European Commission (EC) proposals to lower capital charges for longer-dated unsecured corporate and financial institution bonds should mitigate the capital flight from these asset classes that is a likely side-effect of Solvency II, said Fitch Ratings in a new report.
But the changes represent incremental progress rather than a radical change: holding these bonds would still be less desirable than under current rules according to the ratings agency.
The EC’s proposals do not uniformly reduce charges, but materially reduce them for bonds rated in the A category or higher with duration over five years, and for BBB bonds with 5-20 years’ duration. For example, ignoring diversification benefit a 10-year A rated bond attracts a charge for spread risk of around 15% under the present plans. Under the new proposals this would be reduced to 10%.
Insurance companies are the largest investors in Europe, holding about 44% of European investments, €7 trillion of assets in total. The previously proposed capital charges for long-dated unsecured bonds were extremely onerous, meaning that at best insurers were likely to switch holdings to shorter-dated higher rated bonds only – potentially increasing refinancing risk for borrowers.
These proposals are complemented by the proposed matching premium and counter-cyclical premium, which would further reduce the cost of holding these bonds. The matching premium would allow credit for the illiquidity of bonds, to which insurers are less exposed than other market participants. The counter-cyclical premium would allow the European Insurance and Occupational Pension Authority (EIOPA) to adjust interest rates using a predetermined mechanism during times of market dislocation or turbulence.
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