In a shake-up to the Solvency II regime, the European Commission recently proposed paring back the regulatory capital requirements for EU insurers investing in non-STS securitizations like CLOs.
In this case, regulatory capital requirements tell insurers how much capital to hold when taking positions in securitizations that do not bear the 'simple, transparent and standardised' (STS) label.
The reforms, which are expected to apply from January 2027, are subject to a three-month ‘non-objection’ period and form part of wider reforms to EU securitization regulations.
The Commission has lowered the stress factors used to calculate the capital charges for insurers’ non-STS securitization investments.
But it has also carved out a separate basket for senior non-STS positions with lower stress factors than those of mezzanine non-STS holdings.
For example, the stress factor on an investment in a four-year CLO triple-A tranche has been slashed from 50% to 10.8%.
All of this is good news for the European CLO market. Cheaper securitization investment will mean more insurers investing in the sector's triple-A rated notes. This should tighten pricing, reducing the basis between US and European CLO triple-A spreads.
Insurers are a miniscule share of European CLOs’ investor base, as the capital charges can make CLO investments so expensive they result in negative net spreads.
As Solvency II rules are a bulwark against spread risk, accounting for seniority is rational. Triple-A CLO notes enjoy high levels of credit enhancement and the prices of these notes tend to be stable in secondary market trading.
The risk of an insurer being unable to cover its liabilities when liquidating a triple-A CLO investment is low. Why then should such an investment attract a sky-high capital charge?
Further progress could still be made, however. Even highly rated mezzanine CLO tranches still incur high capital charges, as credit for tranching is only given to investments in ‘first-pay’ tranches — the most senior.
Additionally, it is often too complex for insurers to match their securitization assets with their liabilities under the matching adjustment regime. This would allow insurers to discount the value of these liabilities when calculating capital charges.
But the Commission has delivered a major coup for the CLO market. It is also right to impose some limits on reform. Investments in securitizations must not cost insurers the ability to honour their claims.