Solvency II transition leaves insurers (and bondholders) in better place

This year will go down as an important period for the European insurance sector, which is concluding its effort to phase out capital instruments issued under the old Solvency I framework and replace them with more modern Solvency II structures.

For readers less familiar with insurance regulation, Solvency II plays the same role that Basel III plays for banks. In a nutshell, it is a regulatory framework whose aim is to have well capitalised institutions with limits around what they can and cannot do, to ensure financial stability and the appropriate provision of financial services. This transition has gone smoothly, and in our view has left European insurers with more robust capital structures that will help them to address any unexpected headwinds. It goes without saying that we believe this is a positive development for insurance bondholders, but it is worth reflecting on some of the other changes that have occurred alongside the Solvency II transition and what its conclusion could mean for the supply of insurance capital instruments over the next year or so.

Solvency II’s risk-based approach

First, as a step back, European insurers have been regulated under the so-called Solvency I rules since 1970s. In 2001, the European Commission formally launched a consultation paper outlining the need for a modernised, risk-based regulatory framework to replace the existing one. This followed discussions in the 1990s about the lack of risk sensitivity of Solvency I, with the growing consensus being that the rules didn’t reflect the true economic risk of insurers’ assets and liabilities. These regulatory efforts culminated in the Solvency II framework, which came into force on 1 January 2016.

Solvency II differed from Solvency I in a number of ways, though both sets of rules had the overarching goal of protecting policyholders. Most prominently, in terms of capital requirements, Solvency I used simplistic formulas where an insurer’s solvency margin (the minimum capital it had to hold) was calculated based on the volume of its outstanding premiums, rather than any judgement of the risk attached to different types of insurance. As an example, in non-life (general) insurance, the solvency margin was calculated as the higher of (i) a percentage of the average annual claims payments over the previous three financial years, or (ii) a percentage of the annual gross written premiums. Solvency II on the other hand is a risk-based approach which allows holistic assessment of capital requirements through quantitative and qualitative measures. More specifically, Solvency II considers a broad range of risks including market, credit, underwriting and operational. It also introduced two capital thresholds – the Solvency Capital Requirement and the Minimum Capital Requirement – which created a more robust backstop than Solvency I’s solvency margin.

Solvency II and RT1s

While the Solvency II framework has been in place since 2016, the sector was allowed some transitional arrangements (extended timeframes to comply) in specific areas to adapt to the new reality. First, Solvency II includes transitional measures on technical provisions (TMTP), which allow a gradual phase-in of the new valuation rules for pre-2016 insurance liabilities over a maximum period of 16 years (ending 31 December 2031). This straight-line amortisation was intended to smooth the impact on insurers’ balance sheets without delaying full adoption of the framework itself. Insurers were also given 10 years to change the format of their capital instruments, which was largely achieved by rolling over the outstanding bonds and replacing them with new deals that had better risk absorption features introduced under Solvency II. This transition period concludes on 31 December 2025. The banking sector underwent a similar process of replacing old-style Tier 1 bonds with Additional Tier 1 (AT1) bonds under Basel III.

Over this 10-year transition period, European insurers have issued over €30bn equivalent in Restricted Tier 1 (RT1) instruments that were specifically introduced under Solvency II – these instruments have similar features to AT1s issued by banks, a market that now stands at around €200bn equivalent. Some of these RT1 deals were brought to market as early as 2017, but over half of the €30bn was issued across 2024 and 2025 as the end of the transition period approached and insurers’ legacy capital instruments came closer to losing their regulatory eligibility.

Looking ahead, we note that the stock of legacy paper that may be up for refinancing has dwindled considerably this year – we estimate it to be around €5bn equivalent. These bonds may or may not be refinanced through additional RT1s. Any extra net supply beyond the refinancing will obviously depend on market conditions and business needs, but insurers thus far have shown a strong preference for using cheaper Tier 2 structures in their capital mix (the volume of non-RT1 subordinated debt from European insurers is around €150bn vs. the €30bn of outstanding RT1s).

Insurance and private credit

As investors in insurance bonds, the modernised capital stacks and robust risk assessment frameworks of Solvency II give us a high degree of comfort amid press headlines around private corporate credit exposure in the insurance sector (we specify private corporate credit here because “private credit” is a broad asset class that includes markets such as infrastructure and real estate debt, while the press headlines are focused on credit provided directly to companies by non-bank institutions).

Life insurance portfolios will always consist of a high proportion of government bonds, publicly traded debt, and some form of less liquid or other assets. The latter are a natural fit for insurers given the long-term nature of their liabilities and the illiquidity premium these assets tend to offer. In Europe, the less liquid/other assets are often represented by mortgage loans (especially in the Netherlands but also in the UK), equities (French insurers), infrastructure exposures, and commercial real estate. Private corporate credit is naturally in this mix, though the precise definition may vary from one insurer to another.

We are not concerned about insurers’ exposure to private corporate credit in and of itself since we see it as an inherent part of their balance sheets. What is worth monitoring is the pace of growth in these exposures within the asset mix (as is the pace of growth in any less liquid asset), and more importantly any links between private corporate credit originators and insurance firms they own. In the latter case, we see skewed incentives for the originators and the insurance firms, which may turn out to be a source of vulnerability down the line. As always there are some exceptions, but these ownership structures are more prevalent in the US than in Europe.

As year-end approaches, we believe the European insurance sector is closing a successful chapter of transition to a more robust regulatory framework that has left individual players with higher quality capital to address any unexpected headwinds. From a valuation perspective, the end of the transition period for capital instruments, along with insurers’ strong preference for Tier 2 issuance and negligible refinancing needs in the year ahead, point to restricted RT1 supply in 2026, which should provide a strong technical tailwind for outstanding bonds.

Finally, we acknowledge the recent press focus on private corporate credit within the insurance segment but believe these exposures have been and will continue to be an integral part of the asset mix for life insurers. We remain more alert to ownership structures which can create skewed incentives around the acquisition of private corporate credit and any other less liquid assets.