Subordinated debt...

I'm a bit confused.

My reading is that issued subordinated sebt need not be be included as a liability for demonstrating solvency...

But can subordinated debt bought from another issuer be included as an asset?

If so it sounds a bit like fraud.

 

Surely this will be dependent on the territory in which the company records it's accounts & as CA1 is a non-territorial specific exam you should be free to assume what you like & comment on it as best you see fit.

 

I wasn't so concerned about the exam. I was more concerned that such an arrangement (if it works like that) is a regulatory con!

 

Slightly tricky one this! My understanding of how it works is a bit hazy and largely based on Solvency II. Here’s what I think happens.

The issuer of the subordinated debt would record the debt under own funds (i.e. the capital part of the balance sheet) rather than liabilities because the funds are available to pay claims, which is what the regulator is most concerned about. The debt would be recorded at market value.

The purchaser of the subordinated debt would include it as an asset, also at market value, on the basis that this is the value that could be realised by the purchaser in order to pay claims if necessary. However when calculating the purchaser’s regulatory capital requirement, due allowance would have to be made for the likelihood of the issuer defaulting on the debt (subject to the principle of proportionality) and possibly also for the correlation between the underlying cause of such a default and the risks that the purchaser is directly exposed to (e.g. a large natural catastrophe might threaten the solvency of both the issuer and the purchaser.) Indeed, this may prove so difficult that a purchaser with ample available capital might choose to write off the subordinated debt for S2 purposes.

So I don’t think it’s actually as much of a con as it might seem. Of course, if the purchaser is a non-EU insurer then it may be that some “regulatory arbitrage” is possible.

Hope that helps and glad you asked - it got me thinking!

 

My understanding is that subordinated debt is subordinated to policyholder claims. (i.e. claims are paid first).
Thus it does not count as a liability from a solvency point of view, but it still a liability on the balance sheet.

 

Further to tiger's comment, it's worth bearing in mind that many insurers will be preparing balance sheets on several different bases. Broadly speaking the S2 balance sheet reflects the policyholder's point of view and so will show the subordinated debt as part of the own funds.

Insurers will still be publishing balance sheets according to their country's statutory requirements in the same manner as they always have. Traditionally these are closer to the shareholder's view and so will regard the subordinated debt as a liability since the holders of this debt rank above shareholders on wind-up.

(I should add, some of this may be quite UK-specific. This is partly because that's where I'm based and partly because it's very difficult to maintain such a detailed conversation at a completely abstract and general level. I hope it's still of some interest/use.)