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CoCos in limbo under German insurance law

Allen & Overy's Bernd Geier and Goldman Sachs' Stephan Funck explain why regulatory capital's treatment complicates issuers’ modelling of conversion and write-down mechanisms

The treatment of CoCos under German insurance law is in limbo. It complicates issuers’ modelling of conversion and write-down mechanisms

Since the EU's Capital Requirements Regulation (CRR) entered into force on January 1 2014, contingent convertibles (CoCos) have received considerable attention from both banks and regulators. On the one hand, CoCos qualify – if properly structured – as additional tier 1 (AT1) capital. On the other hand, various regulators – including the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht or BaFin) – have raised investor protection concerns based on the risks inherent to these instruments.

CoCos differ from normal bonds insofar as they may, under their terms, be written down or converted into shares of the issuer. Any such write down or conversion is contingent upon the occurrence of one or more predefined trigger events, usually a common equity tier 1 (CET1) ratio of 5.125%. As such, CoCos are hybrid instruments providing for going concern loss absorption. If properly structured, in particular if perpetual, CoCos qualify as AT1 under the CRR. Their use is then incentivised by bank regulation, for example, under the new rules governing the leverage ratio.

With regard to CoCos, bank regulatory incentives partially clash with investor protection concerns and contagion risks (resulting from the negative effects a write down/conversion might have on investors). To this end, BaFin has issued guidance clarifying that CoCos shall not be marketed to retail investors. Further, the European Securities and Markets Authority (Esma) used CoCos as an example for instruments being suitable only for a narrow target market under the incoming rewrite of the Markets in Financial Instruments Directive (Mifid II) regime. The 2012 Liikanen Report to the European Commission on banking sector reforms strongly supported banks being required to issue bail-in instruments such as CoCos. To limit interconnectedness in the banking system, it also recommended that these bail-in instruments be held by non-bank institutional investors, explicitly singling out life insurance companies as such investors alongside investment funds.

German insurance companies face a changing regulatory environment regarding the treatment of CoCos qualifying as AT1. They must consider the German investment ordinance (Anlageverordnung) (Ordinance), which was amended on March 7 2015, and Solvency II which will apply to all but the smaller insurance companies as of January 1 2016 at which time the Ordinance ceases to apply.

The Ordinance

Assets held by German insurance companies are split into so-called free assets (freies Vermögen) and restricted assets (gebundenes Vermögen). The latter cover the technical liabilities and form by far the largest part of insurer's assets. The Ordinance sets out the rules governing investments for the restricted assets. It basically provides for a numbered list of eligible assets as well as quotas for certain asset classes and limits on credit. Further requirements and restrictions are laid down in guidelines by BaFin.

On March 7 this year, the Ordinance was amended to provide for more investment flexibility and update the rules governing investments in funds. This was to align it with the Capital Investment Code (Kapitalanlagesetzbuch) that implemented the Alternative Investment Fund Managers Directive (AIFMD) in Germany. The Ordinance now particularly fosters investments in infrastructure, debt funds, and certain private equity structures. Insurance companies may now, for example, invest not only in high-yield bonds but also certain high-yield loans.

CoCo eligibility under the Ordinance

It's understood that neither the Federal Ministry of Finance (that enacted the Ordinance) nor BaFin have yet reached a final view on the treatment of CoCos under the Ordinance. The reason for this is different political objectives. In particular, bank regulatory and investor protection concerns have not yet been fully consolidated. In this respect, in the absence of a political compromise, BaFin appears to be reluctant to accept CoCos held directly or indirectly by insurance companies.


"Neither the Federal Ministry of Finance nor BaFin have yet reached their final view on the treatment of CoCos under the Ordinance"


The Ordinance contains an asset class specifically aimed at subordinated and hybrid debt in section 2 para 1 no 9, described as 'receivables arising from subordinated debt (nachrangigen Verbindlichkeiten) or profit participation rights (Genussrechte) in companies'. In addition, there is a class for investments in banks (section 2 para 1 no 18 Ordinance) that may be appropriate.

In many ways, CoCos are akin to profit participation rights. Although the term has never been defined under German law, common characteristics of all profit participation rights can be identified. As with CoCos, profit participation rights do not grant membership rights (Mitgliedschaftsrechte) and are subordinated in nature (gone concern loss absorption). They offer participation in the profits of a company. Similarly, payments under CoCos can only be made out of distributable items. Further, profit participation rights may, but need not, provide for going concern loss absorption (Verlustbeteiligung). As for CoCos, going concern loss absorption is mandatory when regulatory ratios are reached. To this end, both instruments may provide for loss absorption, even though the circumstances under which losses would be absorbed on a going concern basis differ.

However, to qualify for the restricted assets of an insurance company, BaFin has stated that '(perpetual) subordinated bonds providing for one or more termination rights' need to comply with further requirements only applicable to structured products. In particular, they need to provide for repayment of the full principal amount at maturity.

For a number of reasons, the write down or conversion element inherent in CoCos does not qualify as a termination right in this sense, resulting in the additional rules on structured products not applying. Profit participation rights providing for going concern loss absorption show risk characteristics similar to CoCos. Those profit participation rights would not qualify as structured products. The application of the write down or conversion mechanism is mandatory when predefined trigger events are reached. In contrast to the exercise of termination rights, the issuer has no discretion as to the application of the write down or conversion. Basically all German unsecured bank bonds are subject to write down or conversion risks under the new rules governing bank recovery and resolution, and many of them will also be subordinated in nature by operation of law, if the newly proposed resolution mechanism act (Abwicklungsmechanismusgesetz) passes parliament. As such, the write down or conversion mechanism should not qualify as a termination right for regulatory purposes either.

To this end, CoCos should – save for issuer call rights – usually be eligible for the restricted assets of an insurance company in Germany under the Ordinance, even though BaFin appears for the time being rather reluctant to follow this view. CoCos that provide for issuer call rights need to comply with circular 3/99, in particular on the full repayment of the notional amount upon the exercise of the call. To this end, issuer call rights need to be looked at separately from equity conversion and write down features.

Even if CoCos did not qualify as subordinated assets under the Ordinance, they may still qualify for the other asset class – investments in banks. This is only available for assets not covered under any other asset class of the Ordinance. Given that CoCos are still a relatively new asset class and driven by new regulatory developments, BaFin might decide at some point in the future to qualify CoCos as falling under this clause instead of that on subordinated and hybrid debt, but this remains to be seen.

Solvency II

Issuers looking to tap the insurance industry as an investor base have so far been disappointed. According to the Bank for International Settlements, in 2013 insurers formed less than five percent of CoCo investors. One of the reasons for this may lie in the upcoming Solvency II rules. The situation is best revealed by applying the standard formula to life insurers, which hold around 80% of all assets held in the insurance sector.

Solvency II marks the introduction of a pan-European, market consistent risk-based capital framework for insurance companies. It aims to cover literally all identifiable risks, both on the asset and liability sides of the balance sheet, with sufficient capital at a value-at-risk confidence level of 99.5% over one year. Calculation of the capital requirements are based either on the standard formula, an internal model or a combination of both. The standard formula applies by default, unless the insurer opts to apply a partial or full internal model, or is required by its regulator to do so.

Solvency II has been enacted under the so-called Lamfalussy process with a framework directive passed in 2009 (Level 1), a delegated Act by the European Commission in 2014 (Delegated Act) so-called Level 2 and some guidelines by the European Insurance and Occupational Pensions Authority (EIOPA). The guidelines are not legally binding but they bind national regulators to a comply-or-explain rule (Level 3). Still to come are so-called technical standards to be issued by the Commission and further guidelines.

Under the standard formula, which is already laid down to a large extent by the Delegated Act, capital requirements for asset-related risks are calculated by subjecting the market consistent valued balance sheet to a series of shock scenarios. These could include a fall in the value of equities, interest rates rising or falling, credit spreads widening, and movements in foreign exchange rates.

One important aspect to keep in mind is that for life insurers, leaving aside currency and concentration risks, assets other than those in loan or bond format incur charges at least twice. First in their respective special sub-module (for example equities or real estate) which is often the focus of discussions, and second – and just as important – in the interest rate sub-module where they are treated as non-entities. As the interest rate sub-module effectively charges any duration mismatch between liabilities and assets, any assets negated there increase that charge. Bonds and loans, in contrast, normally do not incur a charge under the interest rate sub-module, only under the spread risk sub-module. That is why achieving bond treatment with high spread risk charges may be preferable to a treatment as equity even if the headline charge under the equity sub-module may be lower in some cases than that of non-investment grade bonds.

Generally, the standard formula tries to follow the principle of substance over form, calling this the look-through approach. Indirect market risk exposures need to be subjected to the same capital requirements as direct ones (article 84(2) Delegated Act). This means, for example, that investment funds are not treated as one aggregated asset. Rather, the assets (and any liabilities) they hold are subjected to the relevant shock scenarios. Similarly, structured products other than securitisations are supposed to be disaggregated into embedded derivatives on the one hand, and the host instrument into which they are embedded on the other hand.

Those following international accounting rules will feel reminded of the so-called bifurcation rules for structured notes, which today apply under IAS 39. And indeed, wherever possible Solvency II tries to apply IFRS [International Financial Reporting Standards] on the recognition and valuation of assets and liabilities limiting the imposition of own rules to cases where the IFRS rules do not conform with Solvency II's principles (article 9 Delegated Act). This means that unless otherwise required under Solvency II, IAS 39 (until superseded by IFRS 9, once it is endorsed by the European Commission) determines when and to what extent an asset or liability enters or leaves the solvency balance sheet, and therefor which assets and liabilities are subjected to the shock scenarios of the standard formula's market risk module.

It is important to note, however, that IAS 39's bifurcation rules follow different considerations than Solvency II. While IAS 39 looks to whether the risks of any embedded derivatives are closely related to those of the host instrument, the wording and general approach of Solvency II's standard formula aim at capturing all indirect market exposures, regardless of whether closely related to the host instrument's risks or not.

Turning to CoCos, this means that if insurers bifurcate them under IAS 39, this in itself already requires them to subject the embedded derivatives and host instrument separately to the relevant shock scenarios. However, even if insurers decide to not bifurcate CoCos under IAS 39 or to do so only in a relatively limited fashion – and there are several undecided issues under IAS 39 – they may still be obliged to do bifurcate (additionally) for Solvency II purposes. Features of CoCos that require consideration when deciding whether bifurcation is required include issuer call rights and, as the case may be, the equity conversion or debt write-down linked to the issuer's CET1 ratio.

If it's decided that bifurcation is required in principle, the question turns to whether or not the insurer is in fact able to model the bifurcation.

If the insurer is able to model the bifurcation, treatment of the host instrument is relatively easy to describe: it is subject to the interest, spread and potentially currency and concentration risk sub-modules, respectively. Assuming it is denominated in the insurer's domestic currency, and leaving aside concentration risks, for life insurance companies it is likely to attract only a spread risk charge which varies depending the bond's rating quality and duration. For bonds with a duration of 10 years, it varies between seven percent (AAA) and 20% (BBB) of the bond's market value for investment grade, and 35% and 58% for non-investment grade. Unrated bonds with a 10 year duration are only subject to a 23.5% charge.

The problem lies with how to model the equity conversion or, as the case may be, debt write-down feature of CoCos. Exercise of these features affects the host instrument, so this is not a simple constellation of bond-plus-derivative where both elements can be modelled separately and independently, and it is linked to non-market variables, making it difficult to decide which of the market risk sub-modules to apply and how to model CoCos in those scenarios.


"Insurers may conclude that they are not forced to treat the instrument as type 2 equity if they cannot bifurcate"


The standard formula contains an express provision for assets where a look-through is called for in principle, but is not possible to achieve. Article 168(3) of the Delegated Act provides that in those cases, the whole instrument falls under so-called type 2 equities which are subject to a shock of 49%, increased or decreased by up to 10% depending on whether a reference equity index chosen by EIOPA has risen or fallen over the last three years (so-called symmetric adjustment to create anti-cyclical capital buffers). Incidentally, this should mean that it may not be treated as a bond in the interest rate sub-module which is, as described earlier, a serious disadvantage.

Earlier drafts of the Level 2 rules provided variations of the look-through principle that would have led to different results. For example the final advice of EIOPA's predecessor CEIOPS on the Level 2 rules and technical specifications for the European Commission's last quantitative impact study (QIS 5) contained an express provision that subordinated and hybrid debt fell under the spread risk sub-module. This could have been taken to imply that in those cases, the subordination or other hybrid feature of debt did not need to be stripped out and treated separately.

This provision, however, has been qualified in an unclear way in EIOPA's technical specifications for the current preparatory phase. In any case it did not make it into the Delegated Act nor, so far, into EIOPA's Level 3 guidelines. Irrespective of whether this reflects a conscious reversal by EIOPA and the European Commission, at least these texts no longer form a strong basis to argue for an exemption from the bifurcation rules for those instruments.

A provision expressly directed at assets that combine equity and debt characteristics and which cannot be bifurcated was not, however, totally discarded. Instead, it was moved to Level 3 and has become part of EIOPA's guidelines guideline 5 of EIOPA-BoS-14/174 EN). It states insurers should determine which of the sub-modules to apply to the (whole) instrument depending on whether economically debt or equity characteristics dominate. This contradicts the Level 2 rule described above which provides that instruments are to be treated in their entirety as type 2 equities if they cannot be bifurcated.

Counterintuitive results

Strictly speaking, EIOPA's guidelines as legally non-binding rules cannot derogate from provisions of the Delegated Act. However from a practical perspective, given most national regulators follow EIOPA's guidelines, at least in those cases where CoCos include an equity conversion feature, insurers may conclude that they are not forced to treat the instrument as type 2 equity if they cannot bifurcate. Being able to treat CoCos as bonds instead of equity provides benefits even if the spread charge is higher than for type 2 equities. Whether CoCos with debt write-down features qualify for this treatment as well, remains to be seen. If they don't, the surprising and counterintuitive result would be that CoCos with equity conversion features would be more likely to be treated as plain vanilla bonds under the standard formula than those with a mere debt write-down.

By Allen & Overy counsel Bernd Geier and Goldman Sachs' Stephan Funck in Frankfurt

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