Under the Solvency II Directive,1 EU insurers are required to maintain a specific level of capital which is categorized into levels or ‘tiers’: so-called high quality capital (T1), good quality capital (T2) and finally Tier 3 (T3), which can be described as low quality capital. The concept of tiers is similar to the CRD IV/CRR. Both the CRD IV/CRR and Solvency II classify financial instruments into specified tiers based on the valuation of their pre-bankruptcy and post-bankruptcy loss-absorption features. Loss absorption on a going-concern basis is achieved primarily through dividend cancellation in the absence of profit and profit reserves. The same effect brings about non-cumulative coupon deferral in the case of hybrid securities. Another loss-absorbing feature is the conversion of hybrids into common equity or a partial, if not full, write-down of their principal value. In case of insolvency, senior bonds rank before subordinated bonds. Common equity, in turn, has the lowest recovery rate.
KeywordsLoss Absorption Common Equity Lower Recovery Rate Minimum Capital Requirement Solvency Capital Requirement
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