Solvency II: Advantage convertible bonds

The aim of the Solvency II directive is to establish a new better-adapted solvency system to the effective risks incurred by insurance groups by requiring assets and liabilities to be marked at market value. Shareholders’ capital requirements will henceforth be a function of asset allocation, which is likely to lead to significant allocation changes (this constraint has been globally priced-in). The directive is set to apply to all European insurance groups as of 1st January 2013.

SCR (solvency capital requirement) represents the economic capital required by an insurance group to limit the probability of bankruptcy to a 0.5% threshold on a 1-year time horizon. Market SCR reflects the total aggregate impact of 7 recognized risks (equity, credit, interest rate, real estate, currency, cumulative and liquidity risks) incurred within assets and liabilities, via a correlation matrix.

In this context, the results of QIS 5 confirmed that convertible bonds bear low capital cost, like all convex products.

Below, we have detailed the calculation method for intrinsic market SCR for a Euro-hedged convertible bond portfolio (calculated excluding information concerning holder liabilities). 4 market risks apply to a Euro-hedged convertible bond portfolio: interest rates, equities, credit and cumulative risk (currency risk is zero for a portfolio hedged in Euro).

The assorted intrinsic SCR values are aggregated via a correlation matrix defined by CEIOPS (interest rate-hike risk is applied as liabilities are not taken into account).

 Intrinsic interest rate risk will be calculated involving a rate-hike crisis, applying a variable coefficient according to maturity (decreasing coefficient vs. maturity). The intrinsic SCR rate must be calculated for each bond according to duration and sensitivity, on an aggregated basis and applied to UCIT market value.

 Intrinsic credit risk is the result of a penalty coefficient based on a combination of rating, bond sensitivity and market value. The risks incurred by a UCIT are calculated on an aggregated basis, security by security. NB: unrated securities which make up a large proportion of the convertibles market are adversely affected to a lesser extent than high-yield securities (default rates on unrated securities are similar to BBB-rated securities and lower than high yield). Credit analysis skills are therefore of vital importance to permit investments to be made throughout the entire market, including among unrated securities.

 Intrinsic equity risk is calculated on the basis of a 30% markdown in listed equity. It is therefore important to retain a highly convex balanced-investment profile in order to limit the impact of this risk. The -30% markdown corresponds to a symmetric adjustment of market data over 3 years as of end 2009, but the figure will be closer to -49% at the end of 2010, which has led the authorities to reflect on the calculation methodology used.

 Intrinsic cumulative risk is the combined result of market value, breach of exposure threshold per issuer and a penalty coefficient which varies according to exposure. This can be deemed to be zero for convertible bond portfolios, as insurance assets include a low proportion of convertible bonds and the resulting dilution means that no single position is likely to exceed authorized thresholds.

A balanced-profile convertible bond portfolio (equity sensitivity of between 40% and 60%) with optimized convexity therefore obtains a moderate intrinsic SCR (between 12% and 18%) whilst benefiting from “equity” exposure.

An SCR can be improved through the use of instruments replicating convertibles, chiefly the association of equity options + government bonds or high-quality credit (zero or low credit SCR) which make it possible to maintain both convexity and “equity” exposure