Capital requirements under Solvency II are likely to prompt insurers to increase their allocations to government and covered bonds at the expense of equity and long term corporate bonds, according to a BIS report published today (Wednesday), with Swiss experience of solvency requirements supporting this expectation.

The report, ‘Fixed income strategies of insurance companies and pension funds’, was prepared by a working group under the auspices of the Committee on the Global Financial System (CGFS), and examined, inter alia, how insurance companies and pension funds are being affected by forthcoming accounting and regulatory changes in the prevailing low interest rate environment, and what the possible implications of changes in their investment strategies might be for the financial system.

Favourable capital treatment under Solvency II of covered bonds and European Economic Area government bonds is expected to lead most insurers, and pension funds subject to risk-based regulation, to increase their allocation to government and covered bonds, said the report.

“Demand for highly rated bonds may also rise as a result of insurers trying to close their duration gap to reduce the capital charge under the interest risk sub-module,” it added.

The introduction in 2006 of solvency requirements for Switzerland’s insurers, the Swiss Solvency Test (SST), which shares important features with Solvency II, led to such changes, according to the report.

“Consistent with insurers’ objective of reducing their duration gap (but also with other forces during the financial crisis), an increased demand for long term government bonds, swaps and covered bonds was observed, leading at times to an inverted yield curve between maturities of 15 and 30 years,” it said.

The study identified a decrease in government bond yields as a possible consequence of Solvency II, due to firms seeking to compensate for a shortening of corporate bond holdings with longer dated government bonds to prevent a widening of their duration gap, which would boost demand in what is already insurance companies’ “preferred habitat”, the long term public bond segment.

The expansion of insurance companies’ and pension funds’ covered bond holdings, however, would mitigate against a broad-based shift from bank funding toward government funding, it said, while “the trend toward government debt is tempered by growing unease about the sustainability of public finances”.

The CGFS report also noted an ongoing shift from corporate to covered bonds, citing record euro denominated issuance volumes in Q1 2011.

“Heavy covered bond issuance by itself may contribute to making senior unsecured bonds less attractive, as more high quality assets end up in pools of collateral securing covered bonds,” it said.

Another factor cited as favouring covered bond supply is the prospect of unsecured bank debt being made subject to haircuts and bail-ins – the report noted that a European Commission consultation launched in January on the implementation of burden-sharing among bank bondholders excludes covered bonds from its scope.

“In addition, concerns about contagion effects on the euro area banking sector from the European sovereign debt crisis may have driven the investor base of European bank debt more towards secured instruments,” said the report.