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When John Forbes published his paper in 2010, "Ammonites, Extinction Events and the Real Estate Investment Management Industry" looking at the major challenges facing real estate investment managers, the looming introduction of Solvency II was identified as a major challenge. At that point, Solvency II was expected to come into effect on 1st January 2013. The Directive finally came into force on 1st January 2016.
Now that the Directive has come into full effect, it would seem to be a good time to reflect about what it might mean in practice.
Solvency II is a fundamental reform of the capital adequacy regime for the European insurance industry. It aims to establish a revised set of EU-wide capital requirements and risk management standards for the insurance industry and replaces an array of related Directives introduced since 1973. Although it governs all types of insurance businesses, the interest to the real estate industry lies primarily with the treatment of life insurance companies who are major investors in real estate as an asset class. It is life insurers that are most likely to be materially affected by the Directive, particularly where the risk of a mismatch between insurance obligations and the returns on investments sits with the insurer. Where the investment product is unit-linked such that the risk of volatility of investments passes straight through to the unit holders, the product will fall outside the requirements of the Solvency Capital Requirement. Life Insurers with a high proportion of products offering a guaranteed return, for example German life companies, are going to find themselves under most pressure. These will not be apparent immediately as there is a transitional period for the valuation of technical provisions over 16 years. Over this period, we can expect consolidation in the industry, an acceleration of the shift away from guaranteed to unit-linked products and pressure on life insurers to move to investments with a lower capital costs.
Solvency II blog
January 2016
For traditional products which do generate a quantifiable liability, there will be benefits to the insurer for having a pool of investments that qualify for the Matching Adjustment to directly offset assets and liabilities. The conditions are strict, the assets must deliver a guaranteed income without prepayment risk. As such, it will generally be fixed rate, fixed term debt with make good provisions on prepayment, or some form of packaged product that achieves the same end. None of this particularly favours direct property as an asset class.
For those insurance companies that continue to invest in real estate, directly or indirectly, the demands for investment managers are likely to increase. The larger insurers will be generally using their own internally generated models to calculate Solvency Capital Requirements. They will require detailed data on underlying property investments, whether the investment is directly via a separate account or via a fund as the default treatment is that investments through funds will be dealt with on a look through basis. There will also be a heightened focus on risk management, controls environment and the general operational capabilities of investment managers. Those who feel that the due diligence process has already become highly intrusive are likely to find that the direction of travel will remain unchanged.
On the positive side, those managers who are able to offer attractive products and to meet the other Solvency II requirements will have a major competitive advantage.
