solvency ii – investment implications

Solvency II – Investment Implications

January 2011

FOR UK INSURANCE COMPANIES ONLY. NOT FOR PUBLIC DISTRIBUTION

Solvency II_0111_BC.ppt

Good returns from bond markets but yields are historically low

2

Source: J.P. Morgan UK Government Bond IndexLatest data as at December 2010. Source: Federal Reserve Bank of England, Barclays Capital, J.P. Morgan

Government Bond Yields


3

Extremes in the equity markets

35

30 20041998199219911988

25 1987 20061985 20051978 2003

1994 1965 19991981 1962 1997

20 1979 1961 19961976 1956 19951970 1955 19891966 1951 19861964 1945 1984

15 1960 1944 19831952 1927 19821948 1926 19801947 1925 19721940 1923 1963

10 1939 1917 19501938 1916 1946

2001 1921 1912 19432000 1915 1910 1942 19931957 1913 1909 1941 1971

5 2002 1949 1911 1908 1936 19531990 1937 1907 1906 1935 1933 19771969 1930 1903 1905 1934 1922 1967 1968

2008 1931 1929 1901 1904 1928 1919 1958 19591974 1973 1920 1914 1900 1902 1924 1918 1932 1954 1975

-50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100 >100

Source: Elroy Dimson, Paul Marsh and Mike Staunton, Credit Suisse Global Investment Returns Sourcebook 2010

UK equity risk premium relative to bills, 1900 - 2010

2009

2007

2010

2008 2009


Asset allocation

4

Source: Association of British Insurers, Swiss Re Economic Research & Consulting Source: CEA

0%

20%

40%

60%

80%

100%

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Equities Fixed Income

Property, Alternatives, Other

UK Insurers European Insurers

0%

20%

40%

60%

80%

100%

Life Insurers Non-life Insurers

OtherCashReal EstateProperty-secured loansShares and equity trustsBonds, preferred shares and fixed-interest trustsGovernment securities


5

Solvency II

Changes the way:

Regulatory capital is calculated

Projected liability payments are discounted


6

Solvency II – Implication for bonds / credit

* Notes: 1) Under Solvency II QIS5 2) Profile of liabilities may affect the impact 3) Using an internal model can alter the impact

Gilts More use of gilts at high duration where yield is above swaps.Less use at lower duration.

Corporate Bonds More use of corporate bonds at low duration where risk adjusted return is higher.

Less use at higher duration.

Structured Credit, ABS etc 3 Significantly curtailed use of structured credit unless Standard calculation is amended

Source: J.P. Morgan Asset Management - January 2011


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Solvency II - Implication for other asset classes

Property 3 Lower allocation to propertyDue to higher capital charges, with no index based dampener

Issues with the treatment of property backed structures

Equity 3 Lower equity allocationDue to higher base charges that vary under a “symmetric adjustment” to levels

very much higher than currently appliedEEA/OECD listed preferred

Much higher charges will make “other” equity category unattractive.

Other, including: Hedge Funds, Private Equity, Commodity, Infrastructure 3

Lower allocationsThey are not well defined by QIS5

Unless they are sufficiently transparent to allow moving into another risk module (such as Global equity, property or spread (credit) risk), they are subject

to very high “other equity” charges.

Total Return 3 Wider use of total returnDue to investment mandates becoming less constrained with aims to “beat

cash” plus the illiquidity premium




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Solvency II – Implications from liability discounting methodology

Swaps Greater use of swapsDue to the valuation interest rate curve for discounting liabilities is based on the

swap curve.

Generic Credit Unknown at presentCIOs will need to deal with some complex issues for benchmark setting or

asset allocation that arise from the use of an illiquidity premium which is based on a corporate bond index

Illiquidity premium varies by type of business (with-profits, annuities, all remainder)

At present this illiquidity premium is not ‘matched’ by any available investment




9

Solvency II - Transparency and ‘Look through’

Segregated Mandates Attraction of segregated mandates increasesEspecially if using an internal model due to the “look-through” requirements

Collective Investment Funds Transparent funds preferred to those that are notRequirement to apply “look-through” approach will raise a “hassle” factor

barrier that fund managers will have to address to retain insurance investors

Currency overlay mandates Attraction of currency overlay mandatesDue to advantage of hedging currency risk, otherwise currency risk carries a

25% charge




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Summary – attractiveness of asset classes under Solvency II QIS5 versus current position

Short Govts

Short Corp.

Long Govts

Long Corp.

EM Debt

Property

Total Return

Equities

Currency overlay

Swaps

Transparency

Segregated mandates

Generic credit

?

* Notes: 1) Under Solvency II QIS5 2) Profile of liabilities may affect the impact 3) Using an internal model can alter the impact 4) Not drawn to scale

Expected risk

Exp

ect

ed

re

turn



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Known Unknowns

Changes to Solvency II regulations

Changes to accounting standards

Markets ‘price-in’ Solvency II effects

Development of Solvency II ‘efficient’ investment products


Outlook for 2011-2012

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Deflation Disinflation Inflation

Equities drift to new lows in 2011

Equities drift to new lows in 2012

Markets rerated towards new all-

time highs in 2011

Markets trend sideways to up

Bond yields soar, equities suffer,

new lows in 2010

Bonds plummet equities up but underperform commodities

15% 60% 25%

20% 80% 50% 50% 50% 50%

NEW LOWS NEW LOWSNEW HIGHSNEW LOWS NO EXTREMES NO EXTREMES

QE fails

Recovery stalls during 2010

Lost hope

Growth snuffed out by rising

yields in 2012

Dream ticket

Sub-par growth, easy policy

Party Pooped

Policy stimulus removed 2011/12

Stagflation

Yields rise, growth stalls

Fast & Loose

Rapid growth, surging inflation


Conclusion

What to consider:

Resources

Dialogue with asset manager

Investment strategy – including consideration of:

– Profile of liabilities

– Market environment and opportunities

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Important Information

This material is for the use of UK insurance companies only – not for onward distribution

The value of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. Investing in alternative assets involves higher risks than traditional investments and investors should consult a professional adviser prior to investing. Alternative investments have higher fees than traditional investments, may not be tax efficient and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain. The information provided is for use by professional investors within UK insurance companies only and is not for public distribution.

It may include opinions based upon understanding of complex regulatory proposals that may well change or not be implemented at all. The services being promoted are not, are not intended to be and should not be construed as providing investment advice or advice on regulatory requirements or the law. Readers should take appropriate independent professional advice on such matters which is relevant to their particular situation before acting on anything contained in this document. This document is for informational purposes only and is intended solely for the person to whom it is delivered by J.P. Morgan Asset Management. This document is confidential and may not be reproduced or distributed in any jurisdiction without the express prior written consent of J.P. Morgan Asset Management.

The opinions expressed are those held by J.P. Morgan Asset Management at the time of publication and are subject to change. This material should not be considered by the recipient as a recommendation relation to the acquisition or disposal of investments. This material does not contain sufficient information to support an investment decision and investors should ensure they obtain all available relevant information before making any investment.

Issued in the UK by JPMorgan Asset Management Marketing Limited which is authorised and regulated in the UK by the Financial Services Authority. Registered in England No. 288553. Registered address: 125 London Wall, London EC2Y 5AJ.

J.P. Morgan Asset Management

solvency ii – investment implications

Documents

equity charges

higher duration

solvency iichanges

global equity

credit risk

higher capital charges

private equity

lower equity allocationdue