Moderate transformation impact of amended solvceny ||

On 22 September 2021, the European Commission adopted a comprehensive ‘review package’ of the Solvency II rules (Directive 2009/138/EC) which has been applicable for insures in the European Union since January 1, 2016. The review has resulted in two proposals of the European Commission to be discussed by the European Parliament and the Council and finally to be converted into requirements monitored by the supervisors of the respective member states.

PERIODICAL REVIEW OF THE SOLVENCY II DIRECTIVE [1]

The European Commission has a legal mandate to conduct a comprehensive review of pivotal components of the Solvency II Directive, in particular its risk-based capital requirements and rules on valuation of long-term liabilities, and to draw conclusions from the first 5 years of experience with the framework.

Recent review underlined the absence of specific EU-level provisions to address the build-up of systemic risks, to ensure preparedness for crises or to resolve insurers, where necessary. Moreover, the framework needs to be consistent with the EU’s political priorities. In particular, the insurance sector should play a role in financing the post COVID-19 economic recovery, in completing the Capital Markets Union (CMU) and in achieving the targets of the European Green Deal.

The main trade-off in addressing these problems relates to the overall quantitative impact of the review. A significant increase in capital requirements would hinder insurers’ contribution to the green and sustainable recovery. At the same time, a significant decrease would jeopardise policyholder protection and financial stability.

The review has resulted in two proposals of the European Commission to be discussed by the European Parliament and the Council:

1. The amendment of the existing Solvency II directive.
2. The establishment of a framework for the recovery and resolution of insurance and reinsurance undertakings, ensuring that insurers and relevant relevant authorities in the EU are better prepared in cases of significant financial distress.

This article continues with the proposal for the amendment of Solvency II, and more specifically, the potential impact on the insurer’s operations.

IMPROVEMENTS ON THE CURRENT SOLVENCY II DIRECTIVE

The evaluation has concluded that, overall, the Solvency II framework functions effectively, but that certain elements need to be improved:

1. Solvency II still includes disincentives to long-term investment in equity and does not capture the longer-term sustainability risks.
2. Solvency II does not appropriately reflect the low – and even negative – interest rates environment and may unduly generate high volatility in solvency ratios.
3. Solvency II can prove to be overly complex for small and less risky insurers.
4. Recent failures of insurers operating across borders highlighted shortcomings in supervision and confirmed that policyholders are not consistently protected across the EU if their insurer fails
5. The supervisory toolkit to prevent systemic risks may prove to be insufficient.

Most of the improvements won’t require significant transformation efforts.

We elaborate on the second improvement that has been proposed and its impact on the insurer’s operating model. That part of the proposal aims to enhance risk sensitivity of long-term guarantee measures, and better mitigate undue short-term volatility of the insurers’ solvency position. Solvency ratios would become more stable and reduced volatility would incentivize long-termism in underwriting and investment decisions by insurers. Therefore, the EC has proposed amendments to the extrapolation of risk-free interest rates and volatility adjustments.

AMENDMENTS TO THE VOLATILITY ADJUSTMENT AND THE EXTRAPOLATION OF THE RISK-FREE RATE

Extrapolation of the relevant risk-free interest rate term structure

Under a Solvency II balance sheet, the liabilities are valued at Market Value (i.e. the Best Estimate of the Liabilities plus risk margin). The Best Estimate of the Liabilities are calculated by discounting future cash-flows using the risk-free rate (RfR). The determination of the relevant risk-free interest rate term structure shall make use of information derived from relevant financial instruments. That determination shall consider relevant financial instruments of those maturities where the markets for those financial instruments as well as for bonds are deep, liquid and transparent. For maturities where the markets for the relevant financial instruments or for bonds are no longer deep, liquid and transparent, the relevant risk-free interest rate term structure shall be extrapolated. The extrapolated part of the relevant risk-free interest rate term structure shall be based on forward rates converging smoothly from one or a set of forward rates in relation to the longest maturities for which the relevant financial instrument and the bonds can be observed in a deep, liquid, and transparent market to an ultimate forward rate.

The amendments as proposed require that the extrapolation takes into account, where available, information from financial markets for maturities where the term structure is extrapolated. It requires additional data points to assess the term structure of a long term instrument, for example for a 100 years 1% Austrian government bond.

The resulting new extrapolation method is phased in linearly over a period running until 2032, during which insurers will have to disclose the impact of the new extrapolation method without phasing in.

Volatility adjustment

On top of the RfR, EIOPA allows under specific circumstances to add a “volatility adjustment” for long-term guarantees insurance products. The volatility adjustment (‘VA’) is a measure to ensure the appropriate treatment of insurance products with long-term guarantees under Solvency II. (Re)insurers are allowed to adjust the RfR to mitigate the effect of short-term volatility of bond spreads (the difference in the yield on two different bonds or two classes of bonds, i.e. the yield of the US Treasury towards the yield of a corporate bond of the same maturity) on their solvency position. As such the VA aims to dampen irrational market developments that would result in unjustified credit spreads. More concretely, the purpose is to moderate the effect of deteriorating bond prices because of low market liquidity or as a result of an exceptional (non-credit related) widening of bond spreads.

For each relevant currency, the volatility adjustment to the relevant risk-free interest rate term structure shall be based on the spread between the interest rate that could be earned from assets included in a reference portfolio for that currency and the rates of the relevant basic risk-free interest rate term structure for that currency. The amount of the volatility adjustment to risk-free interest rates shall correspond to 65 % of the risk-corrected currency spread which is the difference between the spread as referred to above and the part of that spread that is related to (a realistic estimation) of the expected losses and other risks of these assets.

Each month, EIOPA publishes the VA, which is calculated based on a pre-defined reference investment portfolio, representing an average European insurer.

The following amended requirements for the application of the VA have been proposed:

1. A higher percentage of 85% (currently 65%) of the risk-adjusted spread (‘RCS’) is considered in the VA.
2. To mitigate the risk that the VA compensates beyond the losses on investments from an increase in credit spreads, an undertaking-specific ‘credit-spread sensitivity ratio’ (‘CSSR’) is introduced.
3. the country component of the VA is replaced with a macro volatility adjustment for Member States whose currency is the euro to mitigate the impact of spread crises at country level while avoiding cliff edge effects.
4. New cases of using the VA will become subject to supervisory authorisation.
5. The (re)insurer should demonstrate that it has adequate processes in place to calculate the VA pursuant to the calculated method below:

The VA for a currency = 85% of the product of the CSSR for the currency and the RCS for the currency.

The macro volatility adjustment, applicable for the EURO member states, shall be calculated as follows:

VA for the EURO = 85% of the product of the CSSR for the EURO, the maximum of the risk adjusted spread for the respective portfolio currency or the risk adjusted spread of the EURO multiplied by factor 1.3, and the country adjustment factor for the respective country:

VAeuro,macro = 85% * CSSReuro * max(RCSco -1.3*RCSeuro;0)*ωco

IMPACT ON THE (RE)INSURERS OPERATIONS

So, the proposal provides room for customization for the calculation of the technical provisions. But lunches are hardly for free so which offers should be made for the application of the customized volatility adjustment and the amended extrapolation method.

In terms of data, these amendments may impact an insurer in two different ways:

• The need for additional instrument data: the determination and/or extrapolation of the risk-free interest rate term structure and the VA, will require to have the relevant reference data for these calculations. The impact of this should be relatively low, as the (re)insurer is already sourcing a plethora of market data for other purposes and as such the addition of missing attributes, if at all necessary, should be more of the same.
• The revision of data aggregation: this might be a different matter. Depending on the type of bond (corporate or government), the (re)insurer will have different aggregation levels. Furthermore, for government bonds, the (re)insurer need to take into account the deviation between currency VA and country VA, due to the differences in liquidity which are (not) being taken into account.

Significant changes of the calculation method for the volatility adjustment, should be disclosed together with an analysis of the changes including the quantified effect at the financial position of the (re)insurer.

[1] See 2021/0295 (COD) Proposal for a Directive of The European Parliament and of the Council amending Directive 2009/138/EC