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Solvency II and Its Impact on Existing Subordinated Bonds of Insurers

BY: Chirag Sharma | Category: Others | Submitted: 2012-12-08 23:06:59
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Solvency II has been delayed historically, and was earlier planned around 2010. Thereafter, it was delayed till 01 Jan 2013, but again got stretched for one year to 01 Jan 2014. Now in a current development, it is expected to start somewhere in 2016. In the UK, the initial deadline of 2013 is now extended until 31 Dec 2015.

The applicability of Solvency II is dependent upon adoption of Omnibus II directive. The legal power of Solvency II depends upon agreement of Omnibus II by all the three European institutions - European Parliament, European Commission and European Council. The vote on Omnibus II which itself got delayed to November 2012 is now further delayed to March 2013.

We consider the delay in implementation of solvency II as a great risk in the current low interest rate environment. In a low interest rate environment, due to low risk free rates the present value of liabilities goes up. At the other end scarcity of high yielding assets would compel insurance companies to invest in risky assets, thereby increasing the overall risk profile of investments. If the insurance companies try to lock the long term yields on the government bond, then again there is duration risk if inflation kicks in.

The overall returns are dependent on timely implementation of Solvency II, and there are no clear signals on it. As per Reuter's, it is now expected to go beyond 2016. Implementation becomes complex as the readiness varies from country to country and insurer to insurer. As per a report, 70-90% of British, Dutch, Greek, Polish and Spanish insurers expecting to be ready by Jan 2014, but only 60-70% of Belgian, French, German and Italian insurers will be ready by that deadline. The delays are on account of cost associated with implementation of Solvency II, which has a potential to push pension funds into bankruptcy. Majority of the costs are associated with technology related needs for data governance.

Risks are further expected to increase on account of grandfathering arrangement that would continue to allow the pre-existing subordinated debt as capital, while applying the new rule on the new issuances only. A grandfathering provision would allow insurers to keep subordinated debt as capital till a specified period of time, after which it no longer qualify as capital as therefore could be worth a call. If the grandfathering period is say for a 8-10 years period, then the incentive to make a call goes down for an insurer.

However, there is a high likely hood that in order to match the duration of assets and liabilities, the stronger insurance companies in the market would come forth to replace their subordinated bonds with newer instruments eligible as capital. Also, funds with exposure to equity in their asset portfolios are expected to benefit in a QE driven environment. In this manner, both the assets and liabilities would be in line with the current interest rate outlook. Therefore, investment in subordinated bonds with a nearing call date would reduce the overall risks. The modified duration of 2.6 years for the given fund is attractive in this regard. But duration is based on assumption of call option which depends on progress on Solvency II implementation. Overall, we can expect a call on expensive debt pieces, with high coupon. The fund has a coupon yield of 7.9%, a healthy rate by European standard. Therefore the likely-hood of a call goes up irrespective of a requirement to meet Solvency II, as it would help in matching of asset and liability duration. Furthermore, the discount on these bonds makes them attractive at their higher coupon rates.

About Author / Additional Info:
Chirag Sharma is Digital Marketing Consultant in SJ Seymour group headquartered in Hong Kong. SJS Markets provides research, advisory, execution services and private Wealth Management Solutions.

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