Solvency II Tier 1 take-off

The impact of Solvency II is expected to hit the capital markets in 2015 via the first Tier 1-style structures under the new framework. Bank+Insurance Hybrid Capital surveyed leading market participants to find out how the new asset class is likely to evolve, as well as its wider impact on insurers’ funding and capital strategies, and how it fits in alongside bank AT1.

The EIOPA stress tests have not had much resonance in the market — what are the relevant takeaways from the results at the industry level?

Vincent Hoarau, CACIB: EIOPA released the results of its 2014 stress test for insurance companies in early December. In a nutshell, the results showed evidence of a strong capacity of resilience of the sector with, on the whole, a high level of capitalisation. Only a few instances of weakness were identified. The market hardly reacted to the result since the insurance sector had always been immune from the crisis — or almost immune — and the test was considered a non-event, as were the results. In addition, participants computed the results on a “best efforts” and no-name basis. Participants could use approximations whenever figures would not lead to fundamentally different results and used the Standard Formula, without making use of the Undertaking Specific Parameters (USP). So, nothing that compares to the stress test for banks. And this generated criticism.

Paul Gurzal, La Française AM (pictured below): The EIOPA stress tests had limited impact, as it was an anonymous test with no names revealed. Nevertheless, those tests were useful to move forward to a new debt format.

Julien de Saussure, EDRAM: The EIOPA stress test has had far less resonance in the market than the AQR/Stress Test for banks. This is probably due to (i) name-specific feature of the banking exercise and (ii) immediate loss potential for equity and bondholders on some of these issuers.

The insurance industry seems relatively well prepared ahead of Solvency II. However, the level of preparedness in terms of SCR/MCR coverage, rollout of internal models and ability to use long term guarantees (LTGs) or transitional arrangements is largely skewed in favour of big entities.

Given where rates currently are in Europe, the ability to absorb low rates for longer is at the centre of insurance credit analysis going on at this point of the cycle.

Marco Circelli, SCOR: The results indicate that the European market is well capitalised and resilient. However, the exercise required companies to use the Standard Formula, which does not fully reflect all the risk profiles and makes it difficult to properly analyse the results.

Jozef Bala, Generali: The EIOPA stress test did not have much resonance in the market, most probably because it was not a pass or fail test, and there was no disclosure on individual names. A relevant takeaway is that the results suggest that the shortages were not in the top 30 biggest insurers, but also that structural differences across jurisdictions reveal that certain countries may be more vulnerable to a period of a prolonged interest rates, and therefore a coordinated supervisory intervention will be welcomed.

Dominic Simpson, Moody’s (pictured below): Overall, we believe that the stress test results provide investors with greater clarity around the Solvency II capitalisation and its sensitivity to shocks. One of the main messages is that 14% of the insurers which took part in the EIOPA survey have a Solvency Capital Requirement (SCR) ratio below 100% even before any stress is applied. Although this may appear a large percentage, these companies represent only 3% of total assets, confirming our view that smaller, less sophisticated, insurers are those more vulnerable to the introduction of Solvency II.

As concerns the stresses, of particular note is that in a prolonged low interest rate environment (the so-called Japanese scenario), around a quarter of European insurance companies would not meet their SCR as set by the standard formula, with German insurers losing 20% of their eligible capital. The results also show pre-stress negative net cashflows in around eight to 11 years in various countries, including Germany and the Netherlands, which is broadly in line with our expectations, given the high guarantees and high duration mismatches we find in these countries.

The lack of company-specific information somewhat limits the conclusions that can be drawn from the stress tests, and further caution is warranted as the tests were based on year-end 2013 standard formula results. Insurers may have the opportunity to strengthen their capital position before Solvency II is implemented and/or have their internal model approved, which usually results in higher solvency ratios. However, with interest rates currently at a lower level than EIOPA assumed even in its Japanese scenario and the ECB’s QE program designed to prevent rates from rising, we can infer from the stress test results that the level of regulatory scrutiny will be even higher on insurers in the coming months, while investors will also be increasingly wary of insurers’ solvency.

We expect insurance companies to sell Solvency II Tier 1-style bonds in the near future. How do you see the development of this new market segment?

Circelli, SCOR: The need for Tier 1 paper will vary from one insurer to another. Indeed some benefited from the transitional arrangement and already optimised their Tier 1 capital structure, while others didn’t. For those who didn’t, issuing Tier 1 paper from 2015 will be much more difficult but could enable some groups to optimise their remaining Tier 2 debt capacity and therefore increase their financial flexibility.

There are still some uncertainties about the loss absorption method, if it will be similar to the temporary write-down of Additional Tier 1 capital instruments, which have been issued mostly by Eurozone banks. So far, no Solvency II Tier 1 paper has been issued by insurers. It is still unclear what price will be requested by investors for such a loss absorbency mechanism (temporary write-down), as needed for Tier 1.

De Saussure, EDRAM: It is also our understanding that these structures would be up for sale in H2 2015. Now, some opportunistic issuances ahead of the Solvency II cut-off has probably helped refinance some of bonds callable in 2015-2016.

It is likely to stay a small market, below Eu30bn-Eu50bn, restricted to bigger issuers in the EU.

Gurzal, La Française AM: The market environment is positive for new issues to come: interest rates are at lows and spreads are tight in the financial sector. In addition, with the insurance segment considered stronger than the banking segment and the grandfathering period being long, Solvency II Tier 1 should appeal some investors.

Bala, Generali: We expect this market to grow relatively slowly because of some uncertainties on the structure and the limited need for this kind of instrument due to the grandfathering and the wider space for Tier 2 instruments in Solvency II. We expect issuers to prefer the write-down feature to the conversion mechanism because of the easier marketability of the instrument.

Would you expect the downbeat mood in the bank AT1 market in the second half of 2014 to affect the emergence of a similar segment for insurers?

Gurzal, La Française AM: The slowdown in issuance of bank AT1 during the second half of 2014 is not a worry, but has enabled this new market to be absorbed and let investors become specialised. Therefore we stay positive on the asset class.

Indeed, the growth was huge as Eu40bn was issued in the first half of the year out of Eu50bn in the whole of 2014. We think this period is temporary and closely linked to a troubled macro environment and volatile markets, with the surprising comments of Draghi at Jackson Hole last August, the two rounds of TLTROs, the FED tapering end, and an announcement on ECB QE that nevertheless lacked details…

If new issues were to be positively digested by the market then the whole industry should benefit from it, with some insurance bonds emerging. However, if the first issues are not well accepted by the market, the emergence of a new insurance segment will be tough with bank AT1 competing.

De Saussure, EDRAM: The renewed volatility on bank AT1 in H2 2014 is likely to weigh on the Solvency II Tier 1 segment. AT1s are likely to be the focal point in terms of relative value for Solvency II Tier 1. Wider spreads in AT1 will undoubtedly be reflected in early Solvency II Tier 1 deals.

Now, it could also be an opportunity to create a subordinated segment offering decent yield and some decorrelation versus bank AT1. Some risk factors specific to the banking industry do not have any impact on insurance companies, for example some regulatory developments (TLAC, RWA floor, resolution…) or risk areas (e.g. Russia, oil).

Obviously, any loss (coupon or trigger) on bank AT1s would jeopardize the rise of Solvency II Tier 1.

Bala, Generali (pictured below): There has been an oversupply in the bank AT1 segment mainly due to the low interest rates and the relatively compressed spreads, and the oversupply was also driven by the rush to cover the capital requirement before the EBA stress test results. We do not foresee massive issuances of restricted Tier 1 in the insurance space mainly thanks to the benign grandfathering rules applying for a period of 10 years without any amortisation.

Hoarau, CACIB: I think the situation has evolved positively in the AT1 market since the beginning of the year. The mood is much more constructive and we can’t talk about a downbeat tone anymore. Now, whether or not the Solvency II Tier 1-style segment for insurers will stay immune from any developments in bank AT1 remains to be seen.

Everything being equal, the new Solvency II segment is much more defensive than the bank AT1 segment given the perception of the probability of breach of the SCR for a given insurer. As has been rightly suggested, we don’t expect any surge in supply and the segment should remain relatively small. Insurance companies are defensive animals and they demonstrated an outstanding track record during the crisis. The first issuance should surface in a recovered global credit market and will offer valuable investment opportunities for buy-and-hold investors struggling to find yield in a low interest rate environment. I expect this segment to stay relatively undersupplied compared with the rest of the deeply subordinated space. Investors want yield pick-up from rare and conservative borrowers issuing subordinated instruments with generally investment grade ratings. This is precisely what the segment will offer. Given the profile of the issuers — it’s fair to say that insurers are safer institutions — we also expect investment constraints to be much more limited compared with what we can observe in the bank AT1 space. It will be very interesting to see the approach adopted by the Germans when the first issuance emerges. They have been reluctant to buy in bank AT1 so far — I would be surprised to see the same strict attitude toward Solvency II instruments.

What do you expect from the rating agencies in terms of rating approach with the upcoming finalisation of the Solvency II framework? How do you expect rating agencies to address the grandfathering rules in their criteria, notably regarding equity credit?

Bala, Generali: Yes, we expect rating agencies to assure a smooth transition to the new Solvency world, especially for the equity credit/treatment that is surely a relevant contributor to the issuer’s capital structure.

Circelli, SCOR: We cannot anticipate the rating agencies’ reactions, but we don’t think that this will impact the equity rating. The S&P rule is currently as follows: as long as the bond is eligible as capital under the current solvency regime and is also eligible as equity credit, according to their methodology, the bond is considered in the Total Available Capital. We expect this to remain the same under Solvency II.

Michael Benyaya, CACIB: Rating criteria in the FI space often move in tandem with the regulatory framework, although rating agencies can impose additional requirements. In the context of the transition to Solvency II and now that the Delegated Acts have been published in the EU Official Journal, we can expect rating agencies to communicate more formally on the hybrid topic. In terms of grandfathering, I agree with Jozef. It is expected that insurance subordinated bonds will retain their respective equity credit as long as they form part of regulatory capital due to the transitional rules and meet all other rating agency requirements. I also think that the current insurance hybrid rating criteria may be reviewed, notably to include a framework to rate the future Solvency II Tier 1 instruments.

Internal model: some insurance companies have adjusted some of their assumptions — do you see any implications, notably in the context of internal model validation?

Circelli, SCOR: We don’t see any impact/change in the treatment for hybrid capital under Solvency II. Delegated acts have been approved by the European Parliament and Council, and published, applying directly to French law. Internal model application may have an impact on the SCR calculation, but not on the hybrid capital treatment in the own funds.

Bala, Generali: We do not foresee any implication of the changes and adjustments made on the internal models since these are the result of dialogue with the regulator and are aimed at obtaining the validation.

How do you see the volatility of the SCR ratio versus the Solvency I ratio? Is there any implication in terms of capital management?

Bala, Generali: The SCR ratio is sensitive to the interest rate movements on both sides of the ratio, while the Solvency I ratio is sensitive only on the numerator if the national regulation and the supervisor allows the use of unrealised gains (the local approaches are different also in terms of limits). Looking forward, capital management should take into consideration adequate buffers based on the new metric.

Circelli, SCOR: Given that Solvency II is an economic framework, one should generally expect a higher level of volatility compared to Solvency I. Overall, this is certainly impacting the industries’ capital management approach. The increased volatility requires a close monitoring of capital levels and creates opportunities for innovative financing solutions.

Benjamin Serra, Moody’s (pictured below): In most jurisdictions the volatility in current Solvency I ratios is easy to understand and essentially tracks changes in the market value of assets and does not reflect the changes in market value of liabilities. In contrast, under Solvency II, solvency ratios’ volatility will be more difficult to interpret. As a simple example, life insurers with reinvestment risk will show weakening Solvency II ratios as interest rates fall, whereas under Solvency I they would have shown a solvency strengthening. Conversely, companies with low interest rate risk (e.g. those who have good asset-liability matching) should show lower ratio sensitivity to interest rates under Solvency II than under Solvency I. Overall, we expect that available capital (the numerator of solvency ratios) and solvency ratios will not necessarily be more volatile under Solvency II (and may actually be less volatile under certain circumstances) and this will depend on the assets/liabilities duration mismatch. However, required capital (the denominator of the ratio) will definitely be more volatile under Solvency II.

Solvency II ratios’ volatility will surely gain investor attention and the complexity of this volatility will likely reinforce the already-existing perception of complexity within the insurance sector, especially for non-specialists. Higher solvency ratios’ volatility, coupled in some instances with potential lower absolute levels of solvency coverage, would also increase the risk of approaching or breaching the 100% regulatory coverage threshold. Therefore, under Solvency II, we believe that investors’ appetite to provide capital to insurers could be reduced compared with Solvency I, and/or cost of capital could increase. We expect that most insurers will strive to manage and reduce volatility in their solvency ratios, notably by improving their asset-liability management, but we also believe that investors will impose discipline on insurers, and indirectly impose higher levels of capital.

For many issuers, the overall subordinated debt capacity is higher in the Solvency II capital structure vs. Solvency I: does this have any implications regarding the role of senior debt?

Circelli, SCOR: We don’t think so. The role of senior debt is and will remain cash financing, or in a structured way collateral funding, when hybrid debt aims to achieve capital credit. Each type of debt has its own purpose and this will not change under Solvency II.

Bala, Generali: In our capital structure the senior debt is already residual. In the near future this trend in the overall insurance space may be accentuated, increasing layers of subordinated instruments while lowering the weight of senior debt.

Simpson, Moody’s: Under Solvency II, Tier 1 and Tier 2 hybrid instruments are able, on a combined basis, to represent up to 60% of an insurer’s solvency capital requirement, compared to 50% (or 25% for dated instruments) under Solvency I. With the assumption that capital requirements for the majority of insurers will increase under Solvency II, then we would agree that the overall subordinated debt capacity is higher under a Solvency II capital regime. Whilst this might argue for increased levels of subordinated debt issuance, especially in such a low interest rate environment, we would caution that financial leverage remains a constraint and the European insurance sector has been reducing its leverage in recent years notwithstanding the exceptional low cost of financing. In fact, in 2013, financial leverage was at its lowest level for the industry since the 2008-2009 global financial crisis.

With regard to senior debt, the reality is that issuance is already small compared to subordinated debt and its relevance has been declining over the past few years; we expect this to remain the case going forward. According to our analysis, over 60% of the debt issued by European insurers at year-end 2013 was subordinated in nature, with senior debt on average accounting for only around 25% of total debt. These proportions are reasonable given the regulatory solvency benefits of the subordinated instruments relative to senior debt and their generally longer term nature.

How do you see the role of Solvency II Tier 1 in the capital structure? What are the potential benefits of having these types of instruments in the capital structure? Do you have any concerns regarding the structure of this instrument?

Bala, Generali: Since the space is limited to the 20% of the total Tier 1, we see this instrument as a buffer to cover the volatility of the Tier 1 unrestricted items, ensuring an overall good quality of capital. We still have some doubts on the structure, for example how the “appropriate margin” will be defined in different regulations, and the write-up mechanism details.

Circelli, SCOR: As mentioned before, the development of this market will depend very much on the price required for such structures (e.g. loss absorbency mechanism), and could be limited to groups under pressure with little Tier 2 capacity. Other than the issuer’s Tier 2 capacity limitation, there is no benefit for the issuer to raise Tier 1 debt.

Benyaya, CACIB: The instrument can partly address the potential volatility of the overall Solvency II capital position. This is because the 20% limit is set against total Tier 1 capital, whereas Tier 2 and Tier 3 cannot exceed 50% of the SCR. In terms of rating agencies, a Tier 1 is unlikely to be granted a higher equity credit than a 30 or perpetual non-call 10 Tier 2 in the S&P capital model. It could still be eligible in a higher basket under Moody’s criteria.

The PRA has already communicated on the future Solvency II Tier 1 (partial write-down not allowed) while EIOPA will probably not go beyond the Level 3 guidelines in terms of specifications. Would you like to see some form of harmonisation in terms of structures at the European level?

Circelli, SCOR: Solvency II is a major step for the European insurance and reinsurance industry. This single regulatory framework should be completed by uniform supervisory practices on all aspects of the regulation. In this respect, a single supervisory mechanism for (re)insurers, could contribute to the harmonisation of the EU (re)insurance market and to a truly level playing field for the European industry.

Benyaya, CACIB: Indeed I do not expect the Solvency II rules to be more specific than they are today in terms of structuring guidelines. The PRA has launched a consultation on the quality of own funds under Solvency II which includes some specific guidelines on Tier 1. I do not expect other regulators to communicate on the topic to a large audience, at least in the short term.

Some structuring aspects remain elusive at this stage, notably the write-up mechanism, which seems to be rather flexible in the Level 3 guidelines. In addition, the role of EIOPA remains to be seen and we don’t know if it will develop along the lines of EBA’s role in the banking space.

Bala, Generali: We understand that the regulators may have different sensibilities and focus on some points rather than others, but the harmonisation is surely welcome.

What is your view on the G-SII framework, notably the BCR? How do you envisage the development of the Higher Loss Absorbency (HLA) requirement? Do you see any potential conflict or inconsistencies between the G-SII and Solvency II frameworks?

Benyaya, CACIB: The development of the G-SII and more generally the Insurance Capital Standards will be a multi-year process and it’s difficult to say today what will be the outcome and potential implications for insurance companies. The BCR framework was endorsed by the FSB in October 2014, but the FSB also stated that the ICS are expected to replace the BCR in its role as the foundation for higher loss absorbency requirements. It remains to be seen how this framework will interact with Solvency II.

More generally, it’s probably an additional operational and reporting burden for insurance companies because they have to monitor their capital position in light of this specific framework along SII and the rating agencies’ capital models. In this respect, I can understand that Insurance Europe supports the idea that Solvency II will represent an acceptable implementation of the ICS framework.

Bala, Generali: There has been a growing likelihood since the initial G-SII designation of a potential conflict between the G-SII policy framework and Solvency II. Europe comprises five of the nine global systemically important insurers so the impact could be significant. The insurance industry is no different from any other highly regulated industry in needing certainty and clarity of purpose from its regulators. There is an urgent need to digest the numerous regulatory initiatives and consider their impact and interaction at the risk of not clearly seeing potential unintended consequences — specifically, hindering the important role insurance companies play in providing patient capital to the real economy.

Circelli, SCOR (pictured below): First, we believe that there is no clear evidence that insurance or reinsurance is systemic. Before the development of an HLA, there should be an in-depth dialogue with the industry to revise the methodology of designation of systemic entities, with a switch of focus from an entity perspective to an activity perspective. Overall, current discussions on global capital standards, and the very simple design of the BCR, seem to threaten some important achievements of Solvency II, such as the ability to use internal models and economic valuation or the recognition of diversification.

Simpson, Moody’s: Overall, we view G-SII designation as a credit positive because it carries additional regulatory oversight, and to the extent that the HLA requirements, which are not yet defined, result in G-SIIs holding more capital relative to current levels, then creditors and policyholders will benefit. However, these positive implications are muted by the extent to which it reduces insurers’ ability to operate in existing lines of business that generate diversified earnings. In particular, the HLA could make G-SIIs less competitive than those not designated as they could need to raise prices to achieve current return targets.

Specifically on the BCR, we note its simple design, with no explicit treatment of ALM or risk diversification, in contrast to Solvency II. Furthermore, it doesn’t appear to be a constraining capital requirement; in a field test, for G-SIIs, we note the BCR ratio was a high 380%. However, the BCR will be replaced by a potentially more risk-sensitive approach via the global insurance capital standard.

As for the HLA, it is to be set at a level that offsets any advantage arising from G-SII designation. Importantly, the key principle is that G-SIIs hold higher levels of regulatory capital than would be the case if they weren’t so designated, which clearly holds out the potential for capital requirements to be higher than the Solvency II SCR.

Furthermore, because of differences of approach between the Solvency II and G-SII frameworks, some financial resources eligible as regulatory capital under Solvency II may not be eligible under the G-SII framework where HLA capacity requirements should be met by the “highest quality capital”. G-SIIs may therefore have to hold higher levels of “core” capital, which we also see as credit positive.

In its report on financial stability, EIOPA highlighted the following key risks: weak macroeconomic climate, prolonged low interest rate environment, and sovereign credit risk. How do you manage these risks? Have you implemented any specific measures?

Circelli, SCOR: SCOR is well prepared to face any potential headwinds. We are a traditional Life & Non-Life reinsurance company. As presented during our Investors’ Day in September, our liabilities are predominately exposed to biometric risks in Life and catastrophe risks in Non-Life. Therefore, our exposure to macroeconomic changes is low. We meanwhile have prudent asset allocation with good quality of fixed income (AA- on average), no government bonds from Greece, Italy, Spain, Ireland or Portugal, and a high liquidity with short fixed income duration.

We are following our key risks at all levels within the Group. SCOR’s risk appetite framework is approved by the Company’s Board of Directors in connection with the review of new strategic plans, based on recommendations from the Group’s Executive Management team and the Risk Committee of the company’s Board of Directors.

Bala, Generali: Following the designation, G-SIIs have been required to implement a policy framework, including specifically a Liquidity Risk Management Plan and a Recovery Plan. These two plans have been designed, according to the G-SII policy framework, to demonstrate that global systemically important insurers would be able to restore capital and liquidity positions in case they would be deteriorating. Among specific measures, the two plans also highlight metrics and triggers, early warnings, governance and escalation process to promptly manage crisis situations, where EIOPA key risks are also considered.

No Solvency II Tier 1 instrument has been priced yet. What will be the main elements you will look at when assessing the instruments?

De Saussure, EDRAM: As for any other hybrid instruments, it is the fundamental analysis of the underlying issuer that matters most.

Solvency II Tier 1 will raise several questions, however. The hierarchy between equity-holders and bondholders will change, given that stoppers/pushers are banned, similar to in bank AT1. Then the relationship with policyholders will need to be reviewed in light of low rate risks and increased consumer protection. The exact capacity to share losses with policyholders ahead of a solvency breach (and therefore as a cure mechanism) needs to be clarified and tested through the issuer’s track record. The same applies for bancassurance groups that have been big issuers recently, where the ability to upstream/downstream capital to the parent bank ahead of a SCR/MCR breach should be clarified/limited.

Obviously, insurers will progressively amend their financial targets to include SCR/MCR guidance SCR/MCR will need frequent disclosures. As credit investors, we need to get more familiar with these metrics and how insurers would prioritise bondholders versus other stakeholders (i.e. shareholders, reinsurance counterparts and policyholders) before being able to truly assess any buffer to SCR/MCR breach.

Benyaya, CACIB (pictured below): Disclosure will clearly need to be enhanced. Investors will probably dig further into the SCR and the tiering of the capital structure. The current sensitivity analysis to market movements (e.g. equity, spreads, rates) needs to be expanded as investors will want to see scenarios articulated to assess the resilience of the capital position. I also believe that insurance companies will have to explain the role of risk mitigation techniques (e.g. cat bonds, reinsurance) in the SCR. But I reckon that this will be difficult given the complexity of the Solvency II framework.

Gurzal, La Française AM: To assess a Solvency II Tier 1, we will focus on several aspects: the quality of the issuer, looking at the senior rating; the quality of its business, with the volatility of revenues, its size and its country of risk exposure; understanding the trigger conditions and the terms on the coupon; the currency of issue.

Hoarau, CACIB: The risks embedded in the Solvency II structure of loss absorbing instruments will come under less scrutiny compared with bank AT1s given that triggers are perceived to be less likely to be breached by insurance companies whose capital positions and business profiles are in general already very solid. Nevertheless, the market remains untested and I would expect investors to logically have greatest concerns around the volatility of the SCR ratio and subsequently the probability of a breach of the SCR. The interaction with cat bonds and reinsurance policies will require some education as well. In the end, given the complexity of the Solvency II framework, I am afraid that the majority of investors will stick to basics and focus first on the issuer fundamentals more than the intrinsic risk of the underlying instrument. This was the case in the AT1 market when it emerged a bit more than a year ago. And the nature of the metrics used when assessing risks has evolved a lot since then.

What will matter the most the most when assessing this type of instrument: issue size, spread, credit, coupon cancellation, loss-absorbing metrics, etc?

De Saussure, EDRAM: Technical elements will of course matter — such as issue size, investment grade rating, risk of further issuance.

We will also pay attention to any perceived asymmetry in the early call mechanisms, if we feel bondholders bear most of the uncertainty on eligible structures going forward.

References to distributable items in Solvency II Tier 1 will also need a careful review, given the HoldCo/OpCo structures of most of the insurance companies in Europe.

But what really matters is to get familiar with new solvency metrics (whether SCR, MCR), the expected volatility of these metrics, and the resulting probability of trigger breach.

Gurzal, La Française AM: What matters most will be: the credit quality; the coupon cancellation method; the loss-absorbing metrics, to understand the risk and the available buffer; the currency of issue; and the time ahead of the next call date.

Hoarau, CACIB: We don’t expect the size of this market to grow sharply, so I don’t see the size element having the same type of relevance in insurers’ Solvency II Tier 1 as in banks’ Basel III Tier 1 issuance. The concept of a “repeat issuer” will not be relevant to the segment, which we expect to offer only rare and valuable investment opportunities. Per se, the risk of coupon cancellation and the likelihood of a breach of the SCR will be assessed, but only for the sake of doing the necessary due diligence. We all agree on the fact that Solvency II Tier 1 is a much safer segment. The absence of MDA restrictions and lower constraints on write-up mechanisms are elements that will appeal to investors beyond issuer fundamentals. Given the overall market backdrop, the hunt for yield and more importantly the profile of Solvency II issuers, we expect the segment to converge quickly to the average yield of the “must pay coupon” instruments.

What can you say about the spread differential between bank AT1 and upcoming Solvency II Tier 1 instruments?

Gurzal, La Française AM: The spread differential between bank AT1 and upcoming insurance Solvency II Tier 1 will be explained by lower volatility on the insurance segment, making both bonds similar in term of risk-reward profile.

De Saussure, EDRAM: Honestly, we are not there yet internally. All in all, we expect upcoming Solvency II Tier 1 to be priced inside bank AT1 to reflect (i) better overall ratings (issuer and structure), (ii) a better mix of issuers (only big issuers would issue), and (iii) relatively more palatable capital structures with fewer interactions with MDAs, Pillar 2, PoNV or other hard-to-quantify external requirements.

That said, only few insurance companies disclose SCR and MCR levels. Even fewer have committed to a financial policy based on SCR/MCR. Therefore, any assessment of the “buffer to SCR/MCR trigger” or “buffer to coupon cancellation” is a guestimate at this point in time. Another element is that Solvency II SCR/MCR metrics do not have a long track record (though it should somehow behave like economic capital models), hence the feeling that it is difficult to assess the probability of solvency buffers being consumed. We need to get used to the new solvency metrics and their expected volatility.

Optically, it looks like major insurance companies already operate with bigger buffers to SCR breach (most players report SCR of 180%-200%) than banks relative to their CET1 trigger breach, which should support tighter spreads for Solvency II Tier 1. That said, the added Combined Buffer Requirements for banks not only mean coupon cancellation risk is more prominent for banks than for insurance, but furthermore imply that banks have an incentive to maintain a solvency ratio way above the CET1 trigger breach. For insurance, the high levels of SCR currently observed seem to rely more on market practices and economic capital model than an explicit regulatory requirement.

As a consequence of this SCR/MCR volatility, we believe the write-up/equity conversion will actually prove more valuable for insurance companies, all the more so as the write-up mechanisms could be more straightforward for insurance companies (and not restricted by MDA quartile-equivalents, for instance).

Hoarau, CACIB (pictured below): Julien is right to be cautious. Indeed we are not there yet, and the differential between both segments will be dictated by the liquidity situation when the first issuance surfaces, as well as the state of the convergence between high beta and lower beta instruments when this happens. The price discovery will not be trivial and as of today there is a consensus in the market that Solvency II Tier 1 should price 50bp-75bp tighter than Bank AT1.

How much insurance supply can the market absorb going forward?

De Saussure, EDRAM: The insurance Solvency II Tier 1 market is likely to be small compared to the bank AT1 market. The incentive to issue hybrid T1 for an insurance company seems less palatable than for a bank. It may therefore only be a big issuers’ game, implying both a better quality mix of issuers but also a higher attention to the cost-effectiveness of the instrument. Though Swiss Re has a CoCo instrument outstanding, it is likely to be restricted to European insurers regulated by Solvency II. It is our expectation that this market will not be bigger than Eu50bn.

From the sense of indigestion observed on insurance subs back in October 2014, we need to see banks allocate more risk budgets to insurance subs trading before being totally comfortable with the asset class. We understand insurance subs is very often only a portion of the total subordinated financials trading book.

In terms of demand, we expect this supply to be met by a decent appetite for the asset class considering (i) the likely investment grade ratings of these instruments (in any case, better ratings than bank AT1) and (ii) the search for yield in a zero yield environment. However, we still wonder whether institutional investors will be able to buy the asset class, as perpetual instruments are badly treated under Solvency II guidelines. The same applies for retail clients, where we anticipate that FCA restriction or ESMA guidelines on CoCos would include Solvency II Tier 1 at some point.

Jurisdictions where the “Solvency II perpetual Tier 2/grandfathered Tier 1” arbitrage has not been validated by regulators, such as the UK, Spain or to a lesser extent Germany, might be quicker to come to this market.

Gurzal, La Française AM: The market can probably absorb from Eu10bn-Eu20bn of insurance Solvency II Tier 1 bonds in 2015.

You are invested across formats in subordinated debt, between bank AT1/Tier 2 and sub insurance — where do you see most value taking into account risk, the profile of the issuer, current valuation levels and upcoming developments?

Gurzal, La Française AM: The yield differentials among the various layers of subordinated debt are justified by their priority in case of any trigger event. However, we position ourselves on premium companies with sound credit quality and a high senior rating, and offering large buffers before triggers are reached. On these companies, in the case of any trigger event, we believe all layers should be affected. We therefore favour Tier 1 debt on these companies, providing a higher coupon and yield for a similar risk across the different layers.

De Saussure, EDRAM (pictured below): Arbitraging the phasing-out of legacy instruments issued for Basel II and Solvency I has been and will continue to be our major performance driver. Insurance has also been one of our key calls, with close to 30% allocation in our financial subordinated portfolio. Though the bank legacy instruments are disappearing quickly, recently issued “Solvency II perpetual Tier 2/grandfathered Tier 1” somehow benefit from the same dynamics. Some of them might be truly Solvency II-compliant, but we actually expect the majority to be called at the end of the Solvency II transitional period, i.e. close to or at their first call date. We also like European insurance Tier 1s with short-dated calls, given some of them have already been refinanced ahead of the Solvency II cut-off date.

AT1s are attractive instruments on a spread and yield basis. But it feels like the supply/demand dynamic has not balanced yet. Hence the higher volatility potential on this segment, notwithstanding any correlation risk, should one of the AT1 coupons get suspended. Therefore we are very selective in how we approach the asset class.

What are your expectations for 2015 in the global AT1/Solvency II Tier 1 market? What’s your bet in terms of issuance volume and yield spread evolution across sector (bank vs. insurance)?

Gurzal, La Française AM: In the context of Basel III implementation by 2019, banks should continue to fill the 1.5% of RWA with AT1 CoCos. We think that Eu40bn should be issued in 2015. However, spreads should stay unchanged due to a pressured primary market and the significant volatility on this new asset class.

De Saussure, EDRAM: We expect AT1 issuance to stay at a high level, similar to 2014, as issuers are incentivised to issue 1.5% of their RWAs. We expect Solvency II Tier 1 to be launched in the market at the end of H2 2015.

Though more investors can look at AT1s, we are not yet convinced that the supply/demand imbalances observed in H2 2014 have levelled out. The segment offers very decent yields and some spread tightening potential, but will likely continue to be volatile and to be heavily influenced by technical factors.

Though the Solvency II Tier 1 could be a niche market only, we see the supply/demand as more balanced. And it is definitely a segment where we will be able to allocate more risk budget throughout the year.

And finally, do you have any other expectations for 2015?

Gurzal, La Française AM: We think that in 2015 index providers should start considering the subordinated debt market as part of their indices, as it is becoming a significant segment.