Regulation was a main focus at the recently concluded Global ABS 2011 conference held in Brussels in mid June. One of the issues was Solvency II, the proposed new European regulatory regime that, according to a report by Moody's Investors Service, is probably going to increase regulatory capital requirements for both European Union and European Economic Area insurers and reinsurers when it is implemented in 2013.
David Flandro, head of global business intelligence at Guy Carpenter, said that Solvency II is a pan-European regulation that hopefully will lead to a more efficient market where capital transfer will be easier, at least in theory. He explained that whenever there is consistent regulation, the market has a better picture of what capital changes look like.
"It has not been implemented, and there will still be a period of time to wait before it comes in line," Flandro said. "However, hopefully this would lead to more opportunities in securitization and capital deployment."
One of the goals of Solvency II is to encourage insurance firms to manage risk more efficiently, which Flandro said can be seen in some small and medium-size insurance firms. "If you are a medium-size firm and have been using a simple statutory model under Solvency I, you might be using under Solvency II a blended internal model that will help you quantify and enhance your understanding of your own capital needs."
According to Flandro, there are two different issues that could apply to securitization under Solvency II. The first one is determining how Solvency II will affect the European market's understanding of risk transfer and the consistency of data leading to a more homogenous market. The second issue is identifying capital dislocations under Solvency II and how insurance -linked securities can be deployed to address these.
There was a dedicated panel at the Brussels gathering on the subject that Bob Haken, senior associate in corporate and regulatory insurance at Norton Rose, moderated. The panel's main focus was on ABS as an investment for insurance firms under Solvency II. The general feeling at the panel was that, even though Solvency II rules are not finalized, as it is currently written ABS might be too costly as an investment for insurers because of the high capital charge for the product under the regulation.
Elana Hahn, partner in the capital markets practice at Morrison & Foerster in London, echoed these sentiments in an emailed statement.
"Insurance companies and their affiliates have historically been a significant investor in ABS, as these products have typically offered attractive yields compared with other collateralized instruments," she said. "The considerable uncertainty surrounding the capital treatment of longer-term investments including ABS under Solvency II is resulting in many insurance companies avoiding material investments in ABS at present, which is having a chilling effect on the market."
There are also the inconsistencies in the application for different securitization products. It is possible that under Solvency II, subprime RMBS might carry a lower charge than some forms of secured prime lending.
However, one positive that panelists mentioned was that under Solvency II, insurers are free to invest in whatever product they deem suitable to buy. For instance, real estate bonds were prohibited in some jurisdictions. These might require insurers to put against these investments a higher buffer capital, although this might not matter if these firms get other benefits in terms of the timing of their cash flows through duration matching.
"For the insurance industry, securitization is not very high on the list of priorities," Haken said. "Although for banks on the origination side, there is something we can work on to make these originations more attractive for insurers to buy when the rules are finalized."
Flandro added that Solvency II will have a different impact depending on the line of business involved. "Different lines of business are regulated differently, and the cost of transferring risk will depend on a client's needs," he said.
According to Sandrine Sauvel, a partner in debt capital markets and securitizations at Norton Rose, some on the origination front are looking to structure infrastructure and project bonds, which they would be able to offer to insurance companies. These infrastructure and project bonds, which could cater to different types of investors, used to be wrapped to triple-A by bond insurers.
But will insurance companies be willing to buy these deals? "The problem under Solvency II will be how much should be set aside for these investments," Sauvel said. She added that aside from the yields, matching assets and liabilities is also a concern for insurance firms. "It's a wait-and-see what insurance companies will do as investors," she added.
It is also a question of what insurance firms will do as potential originators in securitization. Sauvel explained that insurance firms will be looking at securitizing their own risk. This is mainly because the whole purpose of Solvency II is to encourage a much more sophisticated approach to articulating risk appetite and mitigating risk and this may include reinsurance and the transferring of risk to the capital markets. "This could lead to more securitization transactions, including sidecar deals and reinsurance," Sauvel said
Another source of activity for the capital markets would be insurance companies raising additional capital. "For the most part, the good news is that many insurance companies have enough capital," Haken said.
However, some insurance firms have considered this early on and to prepare for Solvency II have accessed the capital markets for funding. An example is QBE's recent $1 billion transaction.
Sauvel expects smaller players that do not have access to the stock and debt markets other than aggregate structures to raise funds in the near term and not wait for the two years it will take before Solvency II implementation. Funding alternatives for insurance companies include issuing securities and senior/subordinated bonds.
Timing of Implementation
Commissioner Michel Barnier of the European Commission has indicated previously that Solvency II will definitely be effective in 2013 in some form. However, "we are expecting a transition period," Haken said, noting that there's a draft Omnibus 2 Directive that contains additional provisions that are still being worked out.
In terms of consistency with other countries' regulations, there remains a divergence. In the U.S., for instance, Solvency II might have more in common with existing rules in certain U.S. states compared to others. Aside from Bermuda, Switzerland and Japan, which are currently being assessed for equivalence, in other places like the U.S. there will be some form of recognition known as transitional equivalent.
The rules are much more consistent across sectors. "You will be looking at similar rules, and for credit institutions, for instance in terms of regulations on asset-backed investments, Solvency II would just mean different results from a capital perspective," Haken said.