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Investing in non-base currency for Solvency 2 regulated investors

January 1st 2018 marked the second anniversary of Solvency 2 directive coming into force. The EU insurance legislation aims to unify a single EU insurance market and enhance consumer protection. The third-generation Insurance Directives established an "EU passport" (single licence) for insurers to operate in all member states if they fulfilled EU conditions.

Many member states concluded the EU minima were not enough, and took up their own reforms, which still led to differing regulations, hampering the goal of a single market.

The Directive has brought many benefits but it has also brought a sea change in how insurance companies invest their reserves. For example, a requirement to have documented investment risk processes another being the impact of investments on the Solvency Capital Requirement (SCR).

For asset managers targeting insurance clients, an understanding of the impact on the SCR is well known. Though one aspect is less well known – the impact of investing non-base currency securities and the hedging of this foreign exchange exposure back into base currency.

Investing in non base currency assets triggers additional Capital Requirement for Solvency 2 regulated firms. In the Solvency 2 Capital Requirement, the standard formula for Market risk is generating a 25% capital requirement for the currency exposure. Such drag may discourage Solvency 2 regulated investors unless forex hedging is properly organized.

Investing into a non base currency fund

Forex capital requirement comes from the non base currency portion of the fund. Let’s take the example of a EUR based investor investing into a USD-denominated fund that holds 30% of USD assets, 20% of EUR assets and 50% of other currency assets. The forex related capital requirement would be 25% of 80%, that is 20%, if diversification mechanisms are ignored.

Investing into an investor base currency share class

Let’s take the same example with the EUR based investor investing into the EUR share class of a USD fund. A EUR/USD forex forward contract with a nominal of the value of the share class is used to offer a global share class hedge. This contract is lowering the USD exposure from plus 30% to minus 70%, and the remaining currencies remain at 50%. In absolute value, the exposure to currencies is 70 + 50 that is 120%, bringing the forex capital requirement to 30%, higher than the 20% of the USD denominated fund.

Investing into Multiple Passive Currency Overlays (MPCO) fund

Multiple Passive Overlay consists in hedging each currency against the base currency of the investor. The euro share class of the fund has no exposure to any currency other than euro. The forex related capital requirement goes down to 0% (zero pourcent).

The magnitude of the cost of Multiple Passive Overlay, around 0.1%, is much lower than the additional return to generate to cover for the extra capital requirement which would be in percents.

Global forex hedging

Larger Solvency 2 regulated firms are collecting underlying assets of all the funds they are holding with the look through process. They are running a global forex book and are capable to precisely manage their global currency exposure.

For those firms that do not want to manage by themselves this forex exposure, MPCO hedged shares are clearly more appealing than the globally hedged shares or the USD shares.

Promoting a fund that has an unclear forex capital requirement can be more difficult than promoting a fund without FX drag.

Return on Solvency Capital Requirement (RoSCR)

Forex is only one component of the market risk of the Solvency Capital Requirement.

The real game is to compute the market part of Solvency Capital Requirement for various investments when they are not forex hedged (SCR) and when they are forex hedged currency by currency (SCRwFXH), just like with Multiple Passive Currency Overlays.
And then to compare the Expected Return (ER) of these investments to their two capital requirements, with or without forex hedge

The table below shows twelve major market indices, the market part of their Solvency Capital Requirement, that is the sum of requirements for interest rate, equities, spread, concentration, forex and diversification, without and with forex hedge, and expected return of these indices, the respective returns on capital.

The indicator is ratio of Expected Return of Index minus Expected Return of Sovereign Bonds over Volatility.

highlights exposure to currencies other than euro
highlights the best in class

This table indicates that indices investments with exposure to currencies other than euro show rather unattractive returns against Solvency 2 Capital Requirement, unless a proper forex hedge is made.

Conclusion

In summary, it is clear, that, foreign exchange exposure of investments has an impact on the capital ratios, at Solvency II regulated firms.

The mechanisms to achieve the same final economic outcome are numerous and the impact on the SCR varied. The investor and the manufacturer needs to ensure the investment route is the most SCR efficient. 

With both the foreign exchange solutions and Solvency II reporting tools SGSS is equipped to support the investor and manufacturer.

[1]  Asset Allocation Under SCR Constraints by Loïc Brach
[2] Expected return minus Sovereign Bond expected return over volatility
[3] JPM GBI EMU
[4] JPM GLOBAL GBI unhedged
[5] IBOXX EURO CORP
[6] MERRIL LYNCH EHY BB-B CONST
[7] BARCAYS EURO AGGREGATE
[8] JPM GBI-EM GL DIV COMP
[9] JPM EMBI
[10] MSCI EURO
[11] MSCI WORLD
[12] MSCI EM
[13] 70% EUR Bond 30% EUR MSCI
[14] 50% EUR Bond 50% EUR MSCI

Head of Strategic Marketing Societe Generale Securities Services
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