The 5% trap: Solvency II brings more woe for ABS

Risk retention rules threaten to force firms to dump legacy assets

The change in perception of securitisation in Europe, from source of the problem to part of the solution, has been swift. Unfortunately, the statute books are yet to catch up.

Even as European Union policy-makers work on ways to revive the market in asset-backed securities (ABSs) to boost the region's economy, rules written into Solvency II that form part of the response to the financial crisis threaten to force insurers to dump legacy portfolios.

European insurers already face charges for ABSs that many think are excessive. But the largely overlooked rules on risk retention, and their inconsistency with measures outside Europe, mean capital requirements for some ABSs might be two-and-a-half times higher than expected.

"As asset managers are delving deeper into the details, a number of risks are crystallising," says Richard Sarsfield, head of European insurance at Morgan Stanley Investment Management, based in London.

Set out in the Solvency II delegated acts finalised in October 2014, the rules in question are similar to measures for banks and other investors as part of the response to the financial crisis under the leadership of the Group of 20 (G-20) leading economies. Only in recent months have insurers and their advisers started to grasp their full impact, however.

This slipped the attention of many firms for most of the course of last year

Gareth Haslip, head of global strategy in the Global Insurance Solutions Team at JP Morgan Asset Management, says: "Everyone has been bogged down with building internal models and getting their reporting and Pillar 1 and Pillar 2 in place. This slipped the attention of many firms for most of the course of last year."

Insurers are only allowed to invest in ABSs issued after January 1, 2011 if the issuer retains an unhedged 5% interest in the bonds (often referred to as ‘skin in the game'), and must be able to demonstrate to supervisors a ‘comprehensive and thorough understanding' of the underlying exposures.

Firms that hold a securitisation that fails to meet the retention rules or who do not fulfil the exacting diligence requirements must inform the regulator immediately, explains Sarsfield.

Capital charges on non-compliant ABSs for firms that fail to comply through "omission or negligence" are increased by at least 250% for insurers using the Solvency II standard formula, with progressive further increases if the firm continues to hold the securities in question. For a five-year AAA Type 1 securitisation, that would mean capital charges jumping from 10.5% to 36.75%.

Supervisors will also consider whether the failure is a "significant deviation from the undertaking's system of governance", says Sarsfield. Many in the industry see that as meaning supervisors might force insurers to sell offending assets.

How high capital add-ons might be for internal model firms remains unclear, with a spokesperson for the European Insurance and Occupational Pensions Authority (Eiopa) confirming to Risk.net by email: "The regulation does not explicitly specify what a proportionate increase is where the solvency capital requirement is calculated with an internal model."

"The supervisors will need, based on the information provided by the company to decide on the appropriate measures to be taken in case of non-compliant investments," the spokesperson adds.

At JP Morgan, Haslip says: "The general consensus we see in the UK market is you simply can't hold [non-compliant ABSs] under Solvency II. We see some companies looking to divest those positions this year. Others are waiting until Q1 reporting next year to discuss this with their regulator.

"Across Europe, different regulators will be taking different stances on whether firms are simply not allowed to hold non-compliant securitisations or whether they are subject to higher capital charges for doing so."

US deals

Retention requirements for European ABSs are already in place, so most European ABSs are compliant. But similar measures in the US only come into force in late 2015 (for residential mortgage securitisations) and late 2016 (for other types of deals). That means many US deals are unlikely to meet the criteria. Sarsfield says: "This will be of concern for insurers invested in non-EU funds with a securitisation remit."

While asset managers will no doubt help in the process of verifying whether assets comply, the onus is firmly on insurers. The Eiopa spokesperson confirms this: "We would like to underline that it will be the insurer's responsibility to verify the quality of its investment in ABSs. Where the investment activity is being carried out by an asset manager, this does not undo the insurer's responsibility for the ultimate risk management of its investments."

The rules will effectively lock European insurers out of the US ABS market, according to Alexander Batchvarov, a securitisation analyst at Bank of America Merrill Lynch, based in London. Meanwhile, some types of securitisations such as student loan ABSs will be exempt from the US rules, he says, meaning the problem could continue to affect future deals.

The precise quantity of ABS held by European insurers that fails to meet the requirements is unclear, Batchvarov says. "But many US asset managers are really concerned about this issue and that suggests to me this is significant."

BAML estimates that ABSs account for about 4% of European insurers' fixed-income allocations. However, some individual firms hold higher amounts.

According to research from JP Morgan Cazenove, examples of firms where ABSs comprise between 15% and 25% of fixed-income holdings (based on year-end 2014 and Q1 2015 numbers) include life insurers Legal & General and Aegon, and non-life insurers Hiscox and Lancashire Group.

David Astor, chief investment officer at Hiscox in London, acknowledges the firm owns ABSs that could be caught by the rules. "There is still some lobbying going on. So we don't want to make wholesale changes only to find out it wasn't necessary," he says. "We are not expecting to make wholesale changes, but we might have to tweak the portfolio."

Denise O'Donoghue, Lancashire Group's head of investments and treasury, based in Bermuda, says the firm is aware of the risk retention issue and is "formulating a plan". Aegon and Legal & General declined to comment.

Kevin Hawken, a partner at law firm Mayer Brown, based in London and a specialist in securitisation, estimates that two-thirds to three-quarters of legacy US ABS will be non-compliant. US deals after 2011 typically include a disclaimer in offering documentation if they do not meet the European risk retention rules, he explains.

However, Hawken thinks investments made by insurers before the finalisation of the delegated acts last year should be exempt from penalty. Before that point, insurers had no rules to work by, he says. He is less confident that supervisors will take an accommodating stance on ABSs issued since late 2014.

Some European insurers with US subsidiaries are understood to be relying on temporary equivalence to avoid heavy capital charges for ABSs held in their US funds. It remains unclear, however, whether risk retention rules might still apply in these cases.

Haslip says this question has not been fully explored or tested with regulators, so whether risk retention rules will affect firms holding US ABSs through subsidiaries will only become clear over the coming year.

Wider debate

Meanwhile, Solvency II rules could yet be overridden as a result of a wider debate about the effect of regulation on the securitisation market. Last year the European Commission pushed aside proposals from Eiopa and softened capital charges for ABSs in the delegated acts, although the reductions still failed to go far enough according to many in the industry.

Standard formula capital requirements for BBB Type 1 securitisations were slashed from 20% per year of modified duration to 3%, for example. But charges remain high for Type 2 ABSs and the process of classifying securitisations as Type 1 or Type 2 is onerous.

Insurers face a due diligence process covering about 15 criteria to secure Type 1 status for ABSs, says Sarsfield. "Asset managers are likely to support this process, but insurers will need to understand and manage the exposures and the risks."

The European Commission's Capital Markets Union initiative, launched in February, also included a consultation on how to encourage the resurgence of ABS in Europe. The European Central Bank, Bank of England, the Basel Committee and the International Organization of Securities Commissions are also working on ways to encourage the revival of securitisation markets.

The commission is expected to put forward further plans before the end of the year, which could include new legislation to supersede Solvency II, or might mean amending the directive. Hawken says an omnibus directive would be complex to put together and believes piecemeal amendment of existing legislation is more likely. "But that will take time," he says.

The hope that measures will be taken to reverse the effect of current regulations explains why insurers might be reluctant to sell ABS holdings now. Until then, however, European insurers will grapple with uncertainty about their legacy investments and the effect of rules that might soon be out of date.