Solvency II and real estate

The implementation of the Solvency II regulations for European insurance companies is of huge significance for the real estate industry. Furthermore, the European Insurance and Occupational Pensions Authority (EIOPA) has a consultation process running until January regarding the extension of a Solvency II type regime to some or all defined benefit pension schemes. This will potentially have an even greater impact for the real estate industry than the application of the rules to insurance companies. The implementation process by the European Union is now reaching the point where much greater clarity is expected. The Level 2 regulations have now moved from the EU Commission to the EU Parliament. Although the Level 2 regulations are not a public document, they appear to have been circulated quite widely and have been commented upon in the real estate trade press.

The key concern for the real estate industry is how insurers and possibly pension funds will view real estate as an investment asset once Solvency II is in force, and in particular, how they will be required to model potential future falls in value of their investments. Insurers can either use a “standard formula” for which the risk factors are set down by the EU regulator or seek approval from their national regulator to use their own internally generated risk model. Much of the real estate industry attention has focused on the amount by which insurers need to write down the value of their real estate investment assets under the “standard formula”. 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. In April, the Investment Property Databank (IPD) published a study focusing specifically upon real estate. This study was funded by a consortium of seven key real estate trade bodies. This identified a number of areas of concern, but specifically in respect of the property shock, the report suggested that 15% was a more accurate reflection of pan-European volatility than the 25% suggested by the regulator. Since publication, the IPD has updated its analysis, continuing to support the view that the currently proposed property shock is excessive. Coverage in the real estate press has stated that the EU Commission has not been swayed by the lobbying and that the 25% market shock remains in the proposals.

The 25% market shock also affects the way that real estate debt is treated in the books of insurers. The standard formula 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 as the owner of the equity is assumed to suffer the brunt of the shock with the lender only suffering once the adjusted value of the collateral is lower than the amount of the loan. Pressure on other traditional lenders to reduce their commercial property lending is creating an opportunity that is attractive to insurers from both a commercial and a regulatory perspective.

The treatment under Solvency II of real estate investment through funds is unclear, which is a major concern as it is encouraging insurers to delay deploying capital with real estate fund managers. For un-geared funds, it would seem that they should 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. Previous commentary has implied that the equity shocks should be used. These are 49% for unlisted vehicles and 39% for listed (subject to an adjustment of up to 10% either way intended to smooth the impact of fluctuations in equity markets). However, it should be noted that these shocks are applied to the net value of the equity whereas the 25% for property would be applied to the gross value before gearing. This is illustrated in the diagram below. The equity shocks are also adjusted depending upon the state of the market at the time, through the mechanism of the dampener. Insurers and fund managers need to know whether funds should be treated as transparent and thus as real estate investments or opaque as equity investments.

Real estate funds cover a broad spectrum, 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 real estate as the underlying asset, 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 hotels, is difficult to distinguish from any other form of private equity fund. Choosing either approach and applying it to all real estate funds would be highly inappropriate for one end of the spectrum or 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 during the last decade to adequately define different fund styles and strategies with only partial success. 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 which of the two approaches is most appropriate, taking into account the characteristics of the underlying investments. One possible solution would be for the regulators to design a set of high level principles which insurers should apply in determining which of a look through approach or the application of an equity stress most accurately reflects the underlying nature of the risks to which the insurer is exposed. These principles may take account the level of gearing present together with the nature of the underlying assets. This would leave the insurer to make the ultimate judgement in each case as to the appropriate treatment. However, commentary in the industry suggests that the Commission is moving towards an approach following the “look-through” approach for all indirect exposures including exposures to geared funds, and this is certainly what is reflected in the proposed reporting regime in the consultation paper issued recently by EIOPA discussed further below.

If the uncertainties can be resolved, there are compelling arguments for insurers to reduce their investment in direct property, but at the same time to increase their exposure to real estate debt and to higher return real estate investments. Real estate debt provides the lower risk element and has a relatively more favourable treatment under Solvency II. Fund and direct investments have a much more capital hungry treatment under Solvency II but provide the potential for upside if the investment is in higher risk / higher return assets. The blended effect gives a better Solvency II result than holding large swathes of direct property delivering not much more than a bond type return. The high capital cost of investing in real estate other than through debt has to be justified by higher returns.

Aside from the fundamental question as to whether Solvency II will change the behaviour of insurers and pension funds in the way they perceive real estate as an asset class, fund managers and others will also need to address the reporting implications. This is again an area of uncertainty. EIOPA published its “Consultation Paper on the proposal on Quantitative Reporting Templates” and “Draft proposal for Guidelines on Narrative Public Disclosure & Supervisory Reporting, Predefined Events and Processes for Reporting & Disclosure” on 8th November. This is a consultation due to run until 20th January 2012, after which EIOPA will consider the feedback received and expects to finalise the package in summer 2012. These snappily titled documents are a significant step forward in the process that will determine the public and supervisory reporting obligations of the insurers, which will in turn determine the level of granularity of reporting at the fund level. As indicated above, the assumption is that funds will be treated as transparent so reporting will need to be in respect of the underlying investments of the funds.

The FSA has this month also launched its own consultation process in respect of implementation of Solvency II in the UK.

Solvency II is clearly going to be a major challenge for the real estate industry, but also potentially a stimulus for product development. This should become considerably clearer over the next two months.