Solvency II Could Push European Insurers Away From Securitizations

STRUCTURED FINANCE RESEARCH Solvency II Could Push European Insurers Away From Securitizations Primary Credit Analyst: Mark S Boyce, London (44) 20-7176-8397; Mark_Boyce@standardandpoors.com Secondary Contact: Andrew H South, London (44) 20-7176-3712; andrew_south@standardandpoors.com Table Of Contents Regulatory Capital Charges For Securitizations Are High Reducing Returns On Capital Not All Insurers Can Depend On Internal Models to Lower Capital Charges Favorable Capital Charges On Property Lending Could Be Credit Positive For Outstanding CMBS Pension Funds Could Also Shift Away From Securitizations Solvency II Could Decrease Securitization Volumes Appendix: Solvency II, In A Nutshell Related Research WWW.STANDARDANDPOORS.COM/RATINGSDIRECT DECEMBER 10, 2012 1

Solvency II Could Push European Insurers Away From Securitizations In October 2012, the European Insurance and Occupational Pensions Authority (EIOPA) released the latest draft technical specifications for Solvency II, the upcoming regulatory overhaul of the European insurance industry. Standard & Poor's Ratings Services believes that relatively high capital charges for securitizations under the new rules could lead European insurers to dramatically reduce exposure to the asset class and invest in covered bonds instead. Pension funds which could soon be subject to regulation based on Solvency II may also have an incentive to move away from the securitization sector, in our view. The final Solvency II rules may differ from the current specifications, and the implementation date may yet be delayed by up to two years. Even after the legislation becomes effective, a possible transitional period means that the insurance industry may not have to meet the capital adequacy rules immediately. Some firms may also apply to use internal models rather than the standard calculation to determine capital requirements, potentially resulting in lower capital charges. Overview The capital charges for senior securitizations under the draft Solvency II rules' standard formula are up to 10 times higher than those for similarly-rated covered bonds, meaning that return on capital is generally lower for securitizations. Therefore, we expect that insurers may opt to invest in covered bonds and other asset classes rather than securitizations a trend which has already begun. Since insurers account for more than 10% of the post-crisis securitization investor base, their potential withdrawal from the sector could substantially reduce volumes, in our view. Upcoming regulation for European pension funds is largely based on draft Solvency II rules, and distinguishes capital charges between securitizations and covered bonds in the same way. We expect that pension funds could also reallocate investments away from securitizations as a result, though the impact of this shift could be smaller than for insurers. Relatively favorable capital treatment of commercial real estate (CRE) loans under Solvency II could lead insurers to increase CRE lending over the coming quarters a potential credit positive for outstanding commercial mortgage-backed securities (CMBS), where refinancing risk has recently come to the fore. However, CRE lending growth among insurers is unlikely to offset the decline in bank lending, in our view. Nevertheless, the insurance industry already appears to be reducing securitization exposure. Insurers' fixed-income allocation to securitizations dropped in 2011 compared with 2007, while covered bond allocations more than doubled over the period. We believe that this trend will continue. The Appendix provides a brief overview of Solvency II. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT DECEMBER 10, 2012 2

Regulatory Capital Charges For Securitizations Are High Under Solvency II, the amount of capital that an insurer must hold against an asset the solvency capital requirement (SCR) depends on its expected mark-to-market loss under adverse conditions. This in turn depends on the nature of the risks posed by the asset, with the legislation categorizing risks into various modules. Corporate bonds, securitizations, and covered bonds fall into the "spread risk" module, because their market value depends on the volatility of secondary market credit spreads. Under the standard formula, the capital an insurer must hold to compensate for a bond's spread risk is calculated as the product of the bond's market value, duration, and a spread risk factor, which depends on the rating and duration of the bond. Table 1 shows the spread risk factors for securitizations (other than resecuritizations such as collateralized debt obligations [CDOs] of asset-based securities [ABS]). Table 1 Spread Risk Factors For Securitizations* Rating AAA AA A BBB BB B CCC or lower Risk factor (%) 7 16 19 20 82 100 100 Maximum modified duration (years) 6 5 4 2 1 1 1 *Excludes resecuritizations. Source: EIOPA (October 2012 Technical Specifications). For example, a 'AAA'-rated securitization with a six-year duration would incur a capital charge of (7% * 6), or 42% of its market value. A seven-year, 'AAA'-rated securitization would also incur a 42% SCR, because there is a duration cap of six years at this rating level. Tables 2 and 3 show the capital charges for resecuritizations, and 'AAA'- and 'AA'-rated covered bond exposures, respectively. Lower-rated covered bonds incur the same capital charges as corporate bonds (see table 4). Table 2 Spread Risk Factors For Resecuritizations Rating AAA AA A BBB BB B CCC or lower Risk factor (%) 33 40 51 91 100 100 100 Maximum modified duration (years) 3 3 2 1 1 1 1 Source: EIOPA (October 2012 Technical Specifications). Table 3 Spread Risk Factors For Covered Bonds (%) Duration (years) Rating AAA AA Five and less 0.7 0.9 More than five 0.5 0.5 Maximum modified duration (years) 178 176 Source: EIOPA (October 2012 Technical Specifications). WWW.STANDARDANDPOORS.COM/RATINGSDIRECT DECEMBER 10, 2012 3

Table 4 Spread Risk Factors For Corporate Bonds (%) Duration (years) Rating AAA AA A BBB BB B CCC or lower Unrated Five and less 0.90 1.10 1.40 2.50 4.50 7.50 7.50 3.00 More than five and up to 10 0.53 0.58 0.70 1.50 2.51 4.20 4.20 1.68 More than 10 and up to 15 0.50 0.50 0.50 1.00 1.80 0.50 0.50 1.16 More than 15 and up to 20 0.50 0.50 0.50 1.00 0.50 0.50 0.50 1.16 More than 20 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 Maximum modified duration (years) 176 173 169 140 107 73 73 130 Source: EIOPA (October 2012 Technical Specifications) For covered bonds and corporate bonds, the spread risk factors decrease as a function of the bond's duration. For example, a five-year 'AAA'-rated covered bond would incur a charge of (0.7% * 5), or 3.5%. With a duration of seven years, it would incur a capital charge of (0.7% * 5) + (0.5% * 2), or 4.5%. Clearly, there are significant differences in regulatory capital requirements among these asset classes (see chart 1). Punitive capital charges for resecuritization exposures likely mean that insurers will not invest in these securities even at the senior level in our view: A three-year CDO of ABS tranche with a 'AAA' rating is subject to a 99% capital charge. However, there has been negligible post-crisis resecuritization issuance, so high SCRs will not have any immediate effect on primary market volumes. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT DECEMBER 10, 2012 4

Chart 1 SCRs for securitizations are lower than for resecuritizations, but still much higher than for covered bonds. In fact, for durations of up to five years, the capital charge for top-rated securitizations is 10 times higher than for covered bonds with the same rating. Almost all European securitization tranches placed with investors since 2009 have durations of five years or less. Reducing Returns On Capital It might still make sense for insurers to hold securitizations despite high capital charges if they could achieve a relatively favorable return on capital when compared with covered bonds or other types of investment. However, securitization spreads have been steadily declining throughout 2012, and may yet grind tighter in the coming months, in our opinion. Spreads have fallen on covered bonds too, but much lower capital charges mean that the return on SCR from investing in covered bonds is generally substantially higher than for securitizations. The current return on capital for a five-year Dutch prime RMBS would be about 4% under Solvency II, compared with 16% for a Norwegian mortgage covered bond of the same duration (see chart 2). WWW.STANDARDANDPOORS.COM/RATINGSDIRECT DECEMBER 10, 2012 5

Chart 2 What's more, several other asset classes compare favorably with securitizations on a return-on-capital basis, too. For example, lower capital requirements mean that the return on SCR for 10- to five-year corporate credit is between 15% and 30%, according to a Morgan Stanley estimate earlier this year (see chart 3). WWW.STANDARDANDPOORS.COM/RATINGSDIRECT DECEMBER 10, 2012 6

Chart 3 As a result, we expect that insurers which account for more than 10% of post-crisis secondary market securitization investments, according to Nomura will re-weight their portfolios away from securitizations and toward assets providing higher returns on capital. In fact, this trend has already begun. Securitizations accounted for 6% of insurers' fixed-income assets at the end of 2011 down slightly from about 7% in 2007 while covered bond allocations more than doubled over the period, to 10% (see table 5). One third of respondents to a survey of insurers conducted in early 2012 by the Association for Financial Markets in Europe (AFME) said that current Solvency II draft rules would cause them to stop investing in securitizations, with the other two-thirds planning to dramatically reduce allocations to the sector. Table 5 Fixed Income Asset Allocation Of Listed European Insurers (%) 2007 2009 2011 Corporates 24.1 27.6 33.0 Securitization 7.1 6.1 6.0 Covered bonds 4.0 6.3 10.0 Sovereigns 24.2 32.0 42.0 Source: AFME, Bank of America Merrill Lynch WWW.STANDARDANDPOORS.COM/RATINGSDIRECT DECEMBER 10, 2012 7

Not All Insurers Can Depend On Internal Models to Lower Capital Charges When calculating capital charges, an insurer may opt to use the standard formula specified in the legislation, an internal model, or a combination that is, they might model certain risks using the standard formula, and others using the internal model. In some cases, insurers may also be able to change the calibration of the standard formula. It might make sense to use an internal model when it would better reflect the risk profile of the insurer's balance sheet, possibly resulting in lower capital requirements. Insurers that were part of a group and which therefore tended to be larger reported a capital benefit of 20% from using an internal model rather than the standard formula calculation under the fifth quantitative impact study (QIS5) for Solvency II, according to EIOPA. Some 56% of respondents to AFME's survey of insurers said proposed capital charges would lead them to develop internal models. Nevertheless, we note that national supervisors must approve internal models for use, and will apply rigorous criteria. In part, the model must: Cover all of the material risks to which the insurer is exposed; Demonstrate high standards of statistical quality; Undergo regular validation; Carry extensive documentation; and Be widely used and play an important role in the organization's risk management system the so-called "use test". In our opinion, some insurers may have difficulty meeting all of these criteria in particular, the use test. Furthermore, building and maintaining a model will require resources that we expect some smaller insurers will be unwilling or unable to expend. It's also unclear whether national supervisors will approve models which result in capital charges that would be significantly lower than those under the standard formula. All of this suggests to us that internal modeling is not a panacea for higher capital charges. That said, we expect that insurers which invest in securitizations might be more sophisticated in general, and therefore more likely to have their internal model accepted by regulators. To the extent that these insurers can demonstrate that securitization assets are consistent with lower capital charges which remains to be seen they may be able to circumvent harsher capital treatment under the standard formula. Favorable Capital Charges On Property Lending Could Be Credit Positive For Outstanding CMBS The latest Solvency II technical specification treats CRE loan exposures as unrated corporate bonds for the purposes of determining capital requirements (see table 4). While the resulting capital charges are higher than those suggested by earlier drafts, the return on CRE loans measured against the capital charge is nevertheless favorable when compared with some other asset classes (see chart 3). For example, the return on capital for commercial mortgage loans is higher than for direct property investment which has a 25% SCR and equity, and is on a par with 10-year corporate credit. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT DECEMBER 10, 2012 8

Part of the reason is that capital and funding pressure has led European banks to reduce CRE lending, pushing up spreads on new loans. U.K. CRE lending declined by more than half in 2011 compared with 2007, while average margins on new loans are currently at their highest levels since 1999, according to De Montfort University's lending survey. Partly as a result, European insurers' CRE lending has picked up in recent months, and could rise by 50 billion to 100 billion in the next five to 10 years, according to a Morgan Stanley forecast. An uptick in insurers' lending volumes would be modestly credit positive for CMBS, in our opinion. The scarcity of CRE finance from banks, combined with weak property prices, have increasingly led to loan maturity extensions and defaults in European CMBS transactions. In October 2012, about 20% of loans backing European CMBS transactions that Standard & Poor's rates were delinquent, with maturity defaults accounting for almost three-quarters. However, we note that insurers are unlikely to be able to plug the financing gap left by the banks, and in any case, not all insurers will be interested in the types of loans typically backing CMBS transactions. Even after accounting for potential new lending by non-bank sources, Morgan Stanley estimates that European CRE loan volumes could drop by 300 billion to 500 billion over the next three to five years. Moreover, insurers are typically risk-averse and are likely to be able to pick and choose their property investments, given the current supply-demand imbalance. As a result, many could shy away from lending against secondary properties the main assets backing CMBS transactions. Pension Funds Could Also Shift Away From Securitizations The European Commission (EC) is currently reviewing the regulatory framework governing institutions for occupational retirement provisions (IORPs) that is, pension funds. It intends to introduce the "IORP II" directive which will overhaul current legislation in mid-2013. The Commission plans to structure the new rules so as to avoid regulatory arbitrage between the pension fund sector and other parts of the financial system including the insurance industry. As such, the technical specifications for the first IORP II QIS scheduled to run from October to December 2012 are largely based on the latest Solvency II implementation rules. In particular, under draft rules, pension funds will have to: Value assets and liabilities on a mark-to-market basis; Maintain a solvency capital requirement based on the expectation of loss under stressed economic conditions; Divide risks into various modules; and Use the standard formula, an internal model, or a combination of both to calculate capital requirements. The calibration of SCRs for covered bonds and securitizations under draft IORP II rules is identical to that under the October 2012 Solvency II technical specifications. In its current form, IORP II is therefore likely to disincentivize pension fund investment in securitizations, while increasing the attractiveness of covered bonds, in our view. However, we believe that the impact of a withdrawal of pension funds from the securitization market would likely be muted. Pension funds bought less than 2% of structured finance new issuance between 2004 and 2007, according to Nomura. Furthermore, we consider the 2013 timeline for IORP II to be tight. Given the delays experienced by Solvency II, it is possible that IORP II legislation may not be in place for some time. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT DECEMBER 10, 2012 9

Solvency II Could Decrease Securitization Volumes In our opinion, the current Solvency II implementation plan could cause insurers to withdraw from, or substantially reduce their exposure to, the securitization market. Given that the insurance sector potentially represents more than 10% of the investor base, we expect that the regulation could cause securitization volumes to fall, while covered bond investment could rise. Solvency II regulation remains subject to change, and transitional periods could soften the blow on the insurance industry. EIOPA's upcoming study on the potential impact of the legislation on insurers' lending could yet lead the EC to tweak the final rules. The implementation date of the legislation could be delayed for another one or two years, and even then, insurers may have up to 10 years of additional breathing room before having to implement the new capital adequacy rules. Still, some insurers have already begun to move away from investing in securitizations, and we expect this to continue if the final Solvency II rules closely resemble the current draft. Appendix: Solvency II, In A Nutshell What is Solvency II? Solvency II is a new regulatory framework for the European insurance and reinsurance industry, currently scheduled to become effective in 2014. The legislation will be harmonized across all European Economic Area (EEA) states, replacing Solvency I. In large part, Solvency II introduces a risk-based framework for assessing solvency. Insurers will have to value their balance sheets on a mark-to-market basis, and will be required to hold a minimum amount of capital the solvency capital requirement (SCR) based on the expected difference in value between assets and liabilities under economic stress scenarios. The SCR that an insurer must hold against a particular asset will depend on its risk characteristics. Under Solvency I, insurers are not required to mark their balance sheet to market, and capital requirements are insensitive to asset risks. Solvency II also introduces rules surrounding firms' risk management systems, policies, and disclosure. Have the new rules been agreed? European legislators passed the Solvency II directive in 2009, but the technical details of the legislation including the calibration of capital charges are not yet final. Since 2005, the European insurance regulatory authorities the Committee of European Insurance and Occupational Pension Supervisors and its successor, EIOPA have conducted five quantitative impact studies (QIS) on behalf of the EC to test the effect of draft rules on insurers. EIOPA published the results of the fifth study, QIS5, in early 2011, and released updated technical guidance in October 2012. In this report, we focus on the October 2012 guidance, but we note that the implementation rules are still under political discussion, and could therefore change. When will it come into effect? Solvency II has been subject to several delays, and its ultimate implementation date remains unclear. Under the current timeline, EEA member states must transpose the European directive into national law by June 30, 2013, with WWW.STANDARDANDPOORS.COM/RATINGSDIRECT DECEMBER 10, 2012 10

an effective date of Jan. 1, 2014. However, in September the EC proposed to the European Parliament a one-year postponement that is, transposition in July 2014 and implementation from Jan. 1, 2015 after asking EIOPA to carry out a study on the potential impact of the draft rules on insurers' financing of the real economy. In October, EIOPA suggested that implementation might not happen until "2015 or 2016". Will there be transitional arrangements? The draft legislation gives the EC the power to delay implementation of the capital adequacy rules for a maximum of 10 years. In the final rules, the EC may opt for an actual transitional period that is less than the maximum. Related Research European CMBS Monthly Bulletin (October 2012): Interest Shortfalls Lead to Further Note-Level Defaults, Nov. 7, 2012 Basel III And Solvency II Could Have Unintended Cross-Sectoral Consequences, Feb. 28, 2012 Standard & Poor's Highlights Differences In Capital Adequacy Between Its Methodology And Europe's Solvency II Framework, Feb. 15, 2010 Additional Contact: Structured Finance Europe; StructuredFinanceEurope@standardandpoors.com WWW.STANDARDANDPOORS.COM/RATINGSDIRECT DECEMBER 10, 2012 11

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