Solvency II is the new region-wide supervisory framework for insurance and reinsurance companies operating in the European Union. The new regime includes three pillars, calculation of capital reserves, management of risk and governance, and reporting to the national supervisory authority. Moving to a risk-based approach in calculating solvency capital requirements (SCR) will require reassessment of investment choice. Risky assets that will require a higher charge may become less appealing vis-à-vis a low risk asset, despite the expectation of better performance.
It falls on insurers to classify assets; certain types are well defined while some types need to be assessed against an extensive list of criteria, including qualitative factors. In calculating SCR, insurers may follow the standard formula, develop an internal model subject to supervisory approval, or use a combination of the two. Focusing on the standard formula approach, insurers will determine the level of instantaneous shocks prescribed for each asset to aggregate into a total capital requirement.
Cash-flow risk, issuer/credit risk, and duration risk are among the key factors in determining the prescribed shock schedule. For example, a government bond issued by an EU member state in an EU member currency has a risk weight of 0%, while a B+ rated, 25-year duration corporate bond will have a risk weight of 66%. In particular, exposure to member state central government debt, certain multilateral development banks, and certain international organizations, as well as debt guaranteed by member states’ central government, are assigned a risk weight of 0% (article 180, paragraph 2 of Regulation (EU) No 2015/35).
Looking at the types of securities that can potentially qualify for lower capital charges, green bonds stand out as one possible candidate for those requiring 0% capital charge. Multilateral development banks and international organizations are among the active issuers in the green bond market. Additionally, sovereign issuers such as Poland and France have initiated issuance in the green bond market. Hence, an index of qualifying green bond securities could serve the industry as a 0% capital charge benchmark for European insurers and reinsurers.
We can highlight a hypothetical basket of qualifying securities by screening for these specific issuers within the S&P Green Bond Select Index, excluding U.S. municipals. The screen produces a hypothetical portfolio of 42 green bonds, representing 31.9% of the S&P Green Bond Select Index market value (Exhibit 1).