Download the article here Download PDF

Matthieu Froger

Head of Allocation & Hedging Insurance and Regulated Client Strategies AllianzGI

Olivier Videau

Head of Credit Insurance and Regulated Client Strategies AllianzGI

Philosophy of the current VA methodology (standard formula):

• Shift in the VA on the RFR curves used to assess economic capital with a general application ratio (GAR) of 65%.
• This VA is calculated for the currency zone (e.g. EUR).
• An alternative local VA model can be activated in specific circumstances (very rare cases).

Volatility has become a concern for insurance investors when it comes to managing their portfolios. Until recently, volatility adjustments had not yet posed a major challenge for insurers; however, after the strong volatility that impacted markets in 2020 during the Covid-19 pandemic, protection against large spread movements has become crucial.

When the Covid crisis hit in March 2020, spreads diverged abruptly. To discount liabilities, much higher rates had to be used. Liabilities lost a lot of value and assets (credit and equity components in particular) declined, giving rise to significant imbalance between movements on the assets and liabilities sides. Post-divergence, the tightening of spreads was equally abrupt (credit re-performed), generating a “saloon door” effect. Asset/liability risk is therefore due to these spread movements in a volatile environment.

Insurers are facing a regulatory interest rate discounting scenario, forcing them to discount their liabilities. This regulatory rate is adjusted for credit spread movements. When the spread changes very significantly, so too does the liability discount rate: spreads therefore have a major impact on liability valuation. Also, to “immunise” liabilities, assets must behave in the same way and must show the same sensitivity to spread movements.

The impact of credit spreads on the liability discount rate (volatility adjustment VA), is calculated by EIOPA (European Insurance and Occupational Pensions Authority). This VA portfolio reference is published by EIOPA in the first quarter and implemented at the end of March, with components being reviewed on a quarterly basis. This regulatory formula is based on the spreads of a benchmark credit portfolio representing the credit portfolios of major insurers.

The volatility adjustment (VA) therefore functions as a regulatory buffer on capital under Solvency II. It aims to offset the impact of market volatility (impacting the asset portfolio) on equity and the economic balance sheet structure. In Europe, the use of this regulatory device is popular with life insurers. Their UK counterparts largely prefer the matching adjustment (MA) alternative, which has a greater impact on equity but is more restrictive.

However, the volatility adjustment methodology also has its limitations: It is defined based on an exclusively European portfolio (reviewed quarterly, the portfolio is only representative of European investment portfolios). It focuses on fixed income investments only, giving rise to a highly concentrated portfolio that is as such “uninvestable” on the market. This methodology fails to take the client’s ALM profile into account: EIOPA has identified a VA overshooting effect on equity, generating uncontrolled volatility in insurers’ solvency ratios and further reducing their room for manoeuvre. As such, it seems that the VA dimension should be considered when analysing the client’s ALM profile and managing its balance sheet.

We have developed extensive expertise and a range of insurance strategies to help our clients protect their portfolios from the impacts of volatility. The Allianz Global Investors teams look at how the spreads of the VA reference portfolio have performed and determine the volatility adjustment to be applied to their management processes to protect client portfolios. The idea is to adjust portfolio assets to better replicate the volatility adjustment.

We have implemented a four-step process:

• We convert the EIOPA VA reference portfolio into an investable benchmark. The aim is to create an index that replicates the characteristics of the VA reference portfolio without the risks linked to the effects of volatility on a single rating or segment, etc. We address each of these main characteristics. When viewed from a matrix perspective, the resulting index is consistent with the VA portfolio reference’s rating and segment breakdown and remains investable thanks to its composition.
• Next, we create a dedicated benchmark that matches the client’s strategic allocation. We are often asked to adjust the “duration” value via this benchmark
• We then enter an optimisation phase: The benchmark includes the typical characteristics of a neutral portfolio position, but we also need to integrate guidance, the investment framework defined in consultation with the client (SCR, amount invested per type of issuer, etc.). To do this, we use a dedicated in-house tool (ISAO). We then build a target allocation to optimise return, SCR and tracking error
  
  By combining these two aspects, we get an optimisation area from our model. We also apply the client’s risk budget and our “house views” to adjust the level of risk we are collectively willing to take on as part of the investment strategy. This results in the “target” portfolio, i.e. the standard allocation.
• The last step involves building the portfolio line by line, in order to obtain the best SCR with the lowest possible tracking error

During this process, we differentiate between three levels of considerations when constructing the portfolio:

• Client objectives: strategic allocation (defining the benchmark and guidelines, i.e. maximum risk the client wants us to take on in managing their portfolio and achieving their objectives (maximum SCR, concentration per issuer, etc.)
• Tactical positioning based on our house views over a 3-6 month horizon. To respond quickly when required, we use tools such as portfolio trading (buying/selling a whole series of securities (usually credit) in a single transaction) in order to quickly reposition the portfolio and ensure that it continues to meet our client’s SCR constraints.
• Portfolio management, bringing together strategic and tactical frameworks, as well as further considerations like ESG objectives.

We draw on our entire insurance management expertise to provide clients with tailored solutions, thereby ensuring they are fully equipped to handle the impacts of volatility on their portfolios and assets/liabilities.

Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested. Investing in fixed income instruments may expose investors to various risks, including but not limited to creditworthiness, interest rate, liquidity and restricted flexibility risks. Changes to the economic environment and market conditions may affect these risks, resulting in an adverse effect to the value of the investment. During periods of rising nominal interest rates, the values of fixed income instruments (including short positions with respect to fixed income instruments) are generally expected to decline. Conversely, during periods of declining interest rates, the values of these instruments are generally expected to rise. Liquidity risk may possibly delay or prevent account withdrawals or redemptions. Past performance is not a reliable indicator of future results. If the currency in which the past performance is displayed differs from the currency of the country in which the investor resides, then the investor should be aware that due to the exchange rate fluctuations the performance shown may be higher or lower if converted into the investor’s local currency. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable at the time of publication. The conditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail. Information on Investor Rights in English are available here (www.regulatory.allianzgi.com). The duplication, publication, or transmission of the contents, irrespective of the form, is not permitted; except for the case of explicit permission by Allianz Global Investors GmbH.

For investors in Europe (ex. Switzerland)
This is a marketing communication issued by Allianz Global Investors GmbH, www.allianzgi.com, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, 60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht (www.bafin.de). Allianz Global Investors GmbH has established branches in the United Kingdom, France, Italy, Spain, Luxembourg, Sweden, Belgium and the Netherlands. Contact details and information on the local regulation are available here (www.allianzgi.com/Info). Information on Investor Rights in English are available here (www.regulatory.allianzgi.com).

For investors in Switzerland
This is a marketing communication issued by Allianz Global Investors (Schweiz) AG, a 100% subsidiary of Allianz Global Investors GmbH.

2013287