Opportunity in Corporate Loans Asset Class: Unlike U.S. insurers, European insurers have shied away from innvestment in corporate loans. Under the Solvency II, European insurers would reduce their allocation to long-dated corporate bonds and will reallocate capital to highly rated corporate bonds. Also under the Solvency II directive, capital charges for loans would be similar to that of corporate bonds with the same maturing/risk profile. The Solvency II directive took into account the illiquid nature of the source of funding for insurance companies (i.e. policyholders premiums) that necessitates a matching investment policy that captures a matching illiquid premium.
Given that corporate loans capture that illiquid premium, European insurers would significantly tilt their balance sheets' asset base towards corporate loans.
Solvency II Stated Goal: Aims to unify a single EU insurance market and enhance consumer protection
Definition: Solvency II is a risk-based system, meaning that capital requirements are aligned with the underlying risks of the company.
Implementation Date: Following an EU Parliament vote on the Omnibus II Directive on 11 March 2014, Solvency II is scheduled to come into effect on 1 January 2016.
Implications: According to the anticipated directive, European insurers would decrease their allocations to long-dated credit and equity assets classes. The directive would apply the "liquidity premium" and the "matching adjustment" to the valuation of insurance liabilities.
Matching Principal: The directive is aimed at reducing the risk associated with spread movements (i.e. credit risk reflected in market values as we have seen very clearly in the recent crisis) by an insurance company that trades bond-like assets. Those risks are driving the European insurance industry away from offering long-term guarantees for policy holders. The Match Principal, is in essence is a mechanism that prevents changes in the value of assets, caused by spread movements, from flowing through to companies' balance sheets for portfolios where companies have fully or partially mitigated the impact of these movements". When insurers are not exposed at all to forced sales because liabilities are predictable and the timing of asset cash flows enables the timely payment of liability cash flows.
"ill"-Liquidity Premium: The illiquidity premium in question represents an increase in the discount rate applied in the calculation of the present value of future payments under certain long-term insurance contracts. That is, the illiquidity premium is designed to reduce the value of certain insurance liabilities.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.