Draft implementing measures of the Solvency II directive circulated by the EC reduce a disincentive for insurance companies to hold long dated covered bonds that was a feature of earlier proposals, The Covered Bond Report understands, with double-A rated issues also treated better.

A spokesperson for the European Commission (EC) said that the Commission at the beginning of November sent to the European Parliament and Member States a draft working version of Level 2 implementing measures of the Solvency II Directive, with late spring 2012 being targeted for their adoption. The text is not a public document.

Level 2 implementing measures are those that will put into practice the Solvency II Level 1 Framework Directive, according to the European Insurance & Occupational Pensions Authority (EIOPA). Specialist insurance market Lloyd’s has said that much of Solvency II’s impact on insurers will come from the implementing measures rather than the directive, which in many places indicates that the EC has powers to adopt implementing measures for specified topics.

According to market participants, whereas under a previous proposal preferential treatment under a spread risk module was only given to triple-A rated covered bonds, the Level 2 implementing measures extend beneficial treatment to double-A rated covered bonds, albeit differentiating between credit quality step 1A (triple-A) and credit quality step 1B (double-A).

In addition, the implementing measures are also understood to distinguish between spread risk charges for covered bonds with a duration of up to five, and duration from five to 10, with the linear relationship between duration and spread risk capital charges being softened, thereby providing more of an incentive to invest in long dated covered bonds. An analyst said he would expect covered bond with a term to maturity longer than 10 years to also benefit from a lower spread risk factor.

He said that the proposed measures would reduce the additional pick-up for a double-A rated covered bond versus a government or supranational, sovereign or agency (SSA) bond in the 10 year segment from 100bp to 45bp.

“There is indeed a much stronger incentive to invest in longer dated covered bonds,” he said.

Limiting preferential treatment of covered bonds in the spread risk component to only triple-A rated covered bonds and the linear relationship between duration and capital charges are two aspects of previous, or existing, Solvency II proposals that another covered bond analyst previously identified as encouraging insurance companies to focus their long dated investment exposure toward sovereign bonds and reduce the average duration of their capital intensive products, to the disadvantage of long dated covered bonds.

Insurance companies are the largest investors in Europe, holding, according to Fitch, about 44% of European investments – around Eu7tr of assets.

The rating agency on 22 November wrote about the implications of the latest European Commission proposals for longer dated unsecured corporate and financial institution bonds, saying that the proposals to lower capital charges for this type of bonds “should mitigate the capital flight from these asset classes that is a likely side-effect of Solvency II”.

It said that previously proposed capital charges for long dated unsecured bonds were extremely onerous, as a result of which at best insurers were likely to switch holdings to shorter dated higher rated bonds only – potentially increasing refinancing risk for borrowers.

However, it said that the changes represent incremental progress rather than a radical change, and that holding these bonds would still be less desirable than under existing rules.