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Why is Solvency so important?

25 July 2018
Richard Kemmish

The preferential treatment of covered bonds for insurance investors might not be as important as we all think it is.

I mean Solvency 2 in the title, obviously. Specifically – because this is a column about covered bonds – the treatment of covered bonds in the capital allocation module of Solvency 2. Under this Directive, qualifying covered bonds are granted a lower capital allocation for insurance investors than would be otherwise afforded them by their credit rating. You probably feel that this is justified by their exceptional credit quality and equally that this is important to the stability of the market. This is where we might start to differ.

On the first point – that covered bonds should get a lower capital allocation because they are such fantastic credits - there are a couple of problems. Firstly, that capital under Solvency 2 is supposed to address price volatility rather than the risk of credit loss. You might reasonably argue that they are the same thing – a bond that defaults tends to lose a lot of it’s value. But as our friends in the securitisation market discovered the hard way, you don’t need to have poor credit performance to have poor price performance. Securitisers keep arguing that most of their bonds survived the credit crunch quite well really, which they did from a pure credit perspective. But not from a market value or liquidity perspective. 

Then there is the point that the great credit performance of covered bonds is already captured in their credit rating.

According to the rating agencies, one AAA is the same as another AAA. It doesn’t matter if it is AAA because the issuer is AAA in its own right or because it is a well structured covered bond that gets an eight-notch uplift from the issuer rating. So why does Solvency 2 (or CRR for that matter) treat a covered bond AAA better than an unsecured AAA? 

I’ve heard several answers, none of them particularly convincing. One is that there is no such thing as AAAA – no covered bond has ever defaulted remember, so they are safer than a mere AAA rating would imply. Sadly, that doesn’t really work because a AA rated covered bond still gets better capital treatment than a AA rated unsecured bond. Another is that the agencies have got it wrong – that AA rated covered bonds should in fact be AAA rated. Difficult to agree with that one. Or that the prudential treatment isn’t a true reflection of risk but also an attempt to encourage the use of more responsible financial instruments. Maybe.

Then there is the question of how important the Solvency 2 prudential preference for covered bonds is. According to a survey that I conducted for a client recently, most investors think that the covered bond rules in Solvency 2 are incredibly important to the well-being of the market. But only about 10% of investors are actually governed by that directive. And for that 10%, according to my own calculations, about three quarters of the improvement in the capital treatment of their holdings comes from the rating uplift rather than the covered bond preferential treatment.

Don’t get me wrong, I think that covered bonds are justified special treatment under Solvency 2. I just think that we tend to overestimate how important it really is.


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