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As markets roil, analysts, investors keeping close eye on insurers' hybrid bonds

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As markets roil, analysts, investors keeping close eye on insurers' hybrid bonds

Recent falls in European insurers' solvency ratios are a long way from triggering default clauses in certain hybrid bonds they have issued, analysts say, but the uncertainty around the coronavirus pandemic means they are monitoring the situation closely.

Downward pressure

The coronavirus outbreak has caused equity markets and interest rates to fall and credit spreads to widen, hitting insurers' solvency ratios. Moody's said in a March 31 report that the regulatory solvency ratios of the European insurers it rates had fallen by 20 percentage points since the beginning of 2020. Lloyd's of London announced March 26 that its central solvency ratio had fallen to 205% as of March 19 from 238% at the end of 2019.

For those European insurers governed by Solvency II capital rules, the ratios show eligible funds as a percentage of the regime's solvency capital requirement, or SCR, which is designed to equip insurers to withstand one-in-200-year events.

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Some insurer-issued Tier 2 hybrid bonds defer coupon payments if the issuer's solvency ratio falls below 100%, or if paying the coupon would push the ratio below 100%.

Restricted Tier 1, or RT1, bonds, suspend coupons and convert to equity when solvency ratios drop below a certain point — typically 75% — or if they remain below 100% for a protracted period. For investors, this means a loss of principal, which in turn could make it more costly for insurers to issue RT1s in future.

Andrew Gillham, asset manager at fixed income investment manager Bridport & Co, said in an interview that if RT1s are triggered, "insurers will have to pay up a lot more on new issues than they have done in the past."

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Position of strength

However, analysts say insurers' solvency ratios have not yet dropped to concerning levels. Large listed insurers typically set a target range for their solvency ratio, with the lower end well above the 100% mark. Benjamin Serra, senior vice president at Moody's, said in an interview that the rating agency has yet to take action on any insurer-issued RT1 or Tier 2 bond.

"The Solvency II ratios, at this stage, remain within the companies' target range, so there is no real change here in the risk for bondholders," he said.

Gillham said insurers entered the crisis with "stronger balance sheets than they have ever had," with Solvency II ratios around 200% or even higher for some large European insurers.

"It would take some prolonged shutdown of the economy for us to get concerned about the RT1s being triggered or coupons being suspended on the Tier 2 bonds," he added.

Although investors take a hit if RT1s are triggered, they are seen as a relatively safe haven, according to Romain Miginiac, head of research at fixed-income investment manager Atlanticomnium SA.

"We still think that insurance RT1s are a very good hiding place in these times because fundamentals of the sector are extremely strong, the structure of the bonds is very favorable for investors, and you are extremely well-protected," he said.

Insurers can take a number of actions to stave off declines in solvency ratios. These include reducing equity market exposure, de-risking their bond portfolios and cutting new business volumes. They can also shrink or cancel dividends, as a number of regulators have advised and many insurers have done.

Insurers are likely to pull these triggers long before their solvency ratios enter the danger zone. Willem Loots, senior director in Fitch Ratings' EMEA insurance group, said in an interview that the majority of insurers define their risk appetites as a solvency ratio between 120% and 140% of the SCR and that they would take action if they felt their ratio would drop to this level.

"That's clearly significantly above 100% SCR level," he said.

Staying alert

Despite the comforting signs, analysts are staying on their guard.

"I think you have got to be prepared to evolve your view over the next few months depending how this plays out," Gillham said.

The uncertainty about the duration and severity of the coronavirus pandemic, and the resulting effects on the capital markets, could further damage insurers' solvency ratios and bring bonds closer to their triggers. Serra noted that as solvency ratios fall, their sensitivities increase.

The turmoil in the capital markets would also make some remedies for falling solvency ratios tougher to pull off. Serra noted that in 2019 insurers had issued hybrid bonds to boost regulatory capital, but that "it is fair to say in the current environment it is probably a little more challenging because last year spreads were relatively low."

Reducing equity exposure could also prove more difficult. Serra said: "I think insurance companies would probably think twice about selling their equity portfolio now."

Dennis Sugrue, EMEA insurance sector lead at S&P Global Ratings, said on a March 30 webcast that if the agency thought the increased risk of coupon deferral in hybrid bonds was "significant" and different from the issuer default risk, "we could explore widening the notching, potentially downgrading hybrid instruments even though we may not downgrade issuer ratings."

Serra said Moody's would watch developments in interest rates and credit spreads "because if the situation changes, that could have ... an additional negative impact on Solvency II ratios and then potentially on the rating of Tier 2 securities."

Loots said Fitch is "watching developments closely."