Convertibles and Solvency II: Commentary
Nicolas Delrue argues that mixing convertible bonds with equities preserves equity upside exposure with lower downside risk – which is good in itself, but great under forthcoming solvency capital requirements
The countdown is on. In less than a year from now the Solvency II Directive will come into force, bringing with it significant implications for Europe’s insurance industry.
But while these regulations may, on the face of things, present challenges for insurers, it also presents significant opportunities for these institutional investors to arbitrage between asset classes. As a result, certain assets such as convertible bonds have the potential to play a much greater role in portfolios and can deliver substantial benefits in terms of returns and diversification.
The Solvency II 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 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 affect 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 (for example, whether or not it contributes to liability matching and diversification).
Put simply, the greater influence of asset allocation on regulatory capital provisions under Solvency II 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.
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 to.
Within this context, convertible bonds seem particularly attractive, particularly compared with equities. Although 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 past few years have demonstrated that a 39% fall is all too possible over a 12-month period – holding stocks is still 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.
“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”
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 index, while also recording significantly less volatility, as shown in the figure.
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 exposure (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. Put more simply, this is the way equity sensitivity increases with market rises or decreases with market falls. 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.