In January 2016 Solvency II – a directive to codify and harmonise insurance law within the EU – became fully applicable to European insurers and reinsurers. The 2,000-page framework covers three main areas: capital requirements, risk management and supervisory rules.
The risk-based capital requirements in part oblige insurance companies to hold their own eligible funds in relation to their risk profiles to guarantee they have enough financial resources to withstand financial difficulties. In 2019, the legislation underwent a revision, with an important resultant opportunity for the European listed real estate sector.
Capital requirements for investments in real estate, or companies operating in the real estate sector, are calculated in the property and equity risk modules. Until recently, investments in listed real estate companies were treated as equity investments, leading to a capital charge of 39 per cent. In contrast, the risk charge for investments in direct property, which is based on the risk of a change in the level or the volatility of real estate market prices, was just 25 per cent.
The 2019 revision has created a new sub-category of “long-term investments in equities” that only requires a 22 per cent capital requirement, in contrast to the previous 39 per cent capital charge. The new Solvency II sub-category, Article 171a of the Solvency II-Delegated Regulation, became applicable in June 2019.
A study by Insurance Europe found that almost half (48 per cent) of insurers cited Solvency II capital requirements as the reason they have invested a sub-optimal amount in equities and listed real estate. This is strong evidence that the rules were ultimately inhibiting the best interests of end-investors, savers and pensioners.
Although there is every reason to treat listed real estate companies as long-term equity investments by reference to their asset base and correlation to other forms of real estate investment, the underlying conditions to apply this new sub-category have been considered by certain insurers as rather stringent.
For example, the sub-set of equity investments as well as the holding period of each equity investment within the sub-set must be clearly identified and assigned to the best estimate of a portfolio of insurance liabilities and as part of an overall (diversified) asset portfolio. This means that these clearly identifiable long-term equity investments are only a fraction of an asset portfolio, which is mapped to a portfolio of insurance contracts.
This allocation must be identified, managed and organised separately from the other activities of the insurance company, and cannot be used to cover losses arising from other activities of the undertaking. Although the assigned portfolio of assets (including the sub-set of equity) is not identified strictly as a ring-fenced fund, it does require documentation in a similar way to the Matching Adjustment regulation.
The European Commission’s proposal for insurance companies to hold listed real estate investments for a 12-year period was successfully lowered to five years.
Nevertheless, insurers must demonstrate their intention to hold the investment for such a period in their risk management, asset-liability management and investment policies, together with their ability to avoid forced sales of each equity investment within the sub-set for at least 10 years.
Insurance companies’ capital in Europe totals approximately €12 trillion. This is considerably more than the size of assets under management of European pension funds and is a significant pool of capital to have been unlocked. The next step is to enable and encourage insurers to take advantage of the new rules.
This is why the European Public Real Estate Association (EPRA) will focus its advocacy efforts on a general Solvency II review, which began this year and is foreseen to last until 2021, to further improve the terms and achieve an even more positive, common-sense investment framework that strengthens our industry.
Interested in knowing more about Solvency II and the listed real estate sector? Visit www.epra.com/public-affairs/policy-areas/financial-regulation.