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Emerging Markets

Insurers forced to reassess FIG assets as Solvency II looms

Solvency II, the insurance world’s version of Basel III, is expected to steer insurers’ portfolios in the direction of less risky assets. With banks among the riskiest of asset classes, at least in the immediate post-crisis years, the regulation’s impact on the FIG market could be enormous. Philip Moore investigates.

  • 28 Sep 2011
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Banks nervous about the challenges of complying with Basel III may console themselves by reflecting that some of their counterparts in the insurance industry may face a similarly onerous challenge. Although it imposes a very different range of requirements, Solvency II is described by a number of industry commentators as the insurance industry’s version of Basel III.

In a nutshell, Solvency II is designed to reduce the probability of default among insurance companies to below 0.5%, or ensuring that defaults in the sector occur less than once every 200 years.

It aims to do so by using a range of detailed insurance and market risk tests to determine how much capital insurers will need to hold.

Apparently simple enough on the surface, Solvency II has been described by analysts at CreditSights, somewhat dauntingly, as a "black box... notorious for its complexity". By contrast, CreditSights says that Solvency I "shines by its simplicity".

Like most of their counterparts in the banking sector, leading European insurers have sailed relatively painlessly through recent stress tests designed to assess their ability to withstand a number of external shocks occurring simultaneously.

Conducted by the European Insurance and Occupational Pensions Authority (EIOPA), the tests measured the impact on insurance companies of adverse movements in equity prices, interest rates and sovereign debt markets on the asset side.

No theoretical allowance was made for the impact of a sovereign default, which some analysts regarded as a weakness of the tests, given continued jitters over the European periphery. Nevertheless, the results gave an encouraging snapshot of the resilience of the sector, with only one in 10 insurers lacking the necessary resources to meet the minimum capital requirement (MCR) of Solvency II.

None of this should suggest, however, that insurance companies’ asset allocation strategies will not be affected by Solvency II. Far from it. As the BIS Committee for the Global Financial System (CGFS) commented in a report published in July, "quantitative impact studies suggest, and many industry analysts indeed expect, that the main impact of Solvency II will occur not on the liability but on the asset side of insurers’ balance sheets."

Bankers agree. "Solvency II will certainly reshape insurance companies’ asset allocation and as a result will have a big impact on the global capital market," says Thomas Rivron, Solvency II specialist at Natixis in Paris.

The potential magnitude of this impact is clear enough from the sheer size of insurers’ bond holdings. According to a report published in July by the Committee on Global Financial Systems (CGFS) at the Bank for International Settlements (BIS), insurance companies and pension funds (which may also become subject to Solvency II rules at some point) held financial assets of €7tr as of Q3 2010.

According to the same data, "28.4% of [these investors’] euro area debt exposure is to MFIs [monetary and financial institutions], which represents some 11% of the outstanding stock of debt securities issued by euro area MFIs. With €1,348bn (47%) of the sector’s combined holdings of euro area debt securities and deposits being claims on MFIs, changes in the ability of insurance companies and pension funds to take on bank exposure can be expected to affect bank funding conditions."

This echoes the view of many industry analysts. "Solvency II implies a step change in the way market risks are assessed for solvency purposes," notes a report published last year by Morgan Stanley and Oliver Wyman. "Under Solvency I, solvency capital requirements were based on fixed factors that did not reflect the asset-liability mismatch and market risk taken. The bottom-up, risk-based calculation of the Solvency Capital Requirement under Solvency II reflects both asset liability duration mismatches and the market risk of different investment classes."



Senior debt holed

How insurers’ asset allocation policies will evolve under Solvency II will depend on whether they choose to adopt a standardised or an internal model. "Given the bail-in provisions we expect to see under Basel III we would expect insurers to significantly reduce their holdings of senior unsecured debt," says one FIG banker. "Most of the largest insurers, however, will run their own internal models which will lead them to make more independent assumptions about the credit quality of the assets they hold."

As a general rule of thumb, however, Solvency II is expected to steer insurers’ portfolios in the direction of less risky assets. Although recent market turmoil has led to a wholesale reappraisal of what constitutes a low risk asset, at the simplest level, this implies a gravitation towards shorter dated credit and government bonds. More broadly, it also implies a move away from equities and towards the fixed income market.

This alarms some market observers who view Solvency II as a short term fix which may jeopardise longer term economic recovery. "In the case of the new Solvency II regime for insurers, there is a risk that political considerations may lead legislators to tip the balance in favour of insurers investing in EU government debt and against alternative investments," says Michael Wainwright, partner at law firm Eversheds.

"This might assist struggling EU economies in the short term, but the Bank for International Settlements is right to warn that it could have a serious adverse effect on the stability of the financial system. In addition, by constraining the returns that insurers can earn, it could also make insurance considerably more expensive in the future."

There is already evidence that at least in some countries Solvency II has led to the reallocation of some assets into government bonds at a very inopportune time. "Some insurance companies in France began to reallocate assets too early," says Rivron at Natixis. "To reduce their cost of capital under Solvency II a number started to buy Greek bonds, which they saw as a way of earning higher yields without incurring higher capital charges."

As well as leading some insurers to shift into government bonds, bankers say that Solvency II may lead to a localisation of their exposure as they gravitate towards domestic markets. As bankers say, no investment manager at an Italian insurance company is likely to be fired for buying Italian government bonds, no matter how badly they perform. A manager at a French or German insurance company going off-piste and buying government bonds in peripheral Europe may not be so fortunate.

As with Basel III, covered bonds seem to be one of the clear winners under Solvency II, perhaps at the expense of bank senior debt. "The capital charge means it does not really make much sense for insurance companies to buy senior unsecured debt," says Thibaut Adam, head of capital markets structuring at BNP Paribas in London. "But it is pretty clear that from a capital charge perspective covered bonds will become more appealing. Although these aren’t zero weighted in terms of capital requirements they are the closest you can get to government bonds under
Solvency II."

That’s not as bizarre an idea as it may have sounded some years ago, given that in some European peripheral markets covered bonds are now trading inside governments.



Slowly does it

Although there seems to be broad agreement about the likely long term winners and losers in terms of banks’ capital structures arising from Solvency II, it would be premature, however, to expect to see wholesale changes in insurers’ asset allocation policies manifesting themselves across the board either at a primary or secondary level. Asked by EuroWeek to comment on how its asset allocation is changing in anticipation of Solvency II, for example, one large German insurance company responded that it would be better positioned to do so in six to 12 months.

That makes perfect sense, given that the implementation timetable for Solvency II is a protracted one. As Rivron explains, the final version of a new directive (Omnibus II) is due to be released at the end of this year and endorsed by the European Parliament at the start of 2012. That will allow the EIOPA to publish its level two draft by September 30, 2012, and for Solvency II to take effect on a dry run basis on
January 1, 2013.

Even then, insurers will have more than enough time to adjust to the new rules, because as Fitch points out in a recent analysis of Solvency II, transitional arrangements may give insurers up to 10 years to adapt their business and investment strategies to the new regime.

Even when the structure of insurers’ portfolios starts to shift in response to the requirements of Solvency II, however, bankers caution that it would be an over-simplification to assume that this will prompt a sell-down of unsecured bank bonds and a stampede towards covered bonds, for a variety of reasons.

The first of these is that it is not risk per se — as measured simply by ratings or duration — that will govern insurance companies’ asset allocation going forward, but risk-adjusted returns. "If insurers are to hold longer dated or lower rated instruments they will need to earn a commensurately higher return for doing so in terms of spread," says Jake Atcheson, head of European insurance DCM at Citi in London. "So it is perfectly reasonable for insurers to hold longer dated paper as long as it pays them an adequate return relative to short dated issues.

"Longer dated covered bonds, for example, may still be attractive to insurers under Solvency II because the risk charges are lower for covered bonds than for senior unsecured paper," Atcheson adds. "On the other hand, you could construct an argument that the returns insurers can earn at the long end of the German covered bond market may not compensate them for the amount of capital they would have to hold. So it’s not a simple broad-brush question of whether or not insurers will hold bank bonds under Solvency II."

The current shape of the credit curve, says Atcheson, means that insurers are unlikely to be adequately rewarded for holding longer dated bank or corporate paper, with the three to five year area of the curve probably the sweet spot in terms of risk-adjusted returns for insurance companies.

There are other reasons why bankers warn that it is a mistake to get too carried away with the notion that covered bonds are the new government bonds in terms of their risk profile, and that insurance companies will therefore fill their proverbial boots chock-full of Pfandbriefe, obligations foncières and the new sterling covered bond issues.

Foremost among these is that insurers have already been very influential supporters of covered bond markets across Europe, accounting for as much as 40% of outstanding bonds in some jurisdictions. That may limit their capacity for adding to their existing exposures. "Increasing their investment in covered bonds may give rise to concentration risk at some insurance companies," says Rivron. "Some insurers are already too exposed to FIG risk and are looking to reduce their exposure to senior unsecured and covered bonds."



In search of alternatives

If there is a limit to the volume of insurance companies’ assets that can migrate to covered bonds, and if government bonds no longer appear quite as risk-free as they once did, where else can insurance companies look to earn the returns they will need?

Bankers say that they are exploring options to address this dilemma, with Lucio Di Geronimo, managing director in the FIG insurance team at UniCredit in Munich, pointing to two examples. "With yields on government bonds so low that they don’t match the guaranteed returns on their liabilities, insurance companies are entering into term securities lending structures with banks," he says. "On the one hand, this gives insurers a yield enhancement. On the other, it gives banks the opportunity to use their less liquid assets to generate funding at a lower cost than in the senior unsecured market."

"We are also seeing an increased interest among insurance companies in direct participation project finance and infrastructure loans, as well as SME financing," says Di Geronimo. "They are building up their credit expertise and rather than originate loans themselves, they are looking to risk-share with the banks. So we are seeing more convergence between banks and insurance companies in the loan market."

Looking to the much longer term, the majority view on the likely impact of Solvency II on bank funding supports the interpretation from the recent CGFS report. This is that "insurers with low capitalisation might have to reduce their holdings of equity and credit positions, as well as to limit the duration gap between their assets and liabilities."

That has serious implications for corporate issuers looking to access longer dated debt finance, given that insurers hold more than 30% of corporate bond supply, according to the CGFS data.

It also has negative ramifications for a number of other asset classes. "Life insurers have traditionally used property and even equities to match their long term liabilities under the assumption that they had long durations from an ALM perspective," says Rivron at Natixis. "Since QIS5 they have recognised that neither equities nor real estate qualify for duration under Solvency II and that their previous asset allocation optimisation assumptions was quite costly in terms of capital."



Appetite in doubt

Views on how much insurers’ expected shift into lower risk assets matters for FIG issuers vary, at least in the senior market. Solvency II sub-divides the fixed income world into corporates and covered bonds, with financials coming under the general corporate umbrella. Within that space, BIS sees insurers paring their holdings of bank bonds. "There is now less appetite for financials than was the case in the past," says the BIS analysis. "Many insurers placed tighter limits on their financial sector exposure in response to the crisis. The desire to diversify the corporate bond portfolio away from banks is seen as a reaction both to high correlations between financials and the prospect of loss-sharing arrangements in the future."

Some bankers say they are relaxed about how far this reallocation may go. "Long term senior bank funding is generally categorised as up to 10 years," says Mark Geller, head of financial institutions syndicate at Barclays Capital. "Insurers have regularly bought assets out to 30, 40 or even 50 years across different sectors and products to match their own liabilities. So a shortening of insurance companies’ appetite for duration down to 10 or 20 years still broadly exceeds the maturity objectives of bank funding. As a result, some may argue that Solvency II may not have such a significant impact on the bank funding space from a practical perspective."

Perhaps. But analysts say that in certain areas of the capital structure new regulation is likely to reduce the participation of insurance companies. It was generally recognised, for example, that they were never likely to be supportive of the market for contingent convertible (Coco) instruments. "Industry interest in new bank debt instruments such as contingent capital appears to be uniformly low," according to the BIS report.

"There could be an appetite for lower tier two hybrid capital on the basis of risk-adjusted returns," says Rivron. "But Cocos are a very different proposition because few insurance companies want to run the risk of holding bank equity in a distressed situation."

"We are seeing insurance companies becoming less relevant in terms of driving some areas of the market, such as in the corporate hybrid and bank tier one markets," says Jeff Tannenbaum, head of European debt syndicate at Bank of America Merrill Lynch in London.

This trend is expected to be maintained as the Solvency II guidelines are applied. "Before 2008, some insurance companies bought long dated hybrid capital instruments to provide cashflow matching," says Atcheson at Citi. "Going forward, overall demand is likely to be reduced for instruments with deferrable cashflows or uncertain maturity dates."
  • 28 Sep 2011

Bookrunners of International Emerging Market DCM

Rank Lead Manager Amount $m No of issues Share %
1 Citi 17,937.65 77 10.67%
2 HSBC 17,202.71 88 10.24%
3 JPMorgan 15,720.00 64 9.35%
4 Deutsche Bank 13,208.40 58 7.86%
5 Bank of America Merrill Lynch 10,749.43 54 6.40%

Bookrunners of LatAm Emerging Market DCM

Rank Lead Manager Amount $m No of issues Share %
1 HSBC 6,221.38 14 11.59%
2 JPMorgan 5,140.67 18 9.58%
3 Bank of America Merrill Lynch 4,497.27 18 8.38%
4 Deutsche Bank 4,264.56 14 7.95%
5 Credit Suisse 4,132.73 8 7.70%

Bookrunners of CEEMEA International Bonds

Rank Lead Manager Amount $m No of issues Share %
1 Citi 6,674.27 20 14.95%
2 JPMorgan 5,884.96 16 13.18%
3 Barclays 4,728.57 10 10.59%
4 Deutsche Bank 4,044.06 10 9.06%
5 Goldman Sachs 3,229.17 5 7.23%

EMEA M&A Revenue

Rank Lead Manager Amount $m No of issues Share %
1 Goldman Sachs 182.99 41 13.58%
2 Bank of America Merrill Lynch 90.70 28 6.73%
3 JPMorgan 88.18 43 6.54%
4 Deutsche Bank 85.13 29 6.32%
5 Lazard 80.06 43 5.94%

Bookrunners of Central and Eastern Europe: Loans

Rank Lead Manager Amount $m No of issues Share %
1 ING 382.49 5 8.60%
2 Commerzbank Group 292.65 4 6.58%
3 UniCredit 275.33 3 6.19%
4 SG Corporate & Investment Banking 271.81 3 6.11%
5 Raiffeisen Bank International AG 207.65 3 4.67%

Bookrunners of India DCM

Rank Lead Manager Amount $m No of issues Share %
1 Standard Chartered Bank 1,072.16 12 9.37%
2 Deutsche Bank 1,008.26 15 8.82%
3 AXIS Bank 1,000.88 27 8.75%
4 Barclays 699.87 9 6.12%
5 Trust Investment Advisors 698.72 32 6.11%