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  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Should Life Insurers buy CoCo Bonds? -Regulatory Effects Implied by the Solvency II

    Standards

    Helmut Grundl, Tobias Niedrig

    International Center for Insurance Regulation (ICIR)and Center of Excellence SAFE

    Goethe-University Frankfurt

    May 9, 2014

    Workshop on Banking and Insurance: Interconnectedness, Systemic Risk and Regulation

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 1 / 26

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Contingent Convertibles

    Liikanen Report (2012) strongly recommends the issuance ofcontingent convertible debt as a mechanism to reduce moral hazard created by governments bail outs enhance financial stability

    Contingent Convertibles (CoCos) = debt that converts to equityas a bank approaches financial distress (trigger)

    CoCos can be used as regulatory capital under Additional Tier 1 andTier 2 of Basel guidelines (BIS 2011)

    Suitable investors: well diversified financial institutions with longterm maturities on their funding side and restrictive terminationrights life insurance companies, pension funds, specializedhedge funds (Krahnen 2013)

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 2 / 26

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    CoCo Bonds: Issuance

    Figure: Contingent Capital Issuance volume by regulatory capital classification

    Banks and insurance companies that have issued CoCo bonds

    Bank of Ireland (2013), Barclays (2013), Credit Agricole, Llodys Bank (2009),

    Deutsche Bank (2014), Rabobank (2010), Swiss Re, UBS (2012) etc.

    Sources: Bloomberg, Dealogic, BIS

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 3 / 26

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Research Questions

    In the case of fairly priced CoCo bonds

    1 How does the design of CoCo bonds affect a banks risk situation?

    2 How does the CoCo design affect an insurers risk situation and thusthe Solvency II capital requirements?

    I higher SCR: additional costs of capital must be earned by highernominal interest rate of CoCo bonds fairly priced CoCo bonddisadvantageous

    I lower SCR: fairly priced CoCo bond advantageous

    3 Identification of CoCo design parameters that lead to higher or lowercapital requirements

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 4 / 26

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Literature Review

    Pennacchi (2011) studies the valuation of CoCos within a structuralmodel of contingent bank capital and shows how conversiondecreases shareholder returns in higher risk banks

    Glasserman and Nouri (Management Science, 2012) analyze thecase of contingent capital with a capital-ratio trigger and partial andon-going conversion

    Perotti and Martynova (2013) consider the effect of CoCo bonds onbanks risk-taking incentives and show that CoCo bonds can induceless risky asset choices by the bank

    I To our knowledge, this paper is the first to analyze the effects of aCoCo bond investment on the risk situation of insurers

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 5 / 26

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Procedure

    Develop a stylized model of a bank and an insurer

    Develop a Solvency II internal model

    Compare the insurers capital requirements when holdingnon-convertible bank bonds with those when holding CoCo bonds

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 6 / 26

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Model Framework

    Bank: provides (corporate) loans financed by equity capital,deposits and bank debt (bank bonds/CoCo bonds)

    Life insurer: stylized life insurer with an outstanding stock of lifeinsurance contracts; invests in three asset classes

    Loans

    Equity

    Deposits

    BaBo/CoCo

    Stocks

    GovernmentBonds

    BaBo/CoCo

    Equity

    Liabilities

    BankA L

    Life InsurerA L

    -

    dd ::

    Figure: Financial connection between bank and insurance.

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 7 / 26

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Sequence of Events

    - t = 0 0 < t < 1 t = 1

    Bank decides on riskinessof its loan portfolioInsurer invests intostocks and bonds, andsets equity capitalaccording to Solvency II

    Intermediate returnon loans realizesConversion may occurLiquidity shock may occur

    Asset returns realize

    BaBo

    CoCo

    Bank issues bondInsurer buys bond

    Bank issues CoCoInsurer buys CoCo

    -

    Conversion to stocksif trigger is breached

    Interest payment, orpartial or completedefault

    Interest payment,no or partial interestpayment, or partialor complete default

    Figure: Sequence of events in the model.

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 8 / 26

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Model Framework

    Bank: provides (corporate) loans financed by equity capital,deposits and bank debt (bank bonds/CoCo bonds)

    Life insurer: stylized life insurer with an outstanding stock of lifeinsurance contracts; invests in three asset classes

    Loans

    Equity

    Deposits

    BaBo/CoCo

    BankA L

    dd

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 9 / 26

    I initial value V0, value at time t:Vt = etrV V0

    I return rV is normally distributed,

    rV N (V , V )

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Model Framework

    Bank: provides (corporate) loans financed by equity capital,deposits and bank debt (bank bonds/CoCo bonds)

    Life insurer: stylized life insurer with an outstanding stock of lifeinsurance contracts; invests in three asset classes

    Loans

    Equity

    Deposits

    BaBo/CoCo

    BankA L

    dd

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 10 / 26

    I fulfills the regulatory capital ratio

    EB0 k V0 in t = 0

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Model Framework

    Bank: provides (corporate) loans financed by equity capital,deposits and bank debt (bank bonds/CoCo bonds)

    Life insurer: stylized life insurer with an outstanding stock of lifeinsurance contracts; invests in three asset classes

    Loans

    Equity

    Deposits

    BaBo/CoCo

    BankA L

    dd

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 11 / 26

    I Stochastic liquidity shock on depositsbetween t0 and t1

    I Probability of high liquidity shockincreases with the banks default risk

    I liquidity shock leads to early asset

    liquidation at costs 0

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Model Framework

    Bank: provides (corporate) loans financed by equity capital,deposits and bank debt (bank bonds/CoCo bonds)

    Life insurer: stylized life insurer with an outstanding stock of lifeinsurance contracts; invests in three asset classes

    Loans

    Equity

    Deposits

    BaBo/CoCo

    BankA L

    dd

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 12 / 26

    I Non-convertible or CoCo with facevalue BFV is issued

    I bank pays nominal interest rate rB fornon-convertible bank bonds, rC for CoCos

    I nominal interest rates depend on the

    banks default risk and are set so that

    the initial market values are equal

    (Pennacchi 2011), BB0 = CC0

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Model Framework

    Bank: provides (corporate) loans financed by equity capital,deposits and bank debt (bank bonds/CoCo bonds)

    Life insurer: stylized life insurer with an outstanding stock of lifeinsurance contracts; invests in three asset classes

    Stocks

    GovernmentBonds

    BaBo/CoCo

    Equity

    Liabilities

    Life InsurerA L::

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 13 / 26

    I initial value ST0

    I rate of return rST is normally

    distributed, rST N (ST , ST )

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Model Framework

    Bank: provides (corporate) loans financed by equity capital,deposits and bank debt (bank bonds/CoCo bonds)

    Life insurer: stylized life insurer with an outstanding stock of lifeinsurance contracts; invests in three asset classes

    Stocks

    GovernmentBonds

    BaBo/CoCo

    Equity

    Liabilities

    Life InsurerA L::

    Grundl, Niedrig - Should Life Insurers buy CoCo Bonds? 14 / 26

    I initial value GB0I return rGB equals risk free rate

    I no default risk

  • Introduction Model Framework Insurers Capital Requirements Calibration Results Discussion

    Model Framework

    Bank: provides (corporate) loans financed by equity capital,deposits and bank debt (bank bonds/CoCo bonds)

    Life insurer: stylized life insurer with an outstanding stock of lifeinsurance contracts; invests in three asset classes

    Stocks

    GovernmentBonds

    BaBo/CoCo

    Equity

    Liabilities

    Life InsurerA L::

    Grundl, Niedrig - Should L

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