management (ALM) activities of insurance companies, given its long duration, its contribution to the diversification of portfolio risk, its ability to hedge inflation risk, and its performance. Today, the role of real estate within the ALM activities of insurers must be assessed not only against these traditional indicators, but also in line with the Solvency II regulatory capital requirement.
The 25% capital charge for property investments, required by EIOPA using the British property market as a reference, is highly controversial and often regarded as one of the major obstacles impeding insurers from boosting the real estate share of their portfolios. It restricts the duration matching of assets and liabilities, and also hinders the diversification of assets under management.
“By making use of multiple data sources and complementary methodologies, our study shows that the 25% capital charge imposed on property investments is overestimated. The VaRs calculated in the study are highly variable depending on the geography and the type of property in question (in terms of absolute value, figures are higher for office property and in the United Kingdom than they are for residential property and within the euro area), but they are significantly lower than the benchmark level set by Solvency II. In other words, the risk considered is overestimated. Furthermore, it appears that the potential gains from diversification between property and financial assets have been underestimated”, explains Philippe Foulquier, Director of the Financial Analysis and Accounting Research Centre at EDHEC Business School.
Given the systematic biases identified within estimations of VaR and of correlation coefficients, this study assesses the overall impact of Solvency II calibration choices on the market risk solvency capital requirement (SCR). A simulation using new estimates results in a significant reduction in capital requirements (between 10% and 20% depending on the share of real estate in the portfolio). This confirms that the current calibrations used by EIOPA are a real obstacle, impeding the return of insurers to the property market.
You can download this study here.