OCTOBER 2016

SOLVENCY II

Investing in protected equity strategies, and

not just to save capital...
By Noémie Hadjadj-Gomes, Research financial engineer – Head of
rates and insurance projects

The current environment of extremely low interest rates is prompting investors to look for other
sources of yield, particularly on the equity market, but due to the markets’ volatility and the
accounting and regulatory requirements imposed on insurers, they are adopting strategies that
include tailored risk hedging. These strategies offer exposure to long-term equity returns, while
limiting extreme risks, at a lower regulatory cost.

A favourable regulatory and financial environment

As a result of the financial crisis and the preparatory work for the implementation of Solvency 2,
many insurers have significantly reduced their equity allocations.
For both life and non-life insurance companies, in the financial year 2015 the Market SCR accounted
for 78% of the BSCR (before operational risk and absorption by technical provisions and deferred tax),
and the Equity SCR accounted for 49% of the Market SCR (source: ACPR, Analyse et Synthèses,
December 2015). In other words, there is a lot at stake.

Source: ACPR, December 2015

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The current environment (which may persist for the foreseeable future), in which the stock markets
are seeing a combination of low bond yields and peaks in volatility, increases the challenges that
insurers must meet in their investment policies.

The introduction of asymmetrical strategies, which reduce both volatility and the loss in the event of
an extreme shock on the markets (and consequently the capital cost under Solvency 2), therefore
enables insurers to maintain, or even increase, their exposure to the equity market, to improve the
returns on their asset allocations and safeguard their long-term role in the financing of the economy.

An already vast array of solutions available on the marketplace

Against this backdrop, there has been a rise in the use of protected equity strategies in recent
months, with various underlyings hedged and in various formats, such as the hedging of a
management company’s index-related equity risk or equity strategy, or the tailored hedging of an
insurer’s equity portfolio, through packaged, open-ended or dedicated products combining equity
investment with hedges, or through hedge overlay solutions, and so on.
Leaving aside the underlying and the format, there are two major families of strategies: those that
combine an investment in equities with risk-hedging through options, and those that offer CPPI style
management along with a guarantee of the underlying portfolio’s maximum loss.

Option-based strategies and our Premium solutions

The first major family of protected equity solutions combines an investment in equities with risk-
hedging through options. The most naturally efficient strategy is the purchase of puts (options to sell),
but this is costly over the long term. It therefore needs to be refined to reduce its cost and improve
its market participation.
There are a number of variants in the marketplace, but strategies are most often structured along
two lines:
- A structural hedge (which may or may not be systematic) of the equity exposure, aimed at
stabilising and reducing both the risk profile and the capital cost (subject to a permanent
presence in the portfolio).
- An option-based strategy (which may or may not be systematic) of increasing returns by
selling options with short maturities, aimed at reducing the cost of hedging without raising
the fund’s risk profile.
The choice of hedging strategy (puts or put spreads), strike price, maturity, hedged notional amount,
rebalancing frequency, etc., varies depending on the manager.
As options are liquid and listed, they offer significant scope in terms of hedge size, and these
strategies do not generate a counterparty SCR.
This type of strategy may be applied to any asset class for which there is a sufficiently mature, deep
and liquid option market.
On the other hand, with these strategies it is difficult to assess the basic risk (see the inset below).

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Our Premium solutions fall within the option-based hedging family. The open-ended version
combines exposure to euro zone equities (open-ended fund with a measured tracking error), which is
an option-based hedging strategy aimed at reducing the underlying portfolio’s risks, and another,
discretionary option-based strategy whose goal is to reduce the cost of the hedge.
Note that our hedging strategy is permanently present within the portfolio, but is not systematic. We
capitalise on the different degrees of freedom (type of strategy – put versus put spread, strike prices,
maturities, nominal amounts, etc.) to dynamically manage the hedge as opportunities arise on the
market in order to reduce its cost.
- For example, the choice of strategy (puts or put spreads) will depend on the options’ implied
volatility, as capitalising on the property of returning to the average implied volatility reduces
the cost of the hedge over the long term. If the implied volatility is low, the hedge will
therefore mainly consist of purchases of puts that are sensitive to a higher implied volatility
(vega) and will profit more from a rise towards its average value. Conversely, if the implied
volatility is high, the hedge will mainly consist of purchases of put spreads that are sensitive
to a lower implied volatility (vega) and will suffer less from a fall towards its average value.
- With regard to the maturity of the options, we have decided to use options with a maturity
of between 12 and 24 months:
o The first reason for this is financial and concerns the options’ cost of carry, which is
higher the shorter the maturity. Although short maturity options are more
responsive to market shocks, they are much more expensive to carry structurally
over a long period than long maturity options.
o The second reason concerns the Solvency 2 directive. The “Risk-mitigation
techniques” section, which defines the calculation rules to be applied to hedging
instruments, penalises instruments whose maturity is less than 12 months (either
due to an unfavourable pro rata temporis, or a fairly high estimated roll cost over 12
months, especially given the high cost of carry of short maturity options).
- The strike price is mainly dictated by the target risk reduction and Market SCR for the
product, and is around 80% for puts and around 80% and 60% for put spreads, but may also
be marginally adjusted to increase or reduce the fund’s equity exposure according to the
management teams’ market convictions.
The dynamic management of this structural hedging strategy is a real source of added value.

The secondary option-based strategy, which aims to reduce the global cost of the hedge, mainly
consists of discretionary sales of calls. The maturity of the calls sold is short (between 1 and 2
months) as the cost of carry to be captured is the highest for these maturities. The strike price on the
initiation of the position may vary between 105% and 115% of the market level depending on the
option premiums and our market convictions. We also adopt a prudent approach (reduced
commitment, or no positions) for this type of strategy following a significant downturn in the equity
market. An historical analysis of the call sale strategy shows that the risk of a sharp upturn in the
equity market, and therefore the risk of a loss on the sale of calls, is higher after a steep downward
movement on the market.

We also have dedicated versions of hedged equity solutions, which are based on the same type of
strategy, but are intended to hedge client equity portfolios, with various formats (master/feeder or
overlay, depending on clients’ requirements). Note that the overlay format (a separate fund
allocated only to the hedging of one or more target funds) may be advantageous in accounting terms,

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as it does not require the realisation of the capital gains or losses underlying the investment in
equities. This format consumes more cash than the master/feeder structure, however.
With this type of structure, we are careful to assess the basic risk between the equity portfolio to be
hedged and the underlying of the options used. We calculate our various indicators before products
are launched, and monitor them monthly, in order to quickly alert the client if the basic risk is
excessive.

Close-up on the basic risk

The “Risk-mitigation techniques” section of the regulation states that, for a financial hedge to be
recognised under Solvency 2, the basic risk between the position hedged and the hedging
instrument's underlying must be “non-material”. The texts do not, however, refer to any indicators
or tolerance thresholds to quantify the materiality of the basic risk.

We believe that the first vital step is to analyse the basic risk in a qualitative way, as it may be
misleading to only use quantitative indicators. For example, the correlation between European
equities and US equities in 2009 was around 0.90, but clearly, hedging an investment in US equities
with options on the European equity market generates a not insignificant basic risk.
We must therefore start by examining the overlap between the investment universes, the securities
weighting methodologies, etc., before attempting to quantify the basic risk.

Correlation 26 weeks Equities EUR/ Eq US

Source: Bloomberg, CPR AM Research, August 2015

We can then go deeper using a series of statistical indicators to quantify the basic risk between the
equity fund to be hedged and the underlying of the options used for hedging purposes (the
eurostoxx 50 for the euro zone). These indicators cover the correlation, and also the beta, which
measures the systematic risk, the tracking error for the specific risk, and finally the R², which
measures the share of the equity fund’s variance explained by the variance in the index underlying
the options.

Note: We are well aware that these indicators are often called into question, as they only capture the
linear dependencies between the underlyings considered, but for the use made by us this seems quite
conservative: as our aim is to demonstrate a non-material basic risk (and therefore a strong relationship
between underlyings), we are only interested in the high correlation, beta and R² values, which does not
pose a problem in this regard.

It is well known that the links between assets change according to market conditions; these
indicators must therefore be studied over a sufficiently long period, and monitored over time to
make sure that the basic risk does not become excessive.

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 Source: Bloomberg, CPR AM Research, August 2015

To summarise, we believe that the spirit of the regulation is as follows: not all kinds of equity
investment may be hedged using listed options with a non-material basic risk; a reasonable and
simple approach must be taken.

Strategies with a bank guarantee covering the maximum loss

Regarding the second major family of protected equity solutions, the extreme risk of an investment
in equities is hedged using CPPI style management, whereby a performance-based equity exposure
desensitisation algorithm allows the manager to dynamically adjust their exposure in order to
protect the capital invested, while increasing the risk level if the underlying gains ground, and
otherwise reducing it. The strategy is secured by bank guarantee, which contractually reduces the
fund’s maximum loss and therefore its Market SCR.

The main advantage of this type of strategy is the lack of basic risk, as the guarantee applies directly
to the fund’s net asset value. The services of an investment bank are required, however, and the
bank guarantee generates a counterparty SCR, which is not the case for option-based solutions
involving listed options.
This type of structure applies both to equities and other asset classes, or diversified funds, but the
underlying must be liquid so that the desensitisation algorithm can be applied without too much
friction (which, in theory, rules out its application to high yield physical debt funds, for example).

The disadvantage of this approach, however, is the monetisation risk in the event of a sustained
negative performance, especially in the current low interest rate environment, which would require
the arbitrary reinitialisation of the exposure in order to reassume the risk and hope to generate
returns.

What about reduced volatility strategies?

Reduced volatility strategies (low vol, min variance) also offer a defensive risk/return profile that has
been tried and tested in recent years, but we believe that they do not directly fall into the category
of “protected equity” strategies, as they do not benefit from a reduced shock under Solvency 2. They
are nevertheless useful for insurers, and many adopt such strategies because, in addition to the
financial benefits that they offer, they reduce asset volatility, and consequently the cost of the
options and guarantees on the liability side, therefore also reducing the Best Estimate under

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Solvency 2. Note that pillar 1 of the directive is not restricted to the calculation of the capital
requirement, but also applies to the balance sheet’s economic valuation, especially on the liability
side, through the calculation of the Best Estimate of the technical provisions, which has risen with
the fall in interest rates. This argument remains valid for any type of strategy involving a lower
volatility than the market, and particularly for solutions with option-based hedging.

For these strategies to also benefit from a reduced shock on the balance sheet’s asset side, they must
be combined with a hedge, using options, for example; but to limit the basic risk, these options must
be structured by an investment bank based on the low vol/min variance portfolio, which complicates
the structure and creates a counterparty SCR.

More and more management companies and investment banks have developed a protected equity
solution offering and there is now a huge range for investors to choose from. These various solutions
must be assessed according to two main criteria: firstly, effective eligibility under Solvency 2
(particularly with regard to the basic risk between the underlying to be hedged and the hedging
instrument’s underlying) and, secondly, the global cost of the strategy (the fall in the gains made if
the market rises) per unit of Market SCR saved.
The reduction in the Market SCR achieved through protected equity solutions may be used by
insurers to increase the equity weighting of their allocations or be used for the benefit of other asset
classes. In an increasingly restrictive financial and regulatory environment, this type of solution
therefore allows us to win back a little freedom in terms of asset allocation. Furthermore, whereas
the majority of these solutions offer an attractive risk/return profile over the long term for any type
of investor, they may also produce benefits for insurers other than a reduction in the asset-side
Market SCR, such as the impact on the liabilities’ valuation of the reduction of the assets’ volatility, or
the protection of accounting capital gains.

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About CPR AM Research department

Our Research department is composed of 8 financial engineers who assist portfolio managers in
developing investment processes, tools and solutions:
 Allocation model design (applied to multi-asset and fixed income portfolios)
 Securities selection and performance factor models
 Risk management
 Research on investment solutions
 Monitoring regulation, competition and academic research
 Periodic research papers

Solvency II : partner with insurance companies to face S2 challenges

Since 2010, our Research department and Portfolio Management team have been working together
to develop and enrich a proprietary model dedicated to market SCR calculations. As a pioneer on the
Solvency II directive, CPR AM manages more than €1 bn on the strategy through both open-ended
funds and bespoke solutions.

All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the time. As a
result of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and
shall not be considered as having any contractual value.
This document has not been drafted in compliance with the regulatory requirements aiming at promoting the independence of financial
analysis or investment research. CPRAM is therefore not bound by the prohibition to conclude transactions of the financial instruments
mentioned in this document. Any projections, valuations and statistical analyses herein are provided to assist the recipient in the
evaluation of the matters described herein. Such projections, valuations and analyses may be based on subjective assessments and
assumptions and may use one among alternative methodologies that produce different results. Accordingly, such projections, valuations
and statistical analyses should not be viewed as facts and should not be relied upon as an accurate prediction of future events.
CPR ASSET MANAGEMENT, limited company with a capital of € 53 445 705 - Portfolio management company authorised by the AMF n° GP
01-056 - 90 boulevard Pasteur, 75015 Paris - France – 399 392 141 RCS Paris.