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Integrating sustainability risks into insurance framework
The long-awaited 2020 Solvency II review is finally approaching the finish line. The new directive was published in the Official Journal of the European Union on 8 January and has come into force twenty days later. Member states will then have until January 2027 to transpose it into national law.
Most of the changes published in the directive were expected and in line with the draft compromise package already agreed in 2024. The major impacts are expected on the liability valuation side with the implementation of the new risk free curve extrapolation method, which will be phased in over five years, alongside the volatility adjustment. Both of these changes will increase liability values and negatively impact the insurance balance sheets, but this could be offset by some relief from a lower cost of capital in the calculation of the risk margin.
On the market risk SCR front, the main change is the introduction of the long-term equity investment, which replaces the duration based equity module. The eligibility criteria have been relaxed, reducing the capital charge by 22%. Both life and non-life companies could benefit from this change. The portfolio of long-term equity has to be clearly identified and managed separately. The undertaking needs to have the intention to hold these investments for over five years and demonstrate in the ORSA (Own Risk Solvency Assessment) that it will not be forced to sell under stressed conditions. Finally, it can be applied to OECD equity (not just EEA), listed or unlisted, and at fund level. The list of eligible collective investment schemes will be published in the upcoming delegated acts. This will support investments in alternative investment funds and public equities.
The delegated acts to be published will provide further details on other changes, such as interest rate risk module capital charges and ESG considerations.
In November 2024, The European Insurance and Occupational Pensions Authority (EIOPA) published the final report on the prudential treatment of sustainability risks within Solvency II. It is possible that the conclusions of this report will be implemented in the upcoming delegated acts. We summarise its key takeaways below.
Transition to net zero and market risk charges
There is a desire to accelerate the speed of transition to net zero of the insurance portfolio – but also to adequately capture the risks associated to climate change. In the current framework, those risks were solely treated under Pillar II as part of the Own Risk and Solvency Assessment (ORSA). However, a risk-based analysis combining both backward-looking (value at risk over a 10-year period) and forward-looking models (leveraging among others the scenarios of the network for greening of the financial system) provides strong evidence that additional market risk charges should be applied to assets that are particularly exposed to transition risk. The Solvency II framework is calibrated to capture the 1 in 200-year event; as such, a disorderly transition could have a significant impact on the real economy.
In a nutshell, the assets that are linked to fossil fuels will have an additional 17% shock added to equity solvency capital requirement (SCR) – bringing the shock for type 1 equity to 56%. This is in line with the outcome of the backward-looking value at risk analysis. Similarly, bonds will see their spread SCR charge increased by 40% (in multiplicative terms) which results from the forward-looking assessment.1
Sector identification, real estate, and investment impacts
To determine which assets are affected by this increase, the EIOPA relies on sector NACE codes to identify companies with activities linked to extraction of crude oil, natural gas and the mining of coal as their primary business. A more adequate approach would have been to assess individual asset’s exposure to greenhouse gas emissions and transition plans; however, the data is not complete and would have been highly impractical in terms of implementation.
As part of this report, real estate exposures have also been closely looked at, as there is evidence that low efficiency building suffer from price depreciation. Indeed, in some countries, low efficiency buildings cannot be rented out. This would imply significant enhancement work to improve energy efficiency.
The final two sections of the report looked at the non-life underwriting risk as well as social risks. More data would be required to reach any conclusion, these two areas are therefore left unchanged for the time being.
Insurer’s green investments have significantly increased over the years and the exposure to fossil fuel sectors should be minimal. The share of non-financial corporate bonds and equity investments that are taxonomy aligned and taxonomy eligible assets were 5.7% and 34.1% respectively in 2022 while it is now 10.7% and 48.6%.2 As such, we estimate that these changes will have a limited impact on Solvency ratios. The impact assessment of the proposed increased capital charges suggests solvency ratios might drop by just a couple of percentage points.
1 Source: Prudential Treatment of Sustainability Risks, Report, November 2024
2 Source: EIOPA, Insurers' green investments, November 2024
Author: Valerie Stephan, European Head of Insurance Strategy and Analytics, Global Insurance Solutions
The annual outlook ritual: a tradition of predictions
Each year-end, the investment world becomes inundated with the ritual of outlook pieces. Three characteristics define a good outlook piece: They commonly appear in early December, are often needlessly long, and call a halt to organised sell-side research activities until the New Year. An old friend of ours, a renowned oils analyst, released his 2025 outlook in early November, marking the end of his research year.
What remains unspoken amid the festivities is that outlooks are often incorrect. In fact, we’ve nurtured a pet thesis for a while that a sensible investment strategy might be to simply position against whatever view the sell side outlooks considered a base case. As 2025 looms ahead, we are reminded that cynicism is not always wrong, and that contrarian thinking always nurtures a stronger consensus. We can therefore be sure that the sell side’s belief – say on growth and inflation – is likely wrong. We just do not know why, when, and for how long it will be wrong. Reading this year’s crop of outlooks is a reminder that animal spirits are alive and well, at least in the hopes of sell-side analysts.
The Trump administration's economic impact
As Donald Trump begins his second Presidential term, entrepreneurial enthusiasm is about to find footing. The new administration plans a rapid raft of executive orders, some of which may be growth positive. Overall, we perceive the Trump administration and the Republican Congress as growth conducive, given Mr Trump's agenda. That agenda leans into fiscal stimulus – through tax cuts and other measures. Mr Trump has also talked up tariffs, which has raised concerns around trade flows and global growth. How far and how broadly tariffs extend will be a key area for investors to monitor.
The new US administration’s fiscal stimulus has altered our core expectations. In our most recent quarterly meeting, we raised our expectations of above trend growth from 20% to 40%, while reducing our expectation of sub trend growth from 60% to 40%. The latter expectation has been grinding down over the last 3 quarters. Our committee sees an equal probability of above and sub trend growth – but as an added tweak, they have also increased our expectations of both a recession and a crisis from 5% to 10%. Our committee expects a bifurcated market outcome, with a potential “tipping” into recession or crises. In our committee minutes, the team notes that the changes “mostly reflect the increased uncertainty stemming from the recent US election.”
Opportunities in rising yields and emerging markets
Anticipation of fiscal stimulus drove US Treasury yields upward, consequently exerting upward pressure on European yields. This has not always been a welcome development. In Europe, where higher borrowing costs have pressured stretched fiscal policy, it has been discomforting for some. Before the move, Europe’s monetary policymakers have begun to shift focus from cooling core inflation to stimulating growth. We think further the European Central Bank cuts are possible, given current growth and inflation in the Eurozone.
Rising yields do present opportunities for portfolio rebalancing. They also create opportunities for portfolio diversification. In this quarter’s update, we have included some work on emerging markets corporate debt. For investors impacted by solvency capital, emerging market corporate investment grade credit offers some of the most appealing yields which are available in markets today. In our view, investors are right to target this segment of the market for closer inspection.
Key point: the universe of issuers in the Emerging Market (EM) corporate space is much greater than that within the equity world. Building efficient portfolios is therefore easier for the fixed income community, as the country and sector diversification which can be achieved is appealing. In addition, variable bankruptcy law among EM countries, as well as the high prevalence of family companies among EM issuers makes the latter determined to avoid insolvency. Hence it is possible to be relatively overpaid to take corporate risk, versus more efficient credit markets in developed countries.
We hope it helps.
Author: Giles Bedford, Senior Investment Specialist, EMEA Insurance
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