Research for INREV shows draft insurance rules over-estimate property risk, writes Alex Catalano
The Solvency II proposal that insurers should set aside capital to cover a 25% fall in the value of their real estate investments is much too high and should be lowered to 15%, according to European unlisted real estate funds body INREV.
INREV and six other European trade bodies unveiled independent research to back its argument that the regulatory regime being proposed for European insurers is too harsh and will penalise real estate. “The [real estate] value at risk in the UK is close to 25%, but it isn’t in the eurozone,” says Michael Morgenroth, chairman of INREV and management board member at Gothaer Asset Management.
Solvency II bases its 25% figure on just one data series: IPD’s UK monthly index. This set alarm bells ringing among insurers and fund managers across Europe. They argue that other European property markets have been much more stable and that imposing this ‘one size fits all’ 25% figure on real estate is wrong and would reduce insurance companies’ investment in the asset class.
“The research supports our view that the shock factor for real estate should be no more than 15%,” says Morgenroth. “That was our gut feeling and results show that gut feel is sometimes accurate. “Having a 0% capital charge for Greek government bonds and 25% for German residential property, which is very stable, is unbalanced and would mislead allocators. If nothing changes, insurance companies would switch to government bonds and fixed-income investments. Lowering the real estate capital charge would keep it on a level with other asset classes and would not reduce allocations.”
INREV also argues that the higher capital charge would cause insurers to favour real estate in riskier, more volatile markets and investments, whereas Solvency II is meant to make insurers more prudent. Nearly 40% of eurozone insurers surveyed by the research said they think they will have to cut exposure to core assets if they are forced to use something like the standard 25% formula.
“If you are investing in something with a very high capital charge and an expensive cost of capital, you have to go for high returns,” notes Jeff Jacobson, LaSalle Investment Management’s global chief investment officer. “You’re going to push the risk tolerance if you’re looking for returns.” Jacobson points to the US market, where in the 1980s, higher capital charges for owning equity in real estate led insurers to significantly cut their direct investment in the asset class.
A higher-risk strategy
“The insurance companies morphed into very big lenders and tried to get higher, quasi-equity returns in a bond structure that worked better for the regulators: mezzanine debt and convertible debt with kickers. Any insurance company money that does go to real estate on the equity side is relatively small, but it’s all in the higher-risk, higher-return area because of its costs. I suspect you would see similar trends here.”
INREV has embarked on an 11th-hour drive to persuade European regulators to lower the capital charge. According to Morgenroth, INREV found the regulators to be “open-minded” during initial talks. “They see the weakness of basing parameters on the UK, which is more volatile,” he said.
Morgenroth acknowledges that “having one number for the whole European market doesn’t really make sense, but it is all we can achieve for now. At the moment there is no way the regulators want to add more complexity.” The final form of Solvency II rules will emerge sometime later this year and the legislation is due to come into force at the start of 2013. INREV is planning to discuss the research with European Union officials in May and is hopeful of getting its proposed change adopted. “We are late, but not too late,” says Morgenroth.
IPD takes far less risky view of European property
To get a more nuanced and fairer reflection of real estate risk in Europe, INREV turned to Investment Property Databank. Solvency II used just one index – IPD’s monthly one for the UK market – to reach its 25% market ‘shock factor’ that European insurers will need to set aside capital to cover.
For INREV, IPD looked at data across 15 countries, lease regimes and sectors. It also used a new methodology – the IPD Transaction Linked Index – to provide a better measure of market volatility.
“We created 10-year quarterly indices for each of the main European property markets, which showed how, in the deepest and most closely synchronised of global economic upheavals, those markets have demonstrated three clearly distinct patterns of property investment response,” said Ian Cullen, co-founding director of IPD.
“By adjusting the valuation-based indices one step further – through transaction linking – our analysis revealed patterns of extra volatility and values at risk above valuation-determined levels, which also vary by market and region.”
For the UK, IPD’s analysis indicates a 23.3% capital charge, while for France and The Netherlands, the rates are 8.1% and 8.9% respectively. The blended rate for the eurozone is 10.4%, while the blend for the UK and eurozone came out at 13.3%.
“If the broadest available pan-European property shock factor was requested now of IPD, this would be no higher than 15%,” said Cullen. The research also examined the way in which the current Solvency II proposals reflect correlations between property and other asset classes, and property and interest rates. These correlations also appeared to be heavily weighted toward the UK, making them higher than they might otherwise be.