Restricted Tier 1 issuances and other forms of contingent capital under Solvency II

Introduction

Solvency II allows certain types of subordinated debt as a source of capital, or own funds, for regulated insurers. Since the Dutch insurer ASR issued its Restricted Tier 1 (RT1) debt in 2017, this type of contingent convertible subordinated debt has become commonplace and a number of UK insurance firms, including Phoenix Group, AXA, and Rothesay Life, have also issued RT1 capital instruments. However, there is currently some ambiguity around the treatment of other forms of contingent capital – a question that EIOPA is seeking to address in its 2020 review of Solvency II.

In this blog post we look at RT1 issuance, as well as EIOPA and the insurance industry’s views on the treatment of contingent capital instruments.

What is Restricted Tier 1 debt?

Solvency II Own funds are categorised by quality into 3 tiers. The quality of capital is determined by assessing its permanence and loss absorbency with the aim of ensuring that the capital instruments will be available to meet liabilities when required. Capital instruments which have features such as an early redemption option, might be less likely to be available when required and so are given a lower tier rating to reflect this. The highest quality capital is Tier 1 and at least 50% of the capital held to cover the SCR must be Tier 1 capital. Tier 1 capital can be ‘restricted’ (e.g. junior debt security) and ‘unrestricted’ (e.g. ordinary shares) capital. The value placed on RT1 capital can be no more than 20% of all Tier 1 capital.

To qualify as capital on the Solvency II balance sheet, RT1 instruments must meet criteria such as those laid out in Article 71 of the Commission Delegated Regulation (EU) 2015/35, i.e. perpetual with no step-up in coupon and a first call date being a minimum of 10 years after issuance, with distributions cancelled and repayment of principal suspended in the event of a breach in SCR.

While each RT1 bond has its own specific features, which are laid out in its prospectus, a typical RT1 instrument is written down (or converted to equity) when prespecified trigger events occur. Examples of such pre-specified trigger events include a 3-month breach of the issuer’s Solvency Capital Requirement; a drop of the solvency ratio below a specified level; and a breach of the issuer’s Minimum Capital Requirement.

Examples of RT1 issues in last 12 months

Regulatory Review

The findings of EIOPA’s 2020 review of Solvency II now scheduled for December 2020 will be based on reports by insurers in the various EU territories responding to the proposals laid out in the information request launched by EIOPA in March. One such proposal required firms not to recognise contingent convertible bonds as a risk-mitigation technique in the SCR for either standard formula firms or internal model firms.

Current regulation allows internal models approved by the regulator to recognise the economic impact of contingent instruments. Feedback following the information request demonstrated push back from the industry against the proposed changes to the recognition of contingent convertible bonds. Firms argue that such bonds provide genuine protection by writing off coupon obligations and/or writing down the principal in times of stress. As such, these transactions can improve the security of policyholders. Responses from Insurance Europe, the CFO Forum and the CRO forum highlight that the proposed changes would restrict the flexibility of internal models to capture risk profiles of insurance companies.

In view of the COVID-19 pandemic and its impact on financial markets, EIOPA has issued a new information request in July complementing the request carried out earlier this year in order to obtain updated data on the impact of their proposals and the effect of the pandemic on insurers. It will be interesting to see what EIOPA decides to do in relation to contingent convertible bonds in light of the pandemic and new information request responses. EIOPA’s proposed changes could provide additional incentive for firms to create more innovative contingent capital instruments.

Grandfathering

Solvency II rules allow firms to “grandfather” certain Solvency I capital items until 31st December 2025 so that they may be used to demonstrate solvency under Solvency II. Such instruments with redemption dates beyond 1 January 2026 may need to be restructured or divested.

Irrespective, given the low interest rate environment, it wouldn’t be surprising to see firms issue debt to simultaneously bolster their capital position and take advantage of investor appetite.

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