Creating Opportunities The Role of Convertible Bonds in a Solvency II world

Solvency II in context


Before looking at the impact Solvency II can have on investment portfolios, it is perhaps helpful to briefly review the regulations themselves and what they seek to achieve.


At a basic level, Solvency II seeks to ensure the harmonization of the European legislative framework for insurers. Its key objectives are to improve customer protection and introduce a new supervision process that manages all risks facing insurers’ organizations. The regulations are divided into three distinct pillars covering capital requirements (pillar I), governance and supervision (pillar II) and disclosure and reporting (pillar III).


Of these, changes to capital requirements are particularly important given a focus on the asset side of insurers’ balance sheets. The implication of this is that insurers will need to collaborate closely with their asset managers to meet these more stringent regulatory requirements, as the imposition of capital charges on investments will ultimately impact the way most asset classes can be used. Capital charges will vary, not only based on the nature of an asset class itself, but also according to the role it plays within an investor’s overall portfolio (e.g. whether it contributes to liability matching and diversification).


Put simply, the higher influence of asset allocation on regulatory capital provisions under Solvency II regulations means insurers will have no option but to align their allocation choices to the new regulatory context and focus on concepts such as better duration matching, stronger downside protection and improved transparency of underlying holdings. Insurers will also be required to improve reporting standards and demand timely and accurate information from their asset managers.


The effects of linking capital requirements and asset allocation


Therein lies the overall theory and at first glance one might assume that, in its efforts to reduce the possibility of consumer loss or market disruption, Solvency II might create severe difficulties for insurers.


Under the regulations, insurers are required to value both assets and liabilities at fair market value and thereby define the minimum amount of capital they will need to set aside to cover the risks their assets are exposed to. This Solvency Capital Requirement (SCR) is defined as the economic capital an insurance company needs to hold to limit bankruptcy probability to 0.5% over a one year time horizon. It incorporates six quantifiable risks, of which market risk stands out as the biggest to a company’s SCR, comprising roughly two-thirds of the capital requirement of a life insurer and 50% of a general insurer.


The reality however is that with challenges come opportunities, in this case due to the regulations linking asset allocation and capital requirements. As a result, asset allocations can no longer be based solely on risk considerations, but instead must consider whether the capital charges being incurred can be justified based on returns that will be delivered. As a result, insurers will need to consider allocations to assets they may not have previously given much thought – as a result, this direct link between asset allocation and capital requirements promotes diversification and the opportunity to arbitrage between different asset classes.


Within this context convertible bonds seem particularly attractive particularly compared to equities. The “cost” of equity under Solvency II (a standard 39% shock to the market value of global equities) perhaps does not reflect the full risk of the asset class as measured by Value at Risk (VaR) – the last few years have demonstrated that a 39% fall is all too possible in a twelve month period. However, holding stocks is expensive in Solvency II terms. As a result, insurers have to consider their options and decide which asset class could offer cheaper equity exposure without compromising upside potential.


Convertible bonds carry a much lower regulatory cost for a similar investment risk and potential return than equities (due to their embedded conversion option) and therefore offer an attractive alternative. Historically, convertibles have been a cheap method of buying equity exposure due to markets undervaluing their option component. Yet since the end of 1998, the Thomson Reuters Europe Convertibles Hedged EUR index has outperformed the MSCI Europe EUR, whilst also recording significantly less volatility.


When applying Solvency II considerations to convertible bonds, the results frankly speak for themselves. By introducing convertible bonds into a diversified portfolio (50% equities, 50% fixed income), the cost in SCR terms is reduced and the coverage ratio improved. This result is reached while preserving the same equity (through the embedded option in convertible bonds), interest rate sensitivity, rating and market value.


The key advantage of convertible bonds relative to equities in this particular framework lies in their dual profile: a bond component, which provides downside protection, combined with an embedded option that grants equity upside potential. This dual profile also explains convertibles’ intrinsic convexity and capacity to participate more in equity market rises than falls.


For a given initial equity exposure, if all things are equal the impact of a negative equity shock will be significantly lower for convertible bonds than for stocks due to a positive gamma effect. This effect (more simply, the way equity sensitivity increases with market rises or decreases with market falls) is extremely valuable. The more convertible bonds display a balanced profile (in terms of equity sensitivity), the higher the convex potential is.


The benefits of convertibles are already being identified by investors and while a “grandfathering” clause exists on investments in equities done before January 2016, many insurers are already integrating these changes. In the brave new world of Solvency II, one thing is clear – there is a strong case and role to play for convertible bonds.


About Nicolas Delrue

Nicolas Delrue is an Investment Specialist for Convertible Bonds at Union Bancaire Privée (UBP), a leading Swiss private bank with regional offices in Dubai and Beirut. In his role, he represents the portfolio management team inside and outside UPB. Based in Paris, he previously worked as an investment specialist for the convertible bond desk at Fortis investments and as an investment specialist for the single strategy hedge fund business at SG AM Alternative Investments. His previous experience includes debt capital markets for the Caisse des Dépots et Consignations, an analyst position for a Venture firm and admission to listings at the Paris Stock Exchange.


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