Moody's reveals potential impact of downgrades on Solvency ratios

14 May 2020

The rating agency has run stress tests on European insurers' corporate bond portfolios and reveals that, in the most extreme scenario, solvency ratios could decrease by up to 50 percentage points. Vincent Huck reports



A wave of corporate bond downgrades could decrease European insurers' solvency ratios by between 30 percentage points (pp) to 50pp, Moody's estimates.

Corporate bonds are a significant investment for European insurers as they make one-third of their overall holdings. The COVID-19 pandemic, and the financial crisis it has created, has raised questions about insurers' ability to navigate the choppy waters, particularly because the quality of their corporate holdings has deteriorated in recent years.

While in 2012, 25% of European insurers' fixed income portfolio was Baa-rated corporates, in 2018, Baa-rated corporates represented 37% of their fixed income portfolio. The quality of corporate bond portfolios has a direct impact on Solvency II ratios because under the rules insurers need to hold capital to cover the spread risk attached to these bonds and this capital charge increases when the quality of their bond holdings decreases.

The rating agency ran stress tests on a sample of 24 rated European insurance groups, computing capital charges according to the Solvency II standard formula spread risk module and assuming a similar duration for all fixed income assets. It found that an impact of a three notches downgrade of insurers' corporate bond portfolios would result in a 30% increase in capital requirement, this in turn would mean a decrease in solvency ratios between 30pp and 50pp.

Presenting the findings during a webinar session this week, Moody's Investors Services senior vice president financial institutions group Benjamin Serra caveated the figures saying that "there are some limitations to the calculation we have made because the Solvency II calculation can be quite complex".

"The numbers are big but the stress is big as well," he continued. "We are talking about a downgrade of the entire corporate bond portfolio by three notches which is of course an extreme stress scenario."

But the 30% increase in capital requirement applied "in a very crude way and ignoring all likely offsetting factors such as change in diversification benefits or in volatility adjustment" would see European insurers' Solvency II ratios going down from an average of 200% to 150%, Serra said.

"In practice the impact will be lower but we estimate that this impact would still be somewhere between 30pp to 50pp that is quite significant," he added. "So yes the solvency for the industry remains good at this stage but downside risk remains high."

Serra noted that some insurers, like Axa, had started to disclose these sensitivities. And Axa's disclosures were in line with Moody's findings.

Beyond solvency implications, the COVID-19 pandemic raises issues of profitability for insurers. In the core business, with claims potentially on the rise, and new business falling. But also on the investment side where insurers' profitability will be hit by low interest rates, possible impairment on the equity portfolio and lower dividends and rents. Life insurers will also receive lower fees on their unit –linked business, Serra noted.

Low interest rates are not a new phenomenon, he conceded. "But the intervention from central banks make the 'low for longer scenario' even more likely now, which is negative for life insurers."

In addition, many companies were trying to adapt to the low interest rate environment by selling more unit-linked business, Serra said. "But historically, the sale of unit-linked products is strongly correlated to the performance of the equity market. In France for example, insurers managed to sell more and more unit-linked [products] just before equity markets collapsed and then the proportion of unit linked dropped significantly after the drop in equity markets and it takes a long time before consumers buy the products again."

The transformation of the life business models will become more challenging because of the crisis, he predicted. The pandemic will have long lasting economic and social impacts.

While the insurance industry will be impacted by changing customer behaviours, so will other sectors, and these are sectors insurers invest in.

"What we have here now is a risk of stranded assets," Serra said.

The term is often used in the context of climate change where an asset becomes worthless as a result of changes associated with the energy transition. But Serra believes COVID-19 will create a similar phenomenon. He takes the example of commercial real estate.

"Maybe tomorrow companies will realise that they don't need to have a big office in London or Paris just because the last few months have demonstrated that all employees are able to work from home," Serra said.