ERES 2016: “Solvency II – Optimising regulatory capital required to be held against real estate assets. A Case Study” Charles Ostroumoff 10 th June, 2016

More of a White Paper than a Research Report Discusses the effects of the new Solvency II Regulations on Real Estate Portfolios Includes a Real Life Case Study Using IPD Futures Innovative first of its kind solution Research Drivers / Background to Paper:

Came into effect 1 st January, 2016 Regulation targeting Insurance Companies Solvency Capital Requirement (SCR) – calibrated as a 1-in-200 VaR over 1 yr time horizon Standard Formula vs Internal Models 25% pre-diversification for Real Estate across Europe 15% post-diversification (beta =1 i.e. diversified property portfolio benchmarked to IPD) Background to Solvency II:

Rational profit seeking firms look at Return on Capital (RoC) as a measure to see if risk / capital is well rewarded Under Solvency II, firm’s solvency coverage ratio (degree of surplus in excess of SCR) is a key metric that regulators track Goal is to improve RoC or the solvency coverage ratio Anything that does is attractive Capital Optimisation:

The IPD UK Commercial Property Index is the standard benchmark index Industry uses IPD Data to calibrate their internal models for property risk IPD Futures Contract is a simple instrument referencing a well- used index Regulators are comfortable for firms to trade, model and take credit for using IPD Futures in their SCR calculation Treatment of IPD Futures under Solvency II:

Underlying Index UK IPD Quarterly Total Return Indices for All Property, Segments & Sectors. Contract period Each contract period is for one calendar year, available up to five years forward. Contract expiration Contracts expire in February of the following year. Settlement Cash settlement, due on the first exchange trading day after settlement date Contract size Each contract has a nominal size of £50,000 Exchange Legally binding standardised contracts listed on the Eurex Exchange. IPD Property Futures – Product Characteristics :

Insurance firm had £200m UK Commercial Property Portfolio Regulatory capital required to be posted against this portfolio under Solvency II Firm was holding £30m SCR Desired minimum solvency coverage ratio was 50% Therefore it had to set aside £45m (SCR + 50% Buffer) In addition – other drivers: Risk Management – less risk due to a perceived or actual overweight TAAS – at this point in the cycle it makes sense to hedge Case Study: Rationale behind Trade – Capital Optimisation

Key Points: 1.Trades £200m notional 2.1 Year IPD UK All Property Futures, 6% 4.N.B. Low Basis Risk (i.e. strong correlation between insurer’s portfolio and UK All Property Index) 5.N.B. Initial Margin outlay (defined by the Exchange) Long position – Short position – Hedged Position – Profit Loss Sells £200m IPD Futures – UK All Property at a price of 6% Return Profit Loss Return Effect is to “lock in” a 6% return on IPD. Pays away excess, receives any shortfall. Insurance Company owns £200m portfolio of UK property assets Profit Loss Case Study: The Trade

Firm locks in a 6% return on IPD Pays away any excess Receives any shortfall There is zero VaR over 1 year So firm frees up £45m (SCR and Buffer) Case Study: Conclusion

Key Outcomes Solvency coverage ratio is improved Preserves expected returns (assuming 6% is roughly the expected return for 2015 Improves Return-on-Capital Capital saving can either be banked or recycled to support another return-seeking opportunity Case Study: Key Outcomes

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