17 October 2014 Alternative Risk Transfer

Fitch: Solvency II charges ignore rating differences

The lack of capital charges on securitisations does not account for the variation in risk in these assets under Solvency II.

That is the opinion of rating agency, Fitch Ratings, which says that The European Commission’s failure to adopt more than two of these charges within Solvency II is likely to push insurers that invest in securitisations using the standard model to favour assets in the 'AAAsf' and 'BBBsf' categories.

The Commission said on Friday that charges under the standard formula for 'AAsf', 'Asf' and 'BBBsf' rated tranches of securitisations classified as "type 1 high quality positions" will be 3 percent multiplied by duration. It had previously said the charges would be duration times 3 percent, 4 percent and 5 percent for 'AAsf', 'Asf' and 'BBBsf', respectively. The Commission gives the 3 percent charge for unrated loans as the rationale for capping the charges on these instruments. Charges for 'AAAsf' rated notes remain 2.1 percent multiplied by duration.

According to Fitch, the agency’s study of total losses on European securitisations during the credit crisis revealed that tranches rated 'BBBsf' in July 2007 are expected to incur 2.8x more loss than those rated 'AAsf'.

“But even after the cuts, the charges are high compared to other investment options and may not be enough to encourage insurers using the standard formula to invest significant sums,” said Fitch.

“The undiversified charge for a 'AAsf' rated 10-year securitisation is still 30 percent, compared to 20 percent for a 10-year 'BBBsf' rated loan and is 15 percent higher than the charge for investing in an unrated five-year uncollateralised direct loan. The comparison with covered bond holdings is even starker: five-year 'AAsf' rated securitisation holdings will require 15 percent capital compared to 4.5 percent for covered bonds with the same rating and duration.”

The cuts have only been made on "type 1 high quality positions" rated 'BBBsf' and above, with charges for lower-rated tranches not being reduced, which Fitch says could make finding buyers for these tranches difficult, therefore making it harder to structure deals.

“There may be greater benefit for insurers using their own internal models because they are able to use assumptions tailored to the risks of the specific transaction. As the bigger, more sophisticated market participants, they are also the more likely buyers of securitisations. But supervisors have often not been willing to approve models with large deviations from standard industry assumptions, so we do not expect insurers to be able to reduce capital requirements as low as might be indicated by empirical data,” said Fitch in a statement.

The Commission outlined its intentions in a press briefing and adopted the Solvency II Delegated Acts, making them public on its website for the first time. Another change in the Delegated Acts is that investments in infrastructure project bonds are treated as corporate bonds, even when credit risk is tranched, instead of being treated as securitisations. This will make it more attractive for insurers to invest in the sector.

There will now be a six-month window during which the European Parliament and European Council can challenge the details of the text or accept it.

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