Access to hybrid capital is an important element of an insurer's financial strength, both under Solvency II and in our credit rating analysis. It can provide insurers with additional loss-absorbing capacity and enhance their solvency or liquidity positions. In a sample of 47 of the largest rated European insurers, on average, roughly 20% of Solvency II eligible capital stems from hybrid capital in the form of restricted tier 1 (RT1), tier 2, and tier 3 capital at year-end 2017 (see table 1). By comparison, in S&P Global Ratings' framework, capital is less reliant on hybrid, and on average, hybrid capital represents 12% in our calculation of total adjusted capital (TAC).

We believe that most of the rated insurance companies in our sample have some flexibility to issue further hybrid capital if the need arises. However, the degree of flexibility differs across insurers, particularly in stressed situations, when the capacity to issue capital might be limited.

Indeed, there are restrictions on the extent to which hybrid capital may be used as part of available capital, both within the Solvency II framework and our credit ratings analysis. We typically limit the hybrid ratio to up to 25% of TAC for insurers in Europe, the Middle East, and Africa. Under Solvency II, tier 2 and tier 3 hybrid instrument eligibility is capped at 50% of the Solvency capital requirement (SCR), while RT1 instruments are capped at 20% of Solvency II eligible tier 1 capital (see chart 1).

In our rating analysis, we consider how the flexibility to access hybrids, the quality of capital, and financial leverage interact and could affect our view of an insurer's financial strength.

Table 1

Chart 1

Tier 2 Is Insurers' Hybrid Of Choice

On average, 60% of Solvency II hybrid capacity is unused, with relatively more capacity for RT1 (35%) than for both tier 2 and tier 3 (25%). In our view, most insurers are likely to continue using more of their tier 2 than RT1 capacity because tier 2 is cheaper and a more classic option for investors. Compared to most of the tier 2 instruments we rate, the risk of a write-down of a RT1 instrument is a sensitive issue for investors, especially for insurers with lower Solvency II ratios (see "S&P Global Ratings Comments On Solvency II Insurance Restricted Tier 1 Capital Instruments," published Nov. 17, 2016).

The average unused capacity masks a wide difference between the 47 insurers in our sample (see chart 2). In general, insurers that are more focused on acquisitions or optimizing their return on equity (ROE), or that are subsidiaries of a banking group, have used a greater proportion of their Solvency II hybrid capacity than the insurers that don't fall into one of these categories.

Chart 2

Of the 47 insurers in our sample, 27 have used RT1, with an average capacity utilization under Solvency II of close to 30% (see chart 3). A high proportion of these RT1 instruments were issued before 2015 and are grandfathered from Solvency I tier 1 instruments. As such, the RT1 capacity headroom will likely improve once the grandfathering ends on Jan. 1, 2026, or once these instruments are called, as in our view, they could be partly replaced with less costly tier 2 instruments.

Chart 3

Following the boom in tier 1 Solvency I issuances in 2014, which benefit from grandfathering treatment, and the introduction of Solvency II in January 2016, the issuance of RT1 has been limited to seven rated insurance groups: AEGON N.V.; ASR Levensverzekering N.V.; CNP Assurances (CNP); Royal & Sun Alliance Insurance PLC; Gjensidige; SCOR SE; and If P&C Insurance Ltd. (publ). The total outstanding issuance is approximately $3.5 billion. With the Aegon RT1 issue on April 4, 2019, pricing conditions were returning to the more favorable levels of mid-2018, when most of the other abovementioned players issued RT1 debt.

Tier 2 and tier 3 capital are more widely used, with only seven insurers in our sample having no such hybrids on their balance sheets, and 51% of the capacity being used on average (see charts 3 and 4). Typically, it is mutual insurers--which are often well capitalized and less focused on achieving high ROE ratios--that have demonstrated less appetite for hybrid capital historically.

In our view, tier 2 issuance remains most insurers' preferred option. We expect that most insurers will aim to maintain available tier 2 hybrid capacity, as issuing these instruments might prove easier than RT1 in times of stress. Having said that, five insurance groups have less than 10% of tier 2 hybrid capacity remaining: NN Group N.V., Lloyd's, Societa Cattolica di Assicurazione, Kommunal Landspensjonskasse, and BNP Paribas Cardif (see chart 3). For these groups to strengthen their equity bases, they would likely have to focus on specific management actions or tap the capital markets for RT1 hybrid debt.

We have observed very few insurers entering the tier 3 market. Those that have include CNP and Aviva PLC. Due to the relatively short maturity of tier 3 instruments--typically about five years--the coupon is attractive for insurers. On the other hand, because of their features, tier 3 instruments are less likely to receive any capital credit under the S&P capital model, and we have not seen any that are eligible so far. This might deter rated insurers from issuing tier 3 instruments, especially those with low capital or high financial leverage.

In addition, the tier 3 capital bucket--which can only account for up to 15% of the SCR--include an allowance for net deferred tax assets (DTAs). Consequently, in the event of a loss, some insurers might keep their flexibility for building up further DTA capital credit by not using all their tier 3 capacity. Having said that, many insurers do not have significant DTAs at the moment.

Available Hybrid Capacity Could Provide Significant Capital Resilience In Periods Of Stress

The flexibility to issue additional hybrid instruments could provide an insurer with about 60 percentage points (pps) of additional Solvency II coverage on average (see chart 4). At the moment, Solvency II coverage is healthy, at an average of 215% for our sample of 47 European insurers in 2017, and in general, well within management targets. Therefore we do not envisage many insurers in this sample further leveraging their balance sheets through incremental hybrid issuances, absent specific reasons like mergers and acquisitions financing.

Chart 4

In many stress scenarios, available hybrid capacity is likely to shrink, as the hit to eligible own funds (EOFs)--capital eligible for covering the SCR--would probably outweigh any potential increase in the SCR. In addition, the economic conditions for issuing hybrids may be less attractive in periods of stress than when the market is calm, thus limiting the incentive to issue large amounts of hybrids.

In a hypothetical situation of modest stress of a 30 pp drop in Solvency II coverage, about 70% of insurers would have sufficient hybrid capacity to fully offset the impact of the stress by additional hybrid issuance. For the remaining 14 insurers in our sample, hybrid capacity would appear insufficient to fully restore their solvency positions. These insurers' options would rest on a combination of hybrid issuance with other management actions that would depend on their solvency position post stress, financial leverage, and risk appetite.

Increasing Financial Leverage May Offset The Benefits Of Increased Hybrid Issuance

While having available hybrid capacity provides financial flexibility, accessing the debt market increases financial leverage. This would worsen our view of an insurer's creditworthiness if the size and cost of debt become difficult to absorb using profits alone. In our credit rating analysis of an insurer, we typically take a negative view if indebtedness measured by the financial leverage ratio exceeds our 40% threshold.

Financial leverage would increase materially if insurers used their full Solvency II hybrid capacity. At full capacity, we calculate a 27 pp increase in the average financial leverage ratio of our sample to 42% from 15% (see chart 5).

Chart 5

In comparison, the use of available hybrid capacity to offset a negative 30 pp shock to the Solvency II ratio would have less of an impact, with the estimated average financial leverage ratio remaining below the 40% threshold for our sample (see chart 5). In contrast, relying exclusively on additional hybrid issuance to offset a negative 60 pp shock to the Solvency ratio would increase financial leverage to very high levels above 60% on average, and could weaken creditworthiness, as eligible capacity levels might be breached while capital quality would be reduced.

These scenarios also highlight how regulatory capacity constraints might limit insurers' options in periods of stress. Some insurers, like RSA Insurance Group PLC or NN Group for instance, are not as leveraged as some of their peers, but have relatively less Solvency II hybrid capacity headroom left (see chart 6).

Chart 6

S&P Global Ratings' Allowance For Hybrid Capacity Is An Additional Consideration In Determining Insurers' Financial Flexibility

For insurers in the European Economic Area, we consider treating a hybrid instrument as part of TAC only when it is eligible for Solvency II own funds (see "Credit FAQ: How Evolving Solvency II Insurance Hybrid Capital Structures Are Treated Under Our Criteria," published April 18, 2016). For this reason, the remaining capacity for additional hybrid issuance in our credit rating analysis is limited to the remaining eligible capacity under Solvency II.

For most insurers, the eligibility limit within the S&P capital model for further hybrid issuance is more constraining than the Solvency II limit: the average remaining hybrid issuance capacity is 45% under the S&P capital model versus 60% under Solvency II. This means that many rated insurers consider the implications under our rating analysis in addition to the regulatory benefit. Only for 25% of the insurers in our sample are the S&P limits capped at the Solvency II limits (see charts 3 and 7).

Chart 7

As a proportion of Solvency II EOFs, the Solvency II hybrid limit falls when the Solvency II ratio increases. This is because while RT1 instruments are limited relative to unrestricted Solvency II own funds, the tier 2 and tier 3 capacities are constrained by the SCR. Our approach is different, as the constraint is relative to TAC, and as such, is independent of an insurer's capital requirements.

In cases where TAC is materially higher than own funds, the S&P limit might be as high as the Solvency II limit, which would be binding. In these cases, the S&P model is probably not a concern for rated issuers when they decide to issue hybrids. Such insurers represent roughly one-quarter of the sample of 47.

In other cases where TAC is not higher than the Solvency II own funds, an insurer might be in a position where it can still issue hybrids for regulatory purposes, but we would not give additional credit in full under our capital model due to the 25% threshold of hybrids in TAC. Indeed, once the 25% threshold is reached, we would only give 25% credit for any additional eligible capital that might be issued.

How TAC compares with Solvency II own funds varies widely across insurers. There are several elements--such as risk margin, policyholder bonus reserves, value of in-force life business, or regulatory transitional measures--that could lead to this variation. For instance, in S&P TAC, we do not view risk margin as a liability and policyholder bonus reserves could be given equity content; both would be positive treatment compared to own funds. On the other hand, we would not give full credit for potential life insurance value in force, whereas under Solvency II, there is no explicit haircut.

Hybrid Capacity Is Only Part Of The Equation

Hybrid capacity by itself does not provide a large amount of information for our rating analysis. We consider several factors to understand how an insurer can use any unused capacity effectively in different scenarios without putting undue strain on its indebtedness or quality of capital.

When assessing an insurer's capital flexibility, we also consider alternative capital management options that might be available, such as investment hedging, reinsurance, balance sheet de-risking, and equity raising. Access to hybrid debt is only one of many options.

Appendix

Related Research

• S&P Global Ratings Comments On Solvency II Insurance Restricted Tier 1 Capital Instruments, Nov. 17, 2016
• Credit FAQ: How Evolving Solvency II Insurance Hybrid Capital Structures Are Treated Under Our Criteria, April 18, 2016