Sunday 28 June 2015

Securitisations and Solvency II: An opportunity? Or one to be missed?

To put it mildly, securitisations did not a get a good reputation as a result of the financial crisis.  Things are now changing.   This is illustrated well in a discussion paper from the Bank of England and the European Central Bank extolling the virtues of securitisations (here).    It is difficult to disagree with the key message; securitisations can be a win-win transactions that enhances the ability to redistribute risks more efficiently in the economy while enabling institutional investors to access a wider pool of investment.  

The Solvency II Delegated Acts (‘implementing measures’) built up a more favourable capital treatment for securitisations.  It is now recognised as a category of its own for the purposes of spread risk.  This evolution can be evidenced in the Commission’s Impact Analysis published at the time of the publication draft Delegated Acts (here).  As recognised in the Delegated Acts, this even includes recognising the name ‘securitisation’ instead of the name used in the Solvency II Directive in 2009: ‘investment in tradable securities or other financial instruments based on repackaged loans’.

As one would expect, the calibration of the standard formula spread risk for securitisation reflects the maturity of the exposure and its credit rating.  However, there is an interesting innovation.  The Delegated Acts identify two types of securitisation exposures: ‘good’ and ‘bad’, or in policy terms, type 1 and type 2.  The criteria are set out in the Delegated Acts and are quite detailed.  

Exposures of type 1 must meet 20 conditions including a rating of ‘BBB’ or above, the seniority of the exposure in the securitisation, SPV arrangements, listing in an OECD or EU exchange, and backing by residential loans, commercial loans or auto loans and leases.   The list of conditions is somewhat shorter for securitisations that were issued before the Delegated Acts came into force. Type 2 securitisations are simply those not meeting these criteria.  

Figure 1 shows the significant difference that meeting the conditions for type 1 makes to the capital charges.  It is a noticeably a more important consideration than the rating or maturity of the exposure.  

Figure 2 shows an alternative view of the spread risk capital requirements for type 1 securitisations compared against the equivalent ones for corporate bonds of equivalent ratings.   The differences aren’t that large in particular for short maturities.

All this raises a number of interesting considerations for an insurer’s capital management strategy. 

Firstly, there may be tactical adjustments where insurers find that they are holding type 2 securitisation paper as part of the Solvency II implementation work.  In this case, the insurers may seek to dispose of these investments before 1 Jan 2016 to avoid the capital increases that Figure 1 suggests.  However, given insurers’ relatively small holdings of securitisations, this may not be a material issue.

The bigger issue is the extent to which there is an appetite to consider the capital treatment of type 1 securitisation as a more strategic opportunity and readjust investment strategies.  Indeed, would it be possible to do so before 1 Jan 2016 to enhance the matching of cash flows of annuity liabilities and subject to Matching Adjustment? 

In any event, Figure 2 above suggests that there may be an interesting question about the risk and return trade-off of corporate bonds versus type 1 securitisations.  Would the returns from securitisations be sufficiently higher to justify the additional capital requirements?  Figure 2 suggests that for low maturities, e.g. up to 7 to 10 years, this could be finely balanced in particular for ‘BBB’ bonds.  If so, would insurers be willing to tilt their investment strategies to include more type 1 securitisation?  The answer to this question requires appropriate consideration, cash-flow matching including risk appetite, stress testing and governance.   

However, even if the risk and return trade-off mentioned above appears appropriate, it seems that there may be a limited supply of type 1 securitisations.  If so, there would be a limited opportunity for insurers in the short to medium term.  This would be more of an opportunity for investment banks to structure securitisation transactions.

This post is part of a series of posts on Solvency II.  To see the list, click here

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