As a result of fallout from the coronavirus pandemic, European insurers rated by S&P Global Ratings have successfully weathered the biggest market shock to their Solvency II ratios since January 2016, when the regulatory framework was launched. That's thanks to strong ratios going into 2020 and features of Solvency II that cushion shock from equity price drops and widening credit spreads. However, that doesn't rule out a more severe impact under our capital model, depending on the individual profile of each company. Plus, over the next quarters, potential downgrades of insurers' invested assets to speculative grade from investment grade (so-called fallen angels) could weigh on Solvency II ratios and our own measure of capital adequacy under our model. We do not anticipate that declines in SII ratios will have implications for insurers' financial strength ratings. However, hybrid ratings for issuers with lower-than-average or more volatile SII ratios could experience pressure if ratios decline beyond our expectations. We expect that recent market volatility will erode capital buffers under our model, but this is unlikely to lead to widespread rating actions.

Stabilizers Moderated The Decline In Regulatory Solvency Ratios

We estimate that Solvency II (SII) ratios in first-quarter 2020 fell on average 20 percentage points for the European insurers we rate, based on the insurers' published ratios and sensitivities to market shocks that occurred in the period. In the European Economic Area (EEA), during the quarter:

• Risk-free rates across the 1-20-year curve declined by about 35 basis points (bps),
• Equity markets dropped about 25%, and
• Corporate credit spreads jumped by about 100 bps.

Based on the published Solvency II ratio sensitivities of the top 30 EEA insurers, we estimate the average drop was about 20 points. The range around this average negative impact goes from minus 10-40 points, driven by each insurers' relative sensitivity to the sum of these different market shocks.

A 20-point drop in SII ratios may not appear drastic in light of the most severe market shock since Solvency II was implemented. That's because the measures of the long-term guarantees (LTG) package introduced to mitigate the procyclicality of Solvency II have had a significant stabilizing effect. Those measures include: the volatility adjustment (VA) and its use in internal models, the matching adjustment (MA), and the equity symmetric adjustment (SA) under the standard formula. What's more, the possibility to recalculate the benefit of the transitional measures on capital requirements has also cushioned the impact of the decline in Solvency II ratios caused by a drop in interest rates. However, these transitional measures are only temporary as they are fading out until 2032.

The VA, MA, and SA do not mitigate the impact of the decline in interest rates on the best estimate evaluation of liabilities. As such, we estimate that the moderate decline in euro risk-free rates (see chart 2, row excluding VA) has had a more negative impact than the bigger widening in credit spreads, except in cases where transitional measures dampened the fall in interest rates.

In addition, the drop in interest rates has been anything but parallel, with the 20-year mark falling almost twice as much as the 10-year mark (-38 bps versus -23 bps). As such, the sensitivities published by the insurers may underestimate the impact of lower interest rates on their solvency ratios, and we expect a bigger proportional hit to insurers with longer-tail liabilities.

Chart 1

The VA lessens the impact of widening credit spreads for those insurers that apply it. Insurers can add the VA to the discount rate of their long-term liabilities backed by fixed-income assets, which is periodically calculated by EIOPA (European Insurance and Occupational Pensions Authority). The VA shot up to 46 bps on March 31, 2020 (see chart 2). Based on EIOPA's publications on the benefit of VA at end-2018 and our estimates for the more recent periods, the adjustment likely contributed to more than 30 points of European insurers' solvency ratios on average at end-March. That said, the VA reacts quickly to any normalization of credit spreads and the benefit as of May 12, 2020, had already reduced (see table 1).

Table 1

We view the general purpose of the VA stabilizer as positive, as it reflects insurers' long-term investment horizon, which allows them to capture illiquidity premiums. That said, the benefit of VA varies greatly by insurer under the standard formula and those using a dynamic VA (DVA) within internal models, which allows insurers to model the level of DVA commensurate with the intensity of the market shock, instead of taking a static data point. We believe the calibration of a DVA within an internal model can overshoot the original countercyclical objective of VA. DVA benefits can be very large, making comparisons of Solvency II ratios among insurers difficult and raising doubts about a level playing field for regulatory solvency.

EIOPA in its 2019 report on LTG (long-term guarantee) measures, highlighted that the use of DVA improved the 2018 SII ratios of insurers using it by 74 points on average, three times the benefit of insurers that used constant VA. The largest European multiline insurers such as Allianz, AXA, Aegon, and NN Group use DVA. These findings are driving some of EIOPA's proposals for a review of VA. Indeed, the VA formula could change once the review of Solvency II is finalized (see "Solvency II 2020 Review Could Disrupt Insurers' Solvency Ratios," published on Jan. 13, 2020).

The matching adjustment (used in Spain and the U.K.) allows insurers to increase the discount rate of their long-term liabilities by the spread of the fixed-income assets that back these liabilities. The fundamental credit spread, a proxy of the long-term expected loss of these fixed-income assets, is deducted from the MA. As long as the fixed-income assets remain investment grade, insurers using MA are largely insulated from corporate spread movements. While the benefit of MA is substantial (69 points in Spain and 96 points in the U.K., according to EIOPA), its eligibility rests on strict requirements for matching asset and liability cash flow.

Finally, for insurers using the standard formula, the equity symmetric adjustment (so-called equity dampener), corrects the standard equity charge (39% for OECD countries' listed equities, 49% for other types of equities) by plus or minus 10 points the deviation in equity index prices with respect to their three-year average. The dampener stood at -10% at March 31, 2020, compared with -6.4% at end-2018 when EIOPA stated the dampener-reduced solvency capital requirements by 4% on average. While the benefit is a bit higher now, the dampener is at its maximum, and will not cushion any potential further drops in equity markets.

Our Capital Adequacy Measure Could Potentially Show Bigger Drops Than SII Ratios

When looking at the market shock, together with potential negative rating transitions on insurers' invested assets, we estimate that our capital model may potentially show a bigger drop than SII ratios. However, that will largely depend on each insurer's business mix and application of the Solvency II standard formula or internal model. In addition, different calibrations and valuation methods among the types of risk can either lead to a more benign or more severe impact from a market shock under our capital model than according to the Solvency II framework. We have identified some of these key differences in the table 2 below, with an estimate of the likely difference in magnitude of the impact for most rated insurers (individual cases may differ). Risk factors marked with a '+' indicate that the model is more sensitive to swings in that risk factor.

The comparison in table 2 does not indicate that our assessment of an insurer's financial risk profile would be more volatile than the trend in Solvency II ratios. Indeed, our assessment combines our forward-looking view of capital and earnings, risk exposure, and funding structure. Looking at our rated universe, in about five out of every six cases, the financial risk profile assessment differs from the latest financial year-end capital model outcome. This highlights the importance of other factors outside of the capital model, including the role of analytical judgment in the rating process (see "Credit FAQ: Thinking Outside The Box: S&P Global Ratings' Insurance Capital Model," Sept. 6, 2018).

Potential Fallen Angels Could Hurt Both SII Ratios And Our Measure Of Capital Adequacy

A potential rise in downgrades from investment grade to speculative grade (fallen angels) could weigh on SII ratios and our measure of capital adequacy. Under both methodologies, the jump between the 'BBB' and 'BB' categories is substantial (see chart 2).

Chart 2

That said, a material hit to SII ratios and our measure of capital adequacy would actually depend on a large amount of securities falling into speculative grade. Based on our elaboration of EIOPA data on the credit quality of insurers' investments (excluding unit-linked assets), only about 10% of corporate bonds (including an estimated 75% of amounts reported in debt and money market funds) stood in the 'BBB' equivalent category as of third-quarter 2019. The share of 'BBB' bonds in total asset exposures in the six largest European insurance markets ranged from 6% in Germany to 15% in the U.K. (see chart 3). European insurers' large share of investments in covered bonds and senior unsecured bank bonds (generally rated 'A' or above) explain the relatively moderate concentration of 'BBB' bonds.

Chart 3

S&P Global Ratings has estimated that about 15% of corporate ratings in the U.S. and EMEA in the 'BBB' rating category could fall into speculative grade during the pandemic (see "'BBB' Pulse: U.S. And EMEA Fallen Angels Are Set To Rise As The Economy Grinds To A Halt," April 9, 2020).

Chart 4

EIOPA data indicate that market risk (which includes spread risk) accounts on average for about 60% of European insurers' SCR, and that spread risk is the largest component of market risk. Based on this assumption, the fall of 15% of that portfolio into speculative grade would likely reduce SII ratios by less than 10 points. A sample of insurers' published sensitivities for a 20% downgrade of their credit portfolios adds some empirical evidence to the magnitude of the impact (see table 3).

Table 3

As for our capital model, the relative impact of a downgrade to the 'BB' category from 'BBB' is more than double that under Solvency II (see chart 2). As a result, the above-mentioned scenario of 15% of corporates moving to the 'BB' category from 'BBB' would likely have a bigger incremental impact on our measure of capital adequacy than Solvency II. However, as highlighted in chart 3, European insurers have a much larger exposure to sovereign credit risk than corporate credit risk. Thus, a change in rating category of a European sovereign would have a much bigger impact on insurers' capital adequacy than a corporate rating migration.

The Implications For Our Ratings

When combining the market shock and impact from potential negative rating transitions, we could possibly expect some insurers losing between 20 and 30 percentage points of regulatory solvency in 2020. Those insurers that issue hybrids and have a much lower-than-average starting point of SCR or much higher-than-average sensitivity could potentially see hybrid downgrades. Indeed, hybrids issued under Solvency II have mandatory deferral features at the point of breach of SCR. To reflect increased deferral risk when a hybrid issuer's SII ratio declines, we would consider widening the notching between the issuer credit rating and the hybrid issue rating if the issuer's rating proved resilient to this decline (see "Hybrid Capital: Methodology And Assumptions," July 1, 2019).

For financial strength and issuer credit ratings, we continue to use our capital model to give us a consistent starting point from which to assess an insurer's financial risk profile, by indicating the broad range of capital adequacy on an eight-point scale. In addition, our assessment of capital adequacy (in the form of a three-year forecast) is just one input of our ratings methodology, which also includes our assessment of business position and capacity of management to take action to regenerate capital over the forecast period. As such, a change in our assessment of capital adequacy does not necessarily lead to a change in ratings. We have stable outlooks on over 80% of the insurers we rate based in the EEA. We consider EEA insurers' solid capital positions and broad diversification will continue to support the creditworthiness of many of them (see "COVID-19's Economic Effects Cloud The Outlook For EMEA Insurers," May 18, 2020).

Related Research

• COVID-19's Economic Effects Cloud The Outlook For EMEA Insurers, May 18, 2020
• Credit Trends: Fallen Angels Rose Sharply In First-Quarter 2020 Amid COVID-19 And Oil Price Shocks, April 16, 2020
• Insurers' Dividend Pause Amid COVID-19 Concerns Likely Indicates Caution, Not Credit Risks, April 15, 2020
• Credit Trends: 'BBB' Pulse: U.S. And EMEA Fallen Angels Are Set To Rise As The Economy Grinds To A Halt, April 9, 2020
• COVID-19 Will Test Insurers' Resilience, March 25, 2020
• Solvency II 2020 Review Could Disrupt Insurers' Solvency Ratios, Jan. 13, 2020
• Credit FAQ: Thinking Outside The Box: S&P Global Ratings' Insurance Capital Model, Sept. 6, 2018