When it comes to regulatory capital, banks tend to capture the lion’s share of investor attention. The details of insurance solvency and the associated capital that companies are required to hold to meet regulatory requirements is less well understood by investors, in comparison to banks. However, the insurance industry offers attractive opportunities to fixed income investors, and there is a steady flow of issuance from the sector that can complement the holdings in a traditional bank lender.
Regulatory capital in the insurance industry was the subject of a webinar in HSBC’s 2020 Credit Conference. The speakers described the scale of the market, compared it to the more familiar bank regulatory capital, and explained the different dynamics in the key geographies in Asia as well as Europe.
Price stability and external supervision
In terms of issuance, insurance subordinated debt placed into the international market accounts for a much smaller proportion of global subordinated debt than bank capital and corporate hybrids. It is however, a growing market, with net international subordinated debt supply denominated in USD, EUR, GBP and SGD totalling USD20 billion equivalent in 2019 according to Dealogic. More than half of the abovementioned internationally-placed subordinated debt is denominated in US dollars, with Europe accounting for more than 60 per cent of total issuance from the start of 2015 to May 2020. In the same time period, perpetual structures accounted for just under 30 per cent, while the remaining majority is dated.
From a pricing perspective, the relatively lower volume of supply could be seen as a positive. “The lower volumes of insurance subordinated debt, relative to banks, could been seen as having a positive impact on market technicals and may be helpful in terms of relative price stability,” said Nik Dhanani, Managing Director, Global Head of the Financing Solutions Group, at HSBC.
Insurance companies are generally rated by credit rating agencies, and the majority of companies seek to preserve investment grade ratings. Unlike non-financial corporates, the insurance industry is highly regulated in a similar way to banks, said Mr. Dhanani, with capital adequacy rules in place to protect policyholders. The existence of prudential regulation, including a capital adequacy framework, may also be seen positively by debt investors, on the basis that the regulatory framework should reduce the risk of insolvency.
“The prudential authorities are looking to ensure that the insurance company’s capital base is adequate for the insurer to continue as a going concern for existing and future customers,” said Mr. Dhanani. “Investing in insurance subordinated debt is an interesting opportunity and will continue to be so, because it allows the possibility to invest in a sector that has some external supervision, which is not the case for most non-financial corporates.”
Comparing regulatory regimes – banks and insurers
Although regulators have broadly the same goals for both banks and insurers – namely, to ensure solvency and protect customers – the approach taken in each sector is quite different.
“The concept of leverage is different between banks and insurers,” said Mr. Dhanani. “In many ways, the assessment of leverage is more similar to a traditional corporate analysis and typically the rating agencies have a defined amount of leverage tolerance within each rating band.”
For bank capital, the regulatory focus is on equity capital, or the Common Equity Tier 1 (CET1) ratio, in both absolute terms and relative to requirements (ie. the surplus CET1). The main capital metric for insurers is the solvency ratio, (sometimes referred to as the aggregate solvency margin), which can be seen as equivalent in many ways to the Total Capital Ratio for a bank.
Another way that banks and insurers differ is that banks do not have limits for the different forms of capital they can hold under Basel III. In the insurance sector however, there are specific limits applicable to certain types of instrument. For example, under the Solvency II regime in Europe the volume of recognised Tier 2 Capital may not exceed 50 per cent of the Solvency Capital Requirement (“SCR”), while the limit for Restricted Tier 1 Capital is 20 per cent of total Tier 1 Capital. These regulatory limits could be used to estimate the maximum indicative amount of subordinated debt that an insurance company can issue, though Mr. Dhanani said that in practice insurance companies do not typically reach these upper limits.
Asia focus – Fragmented Regulatory Frameworks, for now
Asia Pacific accounts for just over 10 per cent of global insurance capital issuance from 2015 to May 2020 according to Dealogic. The region’s insurance hybrid supply is dominated by domestic deals denominated in the respective local currencies such as CNY and JPY, driven by activity in its two largest economies – China and Japan.
Across Asia Pacific, instrument criteria differ from jurisdiction to jurisdiction. It is a very different environment to the European Union where rules are harmonised under the Solvency II regime.
“In terms of regulation, the market remains quite fragmented in terms of instrument criteria, as there is no unifying framework that all the jurisdictions follow,” said Krystal Tang, Associate Director, Financing Solutions Group, at HSBC. It is important for investors to understand the regulatory frameworks across the various jurisdictions so that they understand the rationale for differences in instrument features and thus risks associated with investing in each instrument.
However, the potential implementation of the Insurance Capital Standard (“ICS”) by the International Association of Insurance Supervisors might lead to more standardised frameworks and consistency of instrument terms, depending on the adoption of ICS within the region.