STRUCTURED FINANCE RESEARCH

EIOPA's Revised Solvency II Calibration Still Risks Turning European Insurers Away From Securitizations
Primary Credit Analyst: Mark S Boyce, London 02071768397; [email protected] Secondary Contact: Andrew H South, London (44) 20-7176-3712; [email protected]

Table Of Contents
Proposed Securitization Capital Charges Have Fallen But Probably Not Enough To Keep Insurers Interested There's Still Scope For Further Amendments Related Research

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

MARCH 19, 2014 1

1279047 | 301112013

EIOPA's Revised Solvency II Calibration Still Risks Turning European Insurers Away From Securitizations
In December 2013, the European Insurance and Occupational Pensions Authority (EIOPA) released its latest draft calibration of standardized capital charges for insurers' securitization holdings under the Solvency II regulatory framework. For some types of securitizations, the proposed capital charges are substantially lower than those detailed in the previous draft technical specifications published in December 2012. Nevertheless, securitization capital charges remain much higher than for other types of fixed-income investmentsincluding corporate bonds and covered bondsand are significantly higher than the capital charges applicable to global banks' securitization exposures under proposed Basel capital rules. Therefore, while Standard & Poor's Ratings Services views the latest changes to the draft Solvency II standards as a positive sign for the securitization market, we believe thatif adopted in their current formthey would still lead many European insurers to turn away from securitization investments. Overview Under the latest Solvency II draft calibration, European insurers' securitization investments that meet certain structural, asset-level, and transparency requirements are eligible for more favorable capital treatment than under the previous draft calibration in December 2012. In our view, this shows that European policymakers are gradually recognizing that securitization can play a significant role in helping to revive lending to the real economy. However, the proposed capital charges remain high compared with other fixed-income investments and may still deter insurers from investing in the securitization market, in our view.

Proposed Securitization Capital Charges Have Fallen

In December 2013, EIOPA, the European insurance regulator, released its latest draft of technical specifications detailing the standardized spread risk capital charges for insurers' securitization holdings under the Solvency II regulatory framework. "Spread risk" capital charges in this context cover the risk that a security's market value may declineequivalent to a widening of its secondary market spread. The updated proposal defines certain securitizations as "Type A" exposures, and treats these more favorably than other securitizations (termed "Type B"). (Resecuritizations, such as collateralized debt obligations [CDOs] that are backed by other structured finance instruments, are neither classified as Type A nor Type B, and are generally subject to higher spread risk capital requirements than both. The December 2013 specifications did not change the capital charge calibration for resecuritizations.) To qualify as a Type A securitization, a transaction must meet various structural, asset-level, and transparency requirements, which the insurer would have to verify "in the prospectus or applicable data repository." Specifically:

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

MARCH 19, 2014 2

1279047 | 301112013

EIOPA's Revised Solvency II Calibration Still Risks Turning European Insurers Away From Securitizations

Structural features
The securitization is not subordinated to other tranches when it receives principal and interest after the delivery of an enforcement notice. The securitization is rated 'BBB-' or above at all times. The special-purpose vehicle acquires the assets from the seller in a "true sale" transaction, with no severe clawback provisions for the seller. Provisions exist to ensure servicing continuity if the servicer defaults.

Asset-level requirements
Underlying assets must not include any credit-linked notes, swaps, synthetic securities, or derivatives other than those used to hedge foreign exchange and interest rate risk. Only one of the following asset types backs the securitization: residential mortgage loans, loans to small and midsize enterprises, auto loans, leases, consumer finance, or credit card receivables. The lender's underwriting process complies with the European Mortgage Credit Directive (and, in particular, includes a full assessment of the borrower's ability to repay the loan). The originator did not grant any loans to credit-impaired borrowers, or to borrowers self-certifying information relevant to the underwriting process. No loans were in arrears of more than 90 days when sold into the securitization. Borrowers have made at least one payment on all loans.

Transparency requirements
The securitization is registered for trading on a regulated market in the European Economic Area or Organization for Economic Co-operation and Development. Loan-by-loan data is available to investors. The proposal includes a grandfathering provision: For those transactions launched before the regulation's implementation, securitizations only have to meet the first three requirements under "Structural features" and the first two under "Asset-level requirements" to fall into the Type A category. Relative to the previous technical specifications published in December 2012, spread risk capital charges are generally lower for securitizations rated 'BBB' or above, especially Type A securitizations (see table 1 and chart 1). For example, a five-year, 'AAA'-rated Type A securitization incurs a 22% capital charge under the revised specifications, compared with 35% under the previous proposals (see "Solvency II Could Push European Insurers Away From Securitizations," published on Dec. 10, 2012, on RatingsDirect). The capital requirement for a 'AA'-rated Type A securitization is almost one-half that for the same securitization in the earlier specifications. In our view, the revised proposals point to a growing recognition among European policymakers that not all securitizations are created alike, and specifically that the poor credit performance of many transactions linked to the U.S. subprime mortgage market was the exception, rather than the rule. Most European securitization asset classes have shown strong credit performance over the six years or so since the U.S. subprime issues came to light (see "Transition Study: Six Years On, Only 1.5% of European Structured Finance Has Defaulted," published on Dec. 6, 2013). In view of persistently anemic bank lending growth in Europe, some policymakers are also beginning to see securitization as a way to boost consumer and business financing. EIOPA's updated specifications followed a European

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

MARCH 19, 2014 3

1279047 | 301112013

EIOPA's Revised Solvency II Calibration Still Risks Turning European Insurers Away From Securitizations

Commission request in September 2012, asking the regulator to examine whether the previous draft calibration of capital requirements for investments in some asset classesincluding securitizations that provide financing to the real economyrequired "adjustment or reduction."
Table 1

Proposed Standardized Securitization Spread Risk Factors For European Insurers

Rating Risk factor (%) Type A Type B December 2012 specifications* Maximum modified duration (years) 4.3 12.5 7.0 6.0 8.5 13.4 16.0 5.0 14.8 16.6 19.0 4.0 17.0-20.0 19.7 20.0 4.00 82.0 82.0 82.0 1.0 100.0 100.0 100.0 1.0 100.0 100.0 100.0 1.0 AAA AA A BBB BB B CCC or lower

Note: Per year of modified duration. *Excluding resecuritizations. Source: EIOPA (December 2013 technical specifications).

Chart 1

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

MARCH 19, 2014 4

1279047 | 301112013

EIOPA's Revised Solvency II Calibration Still Risks Turning European Insurers Away From Securitizations

But Probably Not Enough To Keep Insurers Interested

Even so, standardized capital charges remain high when compared with other asset classes. For example, five-year 'AAA'-rated covered bonds and corporate bonds are subject to spread risk capital charges between 3% and 5%five to six times lower than for Type A securitizations (see chart 2). The securitization capital requirements for European insurers under the proposed Solvency II rules are also more than 10 times higher in some cases than those for global banks under the most recently-proposed revisions to the Basel securitization framework (see chart 3). In any case, questions remain over how significant a share of future European securitization issuance would qualify for Type A treatment under the rules, without material changes to current market practices. For example, back-up servicing agreements are not the norm in most European securitization asset classes. This raises the question of what other arrangements might qualify as "provisionsto ensure servicing continuity if the servicer defaults"a requirement for Type A treatment. Similarly, while credit card receivables qualify as an underlying asset type, it has not been common historically for originators to make loan-by-loan data available for credit card asset-backed securities. It's also unclear to us how insurers will verify securitizations' compliance with some of the Type A criteria in practice. Many originators already explicitly commit to some of the asset-level requirements in the transaction documentation (or could do so in new transactions). Examples of such requirements are that borrowers have made at least one payment on all loans, or that the originator has not sold any loans in severe arrears into the transaction. However, verification of the true sale of assets and the lack of "severe" clawback provisions generally requires a legal analysis, which we undertake as part of our rating methodology. We don't know whether transaction documentation, or a separate legal opinion provided by the originator, would suffice to meet this requirement. We expect that those insurers investing in securitizations may be more sophisticated, and therefore more likely to model their capital charges internally rather than use the standardized approach. This may mitigate the effect of onerous standardized capital requirements, in our view. However, we note that internal models are subject to regulatory approval. It remains to be seen whether national regulators will accept models yielding capital charges that are significantly below those resulting from the standardized formula.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

MARCH 19, 2014 5

1279047 | 301112013

EIOPA's Revised Solvency II Calibration Still Risks Turning European Insurers Away From Securitizations

Chart 2

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

MARCH 19, 2014 6

1279047 | 301112013

EIOPA's Revised Solvency II Calibration Still Risks Turning European Insurers Away From Securitizations

Chart 3

There's Still Scope For Further Amendments

We understand that EIOPA could submit the final technical standards governing the capital treatment of securitizations to the European Commission during the first half of 2014. The Commission is empowered to adopt these standards, subject to approval by the European Parliament and the Council of the European Union. To our knowledge, there is no planned public consultation on the implementing standards. However, EIOPA has suggested that the European Commission review insurers' spread risk charges following the publication of final revisions to the Basel securitization framework, in order to avoid regulatory arbitrage between the banking and insurance sectors. This suggests that there is some scope for the calibration of securitization capital charges under Solvency II to soften further. While we believe that the December 2013 calibration changes imply greater policymaker support for the European securitization market, we anticipate that unless capital requirements fall further, many insurers would shun securitization investments.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

MARCH 19, 2014 7

1279047 | 301112013

EIOPA's Revised Solvency II Calibration Still Risks Turning European Insurers Away From Securitizations

Related Research
Transition Study: Six Years On, Only 1.5% of European Structured Finance Has Defaulted, Dec. 6, 2013 Underwriting The Recovery: European Securitization Could Fund More Lending, If The Regulatory Stance Softens, Oct. 22, 2013 Solvency II Could Push European Insurers Away From Securitizations, Dec. 10, 2012
Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

Additional Contact: Structured Finance Europe; [email protected]

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

MARCH 19, 2014 8

1279047 | 301112013

Copyright 2014 Standard & Poor's Financial Services LLC, a part of McGraw Hill Financial. All rights reserved. No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor's Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an "as is" basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT'S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages. Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P's opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process. S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription) and www.spcapitaliq.com (subscription) and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

MARCH 19, 2014 9

1279047 | 301112013