European Commission Makes Significant Changes to Securitisation Capital Rules for Insurers

On 29 October, the European Commission adopted a Delegated Regulation amending Commission Delegated Regulation (EU) 2015/35 (the “Solvency II Delegated Act”). The Solvency II Delegated Act makes significant changes to regulatory capital requirements applicable to securitisation investments by EU insurers and re-insurers (“S II Changes”). The S II Changes will enter into force subject to a 3 month “non-objection” period and will apply from 30 January 2027.

The S II Changes form part of a wider set of European reform proposals relating to the regulation of securitisation (including transparency and investor due diligence requirements, as well as bank capital and liquidity rules) that were put forward by the European Commission earlier this year and that are currently being considered by the Council of the European Union and the European Parliament. In this note, we consider the S II Changes and how they may impact the capital requirements for securitisations of leveraged loan portfolios such as CLOs.

Although the S II Changes may encourage EU insurers and reinsurers to invest in AAA CLO tranches and other senior leveraged loan securitisation tranches, capital requirements remain high for investment in non-STS securitisations especially when compared to other types of institutional investors in the EU and insurance company investors in jurisdictions such as the US.

The Existing Framework

The S II Changes capital rules aim to ensure that insurers hold sufficient capital buffers to guard against a potential “worst case” decline in an investment’s value over a one-year period as a result of changes in credit spreads. These capital requirements fall under the “spread risk” sub-module of the solvency capital framework and apply to EU (re-)insurers that must calculate their capital requirements using the framework’s “standard” model (as opposed to those insurers that have regulatory approval to apply their own internal models). Prescribed “stress factors” listed in look-up tables are applied to the value of an investment to determine the capital charge —the higher the stress factor, the greater the spread risk that is assumed to be associated with the position, and the higher the required capital.

The stress factors have been calibrated based on observed price volatility across a range of securitisation positions and time periods. While the S II Changes bring into effect significant recalibrations as further described below, the existing framework of stress factors for spread risk has not changed. The calibrated stress factors depend on two investment characteristics: spread duration^[1] and credit rating. That is, the longer an investment’s duration and the lower its credit rating, the more sensitive its value is assumed to be with respect to changes in credit spreads, and the higher its stress factor.

Although this framework applies to loans and bonds as well as to securitisation positions, securitisations are further divided into simple, transparent and standardised (“STS”) and non-STS transactions based on the criteria set out in the EU Securitisation Regulation. This is a particularly important distinction under the Solvency II framework, because STS securitisation positions have far lower stress factors (for a given duration and credit rating) than non-STS positions.

Additionally, a distinction is made under the framework between “senior” and non-senior positions. Prior to the S II Changes however, this distinction was made with regard to STS transactions only, and there was no differentiation based on seniority for stress factors applicable to non-STS transactions (beyond any differences arising due to differences in the assigned credit rating as mentioned above). Consequently, the capital treatment of senior, non-STS transactions (such as AAA tranches of CLOs) prior to the S II Changes was particularly punitive.

The S II Changes

The S II Changes recalibrate the stress factors described above to align senior, STS stresses with those applicable to comparable bonds and loans (with proportionate reductions for non-senior STS and non-STS stress factors). Notably, for non-STS transactions such as CLOs and other leveraged loan securitisations, the S II Changes also introduce a distinction between senior and non-senior non-STS stresses. Senior non-STS tranches now benefit from significantly lower stress factors than non-senior ones (for a given duration and credit rating), thereby giving credit explicitly to seniority within the non-STS category.

• For example: the stress factor for the most senior tranche (rated AAA) of a CLO of four-year duration will reduce from 50% to 10.8%.Similarly, the first-pay tranche of an A-rated leveraged loan securitisation will benefit from a reduction in its stress factor from 66.4% to 17.6%. When taking into account the pick-up in risk-adjusted spread (relative to a corporate loan or bond of the same credit rating for example), the increase in return on capital for these positions as a result of the S II Changes could be significant.
  
  Such changes will also mean that the average stress factor applicable to a securitised leveraged loan portfolio should no longer be lower than the stress factor applicable to the most senior securitisation position backed by such portfolio (an incoherent result under the existing rules due to a combination of overly conservative stress factor calibrations for non-STS transactions and the failure to give any credit for position seniority).
• For example: investing in an underlying portfolio of B-rated loans of four-year duration following the S II Changes will have an associated stress factor of 30% (compared with 10.8% for a first-pay AAA securitisation position backed by such a portfolio).
  
  Accordingly, the significant stress factor reductions and the creation of a senior non-STS category under the S II Changes may incentivise EU (re-)insurers to invest in senior positions of non-STS transactions such as CLOs and other leveraged loan securitisations. To be sure, benefits appear modest by comparison with the bank capital framework.
• For example: a AAA CLO investment may expect to attract a risk weight of 15% (the current risk weight floor) under that framework, compared with the average risk weight applicable to the underlying leveraged loan portfolio of 150% (under the standardised approach). This 10-fold reduction reflects both a greater recognition of tranching under the bank capital framework and also a significantly lower “securitisation surcharge” (despite exhibiting significant capital non-neutrality — in the sense that exposure to a loan portfolio in securitised form is associated with a higher overall capital charge than direct exposure to the underlying portfolio — the bank securitisation capital framework is much more “capital neutral” than the Solvency II framework).
  
  Following the S II Changes a “penalty” associated with structuring a transaction as a securitisation still applies, since highly rated loan positions backed by leveraged loan portfolios that are economically equivalent to securitisation positions (but that are structured so as to ensure that they are not treated as securitisations for regulatory purposes) will likely have lower stress factors than equivalent securitised positions.
• For example: an A-rated loan (with four-year duration) will have a stress factor of 5.6% compared with a senior, non-STS securitisation position (A-rated, four-year duration) stress factor of 17.6%. By contrast, securitisation treatment typically delivers significant regulatory capital benefits under the bank capital framework (for example, an A-rated loan exposure may attract a risk weight of 50% under the standardised approach compared with 15-20% for an A-rated senior, non-STS securitisation position).
  
  While differing methodologies make direct comparisons difficult, it is also worth noting that securitisation capital requirements for EU (re-)insurers under the Solvency II framework generally remain very high by comparison with the bank capital framework (and the corresponding rules applicable to insurers in the US).
• For example: a AAA senior, non-STS position at the current risk weight floor of 15% would carry a capital charge of only 1.2% under the bank capital rules (compared with the 10.8% capital charge referred to above under the Solvency II framework).

The importance of adding a distinction between senior and non-senior in the non-STS category should also not be overstated: while the most senior position in a transaction’s capital structure will benefit as described above, all positions (even those with high credit ratings) that are not “first-pay” will not be considered senior and will consequently receive a punitive capital charge (as a “non-senior, non-STS” position). This contrasts with the bank capital framework, for example, where the approach to seniority is much more nuanced (based on tranche attachment point and thickness).

Additional Transaction-Structuring Considerations

Two further points should also be borne in mind from a transaction-structuring perspective in relation to the stress factor reductions under the S II Changes described above:

1. Obtaining high credit ratings will be particularly important to deliver the stress factor reductions for EU insurers and re-insurers using the standard model. Specifically, two “public” ratings will be required (as opposed to a single private rating or credit estimate, by contrast with the position that currently applies under the corresponding US rules for example).
2. The position will in fact need to be “senior”, i.e. the first-pay position in the transaction’s capital structure, in order to benefit from the significant stress factor reductions for non-STS transactions described above. In this regard, it should be noted that the definition of “senior” (as defined under the Capital Requirements Regulation) is likely to be amended as part of the European Commission’s broader package of proposed reforms, in particular to include a minimum attachment point or maximum tranche thickness on top of the requirement for “first pay” (and with the possibility that senior status could consequently be lost during the life of a transaction should it cease to comply with such additional requirement for seniority, and any such change to the Capital Requirements Regulation definition is carried over to the Solvency II framework).

High Capital Requirements Persist Despite Stress Factor Reductions

While the stress factor reductions described above are to be welcomed especially for senior non-STS positions such as AAA tranches of CLOs and first-pay tranches of other securitisations of leveraged loans, applicable capital requirements remain high following the S II Changes.  In our view, too much significance is still attached to whether or not a transaction qualifies as STS under the EU Securitisation Regulation and not enough to the position’s seniority, with the result that non-senior STS positions continue to receive materially, and in our view, unjustifiably, lower stress factors than senior non-STS transactions.

[1] The rules reference the (modified) duration of the position, with the method of calculation set out in regulatory guidance, reflecting the average time taken for all payments of coupon and principal (in present value terms) to be paid, and taking account of the potential for early repayment due to amortisation and the exercise of call rights).