Solvency II will have an impact not only on the insurance industry but on the sectors in which it invests. In this article, John Forbes, Partner at PwC, offers a view of Solvency II from the perspective of the real estate industry.
The publication of Omnibus II in July all but confirmed a delay in the implementation of Solvency II until 2014, as well as clarified on a number of transitional and technical matters. Unfortunately it did little to address the continuing concerns of the real estate industry. Areas such as the impact of the property shock under the standard model and the treatment of investments in funds continue to worry the industry.
Life insurance companies are major investors, directly and indirectly, in real estate as an asset class. Although real estate as an asset class represents only a small proportion of the total balance sheet for insurers, for the real estate industry, life insurers represent a major element of the long-term investment capital in the market; as do pension funds that may also in due course fall within the framework of Solvency II. The current uncertainty regarding Solvency II is causing the insurers to delay the deployment of capital. For the real estate market, the anticipated delay is prolonging the uncertainty without adding clarity.
Much of the real estate industry attention has focused on the amount by which insurers need to write down the value of their investment assets under the standard model. Currently the proposal is that the shock to be applied to direct real estate investments is 25% (i.e. insurers should write down the book value of their real estate investments by 25%) from a starting point that the assets are carried in the books at market value. To add to the uncertainty, the majority of larger insurers are expected to seek permission to use an internal model, which could result in a lower write down. But this may take some time as the approval of internal models rests with local country regulators.
The real estate industry thinks the proposed shock is too high. In April, the Investment Property Databank (IPD) published a study on the impact of Solvency II on real estate investment. This study was funded by a consortium of seven key trade bodies, each supporting an aspect of insurance company investment in property and more broadly. It identified a number of areas of concern, but in respect of the property shock, suggested that 15% was a more accurate reflection of pan-European volatility.
Since publication, the IPD has updated its analysis, continuing to support its view of the currently proposed property shock. This will hopefully carry weight with the EU regulator, but perhaps almost as importantly, provide evidence for both insurers preparing their own internal models and the local regulators responsible for approving them.
The 25% market shock also affects the way that real estate debt is treated in the books of insurers. The standard model requires that for loans secured by a mortgage, the value of the collateral is written down by the standard shock. This potentially makes secured real estate lending a more attractive proposition than direct real estate investment.
The treatment of real estate investment through funds under Solvency II is even more unclear. This is a major concern as it is encouraging insurers to postpone deploying capital with real estate fund managers.
It would seem that un-geared funds would be treated as if the assets were held directly, i.e. the 25% write down should be applied. For geared funds, the position is less clear, but it would appear that the equity shocks should apply: these are 49% for unlisted vehicles and 39% for listed.
However, it should be noted that these shocks are applied to the net value of the equity whereas the 25% for property is applied to the gross value before gearing. The equity shocks are also adjusted depending on the regulator’s view of the state of the market at the time, through the mechanism of the dampener.
Clearly insurers and fund managers need to know whether funds should be treated as transparent or as equity investments, whether using the standard models or an internal model. This is not as straightforward as might be assumed
Real estate funds cover a broad spectrum and that should be reflected in the regulation. The nature of the investment vehicles varies considerably, as does the way in which they are financed, the level of gearing and indeed the nature of the underlying investments. For an open-ended vehicle, with low levels of gearing and core, low-risk underlying assets, the transparent treatment would seem most appropriate. At the other end of the spectrum, a closed ended real-estate private equity fund with high levels of gearing and underlying assets with significant operating risk (for example investments in hotels) is difficult to distinguish from any other form of private equity fund.
Choosing either look through or an opaque approach and applying it to all real estate funds would be highly inappropriate given the spectrum outlined above. Furthermore within this spectrum, there are funds that have a broad range of characteristics, some of which would suggest one treatment and some the other.
Defining some form of segmentation through regulation is unlikely to be successful. Many eminent figures and organisations in the real estate industry have attempted to adequately define different fund styles and strategies during the last decade. Their efforts have only been partially successful and it would seem unlikely that the insurance regulator would be better placed to come up with a sensible approach. The most obvious option would be to allow insurers to decide on a case by case basis whether to treat an investment in a real estate vehicle as transparent or equity.
The author is a Partner at PwC. The views expressed are the author’s own.