Insurers unable to make property decisions due to lack of detail on EU rules, writes Alex Catalano
Solvency II, the new regulatory regime for European Union insurers, is casting a long shadow over the industry. The broad principles have been established, but uncertainty over the detailed rules is affecting insurers’ investment decisions. “With still so many unanswered questions as to how property will be treated from a capital perspective, it is slow going,” says Kiran Patel, global head of strategy and business development at AXA Real Estate Investment Managers.
“But insurers need to do something, because the market is moving; they are worried about inflation and they have a lot in bonds. We’re caught between two hard rocks – we need returns, but what do we do about regulation?” The implications of Solvency II for the property industry are potentially immense, since the capital charges required by the new regime will influence the allocations that insurers give to real estate.
“Real estate is right out there in terms of how it is held and capital charges against those holdings,” says Paul Clarke, chairman of PricewaterhouseCoopers’ European steering group on Solvency II. “Investors are not neutral as to whether it is a geared, ungeared, collective or corporate investment.” Current Solvency II proposals say that for direct real estate, insurers must set aside enough capital to cover a 25% fall in the market value of investments. The property funds industry is unhappy about this ‘one-size-fits-all’ formula, which is based on UK data, and is lobbying to change it.
INREV, the industry body for European unlisted real estate funds, and other industry groups have commissioned IPD to research the subject and will be publishing their report this month. However, insurers do have the option of using their own internal models, which may give property a less onerous charge than the standard 25%. “In the UK there is a long history of using internal models,” notes Alexander Taft, European head of investment structuring at Invesco Real Estate. “Around 100 applications have been sent in to the Financial Services Agency for approval. In Germany, the regulator refrains from looking at more than five – it is keen for insurers to use the standard model.”
Equities, including those of quoted property companies and REITs, carry a standard 39% capital charge, but here there is a damper that adjusts this for market downturns and upturns. The adjustment is calculated on where current global equity prices are relative to their average over the past three years. The mechanism is intended to avoid aggravating cycles: the idea is that if values have fallen (or risen) substantially, they are unlikely to continue moving in the same direction at the same rate, so the capital charge is lightened/increased accordingly.
Standard charge for property
However, Solvency II is not extending the same logic to real estate. “It carries a 25% capital charge in all circumstances, even when the market has tanked,” notes Clarke. In the case of other collective investment vehicles, such as property unit trusts and unlisted real estate funds, Solvency II looks at the underlying asset, so these are treated as though they were direct holdings and would also carry a 25% capital charge.
If there is gearing, Solvency II treats the investment as private equity and levies a 49% charge. “This doesn’t account for the amount of leverage and how that changes risk,” says Taft. “As fund managers, we’re putting up proposals for funds, but the question comes back: what is the capital charge? We don’t know. And the more complex things are, such as leveraged funds, the more questions are being raised,” says Patel.
Solvency II’s treatment of mortgages – debt secured on real estate – is even more complicated. Here the capital charge is calculated on the basis of the real estate collateral, net of a 25% haircut, securing the outstanding amount of the loan. If the property value is lower, the part that is unsecured attracts a big capital charge. The charge also zooms up if loans go into arrears.
Moreover, it is unclear where Solvency II positions shorter-term real estate lending. “You’re into the definitional area – does it meet the test of a mortgage or is it simply a loan?” asks Clarke. “It depends on the security arrangements.” The insurance industry is absorbing the results of QIS5, published this week (see news). This was the last major road-test for the draft rules, carried out by European insurance companies late last year; now the rules and ‘binding technical standards’ will be firmed up.
Some of the issues bedevilling real estate may be tweaked out of the final version of Solvency ll. “But at the moment, people can’t plan,” says Clarke. “They can’t design a structure they can market as ‘Solvency II–friendly’. “The EU thinks there is enough out there to plan adequately. But the industry thinks it’s not good enough – they need to make decisions now.”