Conservative investing in a solvency framework
Are conservative credit and equity strategies attractive under solvency regulations? Conservative credits require less solvency capital than credits with average or high risk, which makes them attractive. Conservative equities, however, require the same solvency capital as equities with average or high risk. Investors therefore need to make a trade-off between return per unit of economic risk and return per unit of solvency capital.
• Conservative credits are attractive from an economic and regulatory perspective
• Their lower interest rate exposure can be increased with a swap overlay
• For conservative equities a trade-off may have to be made between return-to-risk and return-on-capital
In a recent study, we have examined the attraction of conservative investment strategies for pension funds and insurance companies that have to adhere to solvency regulations. Our primary focus was on the Nordics and the Netherlands, where the pension fund industry is well developed and the regulatory environments share many characteristics. Still, the insights of this study are more general, and can also be used in other countries with similar regulation.
A quick recap: what is conservative investing?
Conservative investing in corporate bonds means buying short-term bonds from issuers that are considered to be relatively safe. Buying only short-term bonds reduces the volatility from credit spread changes, while the spread itself is typically lower and less volatile for safe issuers. Historically, these conservative bonds have had a superior return-to-risk ratio.
Conservative investing in equities means buying stocks with little stock price fluctuations. This may be done by selecting stocks based on past volatility, beta, credit rating, or other metrics that have predictive power for future risk. Historically, these conservative equities have had a superior return-to-risk ratio, similarly to corporate bonds.
Is conservative investing attractive within a solvency framework?
From an economic point of view, both types of conservative investment strategies are beneficial for pension funds and insurance companies with limited capacity to bear downside risks or that welcome a lower volatility of their financial buffers, while maintaining upside potential. However, the standard models of most solvency frameworks, including Solvency II, treat risks in corporate bonds and equities differently.
Conservative corporate bonds require less solvency capital than corporate bonds with average or high risk characteristics. Therefore, it seems a no-brainer to invest in these bonds. There is a downside, however. Because of their shorter maturity, conservative credits have relatively low interest rate sensitivity or duration, so that they are typically not well suited to hedge long-term pension liabilities. Still, the solution is, in theory, straightforward. The pension fund or insurance company needs to deal with their aversion to leverage or derivatives. They may combine conservative credits with an interest rate swap overlay to increase the interest rate exposure.
Unlike conservative corporate bonds, conservative equities require the same solvency capital as equities with average or high risk. Investors are therefore required to make a trade-off between return per unit of economic risk (for example defined by return volatility) and return per unit of solvency capital. Whether investing in conservative equities is attractive in a solvency framework depends crucially on the whether the investor expects them to have a higher return than the market or high-risk equities. Although the empirical evidence that conservative equities have a higher return-to-risk ratio is overwhelming, whether they also have a higher performance than the market appears to differ across sample periods.
For return expectations equal to (or higher than) the market, the return-to-economic risk can be improved without increasing the solvency requirement, and conservative equities are therefore attractive even for solvency constrained investors.
If the investor expects the relationship between risk and return to be (slightly) positive, the return per unit of solvency capital will be lower for conservative equities. Indeed, one of the reasons why this low-volatility anomaly exists may be that investors cannot easily arbitrage this anomaly. They are forced to act on regulatory capital requirements such as the standard model in Solvency II instead of on economic risks. In such case, a trade-off between return to economic risk and return to solvency capital needs to be made. For investors that are constrained by solvency regulation, developing an internal model that is approved by the regulator might be a solution to reduce the standard Solvency Capital Requirement of investing in conservative equities.
A multi-asset approach to conservative investing is worth considering. Whether this is practically feasible may depend on constraints that we have not covered in our study (but that we would welcome discussing further), and the ability of stakeholders to leave their benchmark-relative investment paradigm.