Solvency II and Derivatives – Part 2

Part 2: Prudent Person Principle and Efficient Portfolio Management

As a firm specialising in managing pure relative value strategies, where derivatives play a central role, we are keen to open the conversation around how these instruments can be used effectively and prudently within the constraints of Solvency II (SII) through a short series of papers.

The first paper, exploring how SII applies to the use of derivatives within a pure relative value investment strategy, laid the groundwork for the series by outlining how we understand the core principles of SII as they relate to derivatives in a pure RV context. In this second paper, we look closely at the Prudent Person Principle and employing derivatives in the context of Efficient Portfolio Management (EPM).

What is the Prudent Person Principle?

The first step in assessing the use of derivatives in a Solvency II portfolio is to see whether or not they adhere to the Prudent Person Principle [PPP]. The Prudent Person Principle requires insurance and reinsurance undertakings to only invest the monies, held for regulatory purposes, in assets whose risks they can thoroughly understand, monitor, and manage.

According to the European Insurance and Occupational Pensions Authority (EIOPA), PPP dictates that “All assets … shall be invested in such a manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole” and includes the need to be adequately diversified. This means that derivatives are permitted to be used in portfolios if they “contribute to a reduction of risks or facilitate efficient portfolio management”.

The key concept is that the use of derivatives should not result in a substantial change in the portfolio’s risk profile or add any material risks, such as unlimited or excessive losses, for example by considerably increasing the leverage of the portfolio.

EIOPA explicitly excludes derivatives that assign risk exposures different to the investment policy as well as naked short-sales, excessive leverage, and high frequency transaction arbitrage strategy-driven products, all of which are deemed to be ‘speculative’ activities that may endanger the quality, security, profitability and liquidity of the overall portfolio.

So, while Solvency II allows the use of derivatives, there are restrictions on the speculative use of derivatives in regulatory capital portfolios. For example, a speculative trade might be a short position in interest rate futures contracts, where the purpose is not risk mitigation but rather to gain from predicted interest rate decreases.

Once the use of derivatives passes the PPP, it is then permitted within an insurance portfolio. It must then be classified as either efficient portfolio management (covered here) or risk mitigation (covered in the next paper), with each classification attracting different capital treatment.

What is meant by Efficient Portfolio Management?

Efficient Portfolio Management is any use of derivatives that are “used to create exposures in a more efficient way, including cost reduction, anticipated re-investments or income enhancement” but not to reduce risks. In short, the use of derivatives to add efficiency but that have been deemed to have no risk-mitigating capabilities under SII. In this case, the SII charge will not benefit from any offsetting negative shock that may have otherwise occurred for a security utilised for hedging purposes.

For example, in the case of a short bond futures position, a downwards shock of interest rates would lead to a decrease in value and thus increase the capital charge.

Naturally in the corresponding upwards shock one would expect this position to increase in value and thus reduce the capital charge, but if the position is deemed as efficient portfolio management rather than risk mitigating then it will receive zero charge. In short, a position will only contribute to the charge under scenarios where it would lose value and increase the charge. In this case there is no risk mitigating capacity of derivatives.

RV Strategies and EPM

Given the theoretical context above, many of the derivatives that an RV strategy employs are implemented for both risk-mitigating and efficient portfolio management purposes. Under the Prudent Person rules, however, derivatives’ use cannot be used for both. Focusing on EPM, many of the derivatives utilised as part of an RV strategy would therefore be considered to be enhancing portfolio efficiency.

For example, an RV strategy often invests in bond options rather than bonds where the relative value metrics are comparable to efficiently gain exposure to both RV and optionality (gamma) at the same time. Further the additional liquidity that the derivatives market provides over and above the physical market is considered “efficient portfolio management”. Trading more liquid assets contributes to a reduction in transaction costs relative to less liquid assets.

Under Solvency II, managers may need to demonstrate that the derivatives employed within a relative value strategy are plain vanilla interest rate instruments, characterised by simplicity and independence. This supports the argument that such instruments do not require overly complex models and can be subject to transparent, daily independent valuation.

In addition, managers may need to show that portfolio exposures are concentrated in high-quality, assets and their associated derivatives, consistent with prudent person principles. Evidence of a robust liquidity management framework is also expected, with stress testing across a range of asset and liability scenarios to demonstrate the ability to meet obligations under different conditions. Demonstrating daily liquidity further reinforces that derivative use is consistent with efficient portfolio management and does not introduce undue risk.

Conclusion

To achieve a pure relative value strategy that complies with Solvency II’s derivative use classification, derivative positions must be applied either for efficient portfolio management or for risk mitigation, but not both simultaneously. In practice, this requires managers to clearly demonstrate the purpose of each derivative exposure and to ensure that its classification is well supported. Independent assessment and robust documentation play an important role in providing evidence that derivative use is consistent with regulatory expectations and is not speculative in nature.

Our next paper will explore in greater detail what a classification of risk mitigation entails under Solvency II, and how this designation can influence portfolio construction and capital treatment.

Important Information

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