CreditSights: European insurers

Philippe Picagne, senior analyst — insurance, at CreditSights, and University Professor, examines the challenges facing the European insurance sector, and explores how Solvency II is affecting their strategies, not least in the capital markets.

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What are the current challenges posed to European insurers?

I think that the current low interest rate environment, together with a marginal deterioration of the property and casualty (P&C) primary insurance market (e.g. commercial motor) has put pressure on European insurers in delivering a satisfying overall level of profitability for their shareholders. For reinsurers, the situation is even more gloomy considering the soft P&C reinsurance market. Even this relatively weak profitability might not be sustainable in the long term. My interpretation of Solvency II is that it will offer European insurers a “plan B” vis-à-vis capital management in order to improve overall profitability. For example, management could look at increasing returns to shareholders via special dividends or buy-backs while issuing Tier 1 debt to maintain an adequate solvency position. In our view, the capital structures of European insurers are far from optimal under Solvency II.

Additionally, one could argue that interest rates will eventually rise in the future considering their present rock bottom levels. If that were to happen, we believe that under the current IFRS rules, some players will be at risk because of the corresponding reduction in the AFS reserve, a significant part of an insurers’ shareholders’ equity. The situation could be particularly critical if interest rates were to increase suddenly and sharply. Ultimately, this situation could lead to a decline in the financial strength of insurers.

In this context, what are the trends in terms of investment strategy?

Over the past few years, we have identified two trends. Firstly, some primary insurers — in their search for higher yield — increased their asset allocations to Italian and Spanish government bonds two year ago. In particular, composite or life insurers with a relatively high guaranteed rate in their liabilities had to increase their return on investment in order to match or minimise the interest rate gap. These insurers are predominantly based in Germany, Austria and Switzerland. One could argue that this strategy has had great results over the last two years, but with the rumblings in Greece ongoing, it will be put to the test again.

Secondly and more recently (i.e. over the last year and a half), European insurers have significantly increased their asset allocation to corporate bonds. This does not come as a major surprise considering the low yield that investors receive on European sovereigns, the staple of an insurer’s investment portfolio. So far, European insurers have focused on high grade corporate bonds with a limited asset allocation to high yield. Prospectively, I would not be surprised if the allocation to high yield continues to grow over time, considering the relatively low marginal cost of capital implied.

Solvency II will be implemented next year. Do you see any major changes in terms of risk profile for European insurers?

After several delays, Solvency II will finally be implemented this coming January. In the very short term, I do not anticipate any significant changes in the risk profile of European insurers, especially with the beneficial transitional arrangements in place. So far, we have seen some insurers optimising their business profiles with Solvency II in mind. In particular, some have broadened their lines of business and geography in order to better benefit from the risk diversification factor under Solvency II. As a matter of fact, the cornerstone of Solvency II is risk diversification; the greater the risk diversification, the lower the required capital. We see Scor as a good example of this approach, given how its business split has evolved following its numerous acquisitions.

But the key question behind Solvency II is whether or not we can rely on the correlation factors that underpin diversification. And to what extent? I fear that some insurers in search of capital optimisation may face financial issues in the medium term.

The value at risk (VaR) approach is sensible in an environment of low volatility. In some regions, such as Japan, insurers quantify their risks through scenarios instead of VaR. More importantly, the key flaw of Solvency II relates to (i) the lack of information to investors regarding the assumptions used in internal models, which impairs the ability to compare Solvency II ratios among European insurers and (ii) the convexity of the 99.5% VaR. In other terms, I believe it would make sense to disclose the required amount of capital at different confidence levels.

How does Solvency II compare with Basel III?

From a debt perspective, Solvency II Tier 1 and Tier 2 debt are relatively similar to Additional Tier 1 (AT1) and Tier 2 issued by European banks. There are a few minor differences that are not significant, in my opinion. Solvency II is certainly less precise and stringent than Basel III.

The key difference between Solvency II and Basel III stems from the quality of capital. In my opinion, paradoxically, Solvency II promotes a weaker quality of capital through the inclusion of 100% of an insurer’s value in force (VIF) as Tier 1 capital, net deferred tax assets as Tier 3 capital (which could account for up to 15% of the company’s Solvency Capital Requirement (SCR)), plus letters of credit and reinsurance covers as Tier 2 capital. The VIF can fluctuate significantly due to the presence of high guarantee rates. For example, Allianz’s VIF declined from Eu12.5bn in 2007 to Eu2.6bn in 2008. If the VIF fluctuates, then the insurer’s capital will change in value, and so will its Solvency II ratio. Correspondingly, I believe that some insurers could be at risk.

Do you think that Solvency II will improve the quality of information disclosed by insurers?

Yes, under Pillar 3 of Solvency II. But I believe insurers will still need to disclose more information to investors if they want to market their debt issuances. In particular, I think there is a need to educate investors on the sensitivity/convexity of the issuer’s SCR, especially with the loss absorbency mechanism in a Tier 1 bond.

Traders and asset managers will have to manage the “distance to trigger” for Solvency II Tier 1 bonds, or they risk getting their fingers burnt in the process.

Do you see substantial issuances of Tier 1 and Tier 2 debt in the near future?

Solvency II is a playground for capital optimisation. In contrast to banks that need to have a minimum amount of shareholders’ equity under Basel III, insurers could virtually run their business without a minimum amount of shareholders’ equity per se under Solvency II. This situation is likely to lead some insurers to swap their shareholders’ equity for Tier 1 debt in order to optimise their overall profitability, as measured through their return on equity. Furthermore, this situation would not materially change the insurer’s Solvency II ratio as the total amount of Tier 1 would remain identical after the swap. The only hurdle I see is maintaining their credit ratings in the process; bearing this in mind, rating agencies do not have stringent requirements in terms of hard capital. If this were to happen, then their risk profiles would deteriorate, to the benefit of equity holders. In which case, I would rather be long equity and short bonds of European insurers.

From a demand perspective, we expect Solvency II Tier 1 bonds to be popular among investors. We believe most are already familiar with the loss absorbency mechanism via bank AT1s. Crédit Agricole’s recent study on the pricing of Solvency II Tier 1 bonds (anticipated spread at a multiple of c. 1.65x Tier 2 bonds) is consistent, in our view. Although from a theoretical perspective, I challenge the pricing of the loss-absorbency feature of Solvency II Tier 1 debt as insurers rarely file for bankruptcy; instead, they are put into run-off.

Investors in hybrid bonds issued by European insurers will also benefit from the issuers’ strong ratings; on average, European insurers are rated in the AA/A range. The current rating methodologies of Fitch, Moody’s and Standard & Poor’s only assign a three notch difference between the senior and subordinated debt ratings, compared with up to six for banks. This situation is rather strange as Solvency II Tier 1 debt characteristics are very similar to AT1s, and Solvency II is unlikely to change materially in the very near future. But even if rating agencies were to change their methodologies in future, most Solvency II Tier 1 bonds are likely to be rated high grade, which will provide an extra incentive to invest in this asset class.

What is your view on the G-SII framework?

I think it is too early to comment on this point based on past experiences with the development of Solvency II. There will likely be a few European players impacted by the G-SII rules. This “VIP membership” will require additional capital and face greater regulatory scrutiny, which in theory should improve their financial strength. With the framework far from being finalised, I am sure that there will be intense discussions and lobbying in order to minimise this additional layer of capital or to find alternative solutions such as letters of credit that would not imply an increase in capital.

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Philippe Picagne, senior analyst — insurance, at CreditSights, and University Professor, examines the challenges facing the European insurance sector, and explores how Solvency II is affecting their strategies, not least in the capital markets.