The Solvency II regulatory framework doesn’t necessarily have to be a burden. New Robeco research shows how a multi-factor approach that integrates a solvency capital requirement, or SCR ‘factor’, can help insurers and those pension companies to which it applies increase their return on capital and thus tailor their corporate bond portfolios to better fulfill capital buffer requirements.
This ‘Basel for insurers’, as it is sometimes referred to, is a regulatory framework that came into effect at the beginning of 2016 and incorporates governance, risk management and disclosure elements. In addition to giving supervisory bodies a better idea of whether companies are in financial difficulty and promoting confidence in the stability of the sector, the aim of Solvency II is to reduce losses suffered by policyholders if an insurer or pension company is unable to meet its claims. To that end, it prescribes capital buffers that these companies are required to maintain to protect against negative market movements. And it is this part of the framework that is causing the companies affected to shift their focus from optimizing risk-adjusted returns to improving their return on capital, (a portfolio’s return divided by the amount of capital it is required to have under Solvency II).
A new paper by head of Quantitative Credits Patrick Houweling and quantitative researcher Frederik Muskens looks at how the integration of Solvency II capital requirements into factor credit strategies can increase a portfolio’s return on capital. Their analysis focuses on the credit risk solvency capital requirement (SCR) for corporate bonds, which stipulates that institutions must hold more capital for longer-dated and lower-rated bonds. For example, the SCR for a BBB-rated bond with 5-year duration is nearly four times as high as for an A-rated bond with 2.5-year duration. This means that to generate the same return on capital, the return will also need to be four times as high.
Research has already demonstrated that a portfolio that targets factors such as value, momentum, size, low risk, and quality generates a higher Sharpe ratio than a passive credit portfolio by harvesting factor premiums. The authors of this paper go on to show that there is a positive correlation between the SCR and volatility, but that shorter-dated bonds are treated more favorably under Solvency II: their SCR is relatively low compared to their volatility. In addition to its higher Sharpe ratio, a factor portfolio also generates a higher return on capital than a passive credit portfolio. But, as illustrated in the bar chart below, if the SCR ‘factor’ is then also explicitly taken into account, the portfolio can be tilted to provide optimal exposure to those bonds that score well on factors, but require a limited amount of capital, thus further improving the return on capital.
On a practical level, because factor investment strategies are systematic by nature, it is not difficult to efficiently incorporate additional parameters, such as this SCR metric. The approach can be implemented in a flexible way so the importance of the SCR element in a portfolio can be adjusted. This is especially important, given that the optimal level of SCR integration can vary significantly from one client to another and is highly dependent on their specific goals and guidelines; for example, the level of risk they are willing to take, the corresponding level of Solvency II capital required, and the desired level of credit returns.
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