Now awaiting passage into law is a major review of the 2016 Solvency II regulation governing the solvency capital requirements (SCR) of European insurers. The amendments proposed by the European Commission (EC) and the European Insurance and Occupational Pensions Authority (EIOPA) are intended to ensure the insurance sector remains fully resilient to future market shocks.
BNP Paribas Asset Management’s Sophie Debehogne, Senior Client Solution Manager, Solution and Client Advisory Group (Multi Asset Quantitative and Solutions Group), and Mehdi Hacini, Quantitative Analyst, Quantitative Research Group, argue that while the EC proposal does not revolutionise Solvency II, eight of the amendments it contains do have important implications for insurance companies. In a new paper, they explain why.
The aim of the Solvency II review is not to undermine the insurance industry’s solvency, which is reasonably strong and has resisted the Covid-19 crisis well.
Rather, the proposed amendments are intended to better align Solvency II with:
- Market realities, for example a low return environment and its associated risks
- Insurers’ long-term investment horizon profile and their significant role as contributors to the economy
- The particular nature and credit sensitivity of individual insurance companies
- Reducing the industry’s sensitivity to market fluctuations
- Being better able to deal with certain risks, such as those linked to climate change.
Overall, the EC expects the proposed measures to free up EUR 90 billion of capital in the short term. That said, as measures such as those concerning the discount curve and interest-rate shocks look set to increase insurers’ capital requirements, the actual amount of freed capital will likely be reduced to EUR 30 billion over the long term.
The eight amendments likely to have the most impact
1. Modification of the discount curve
There will be a new Risk Free Rate (RFR) curve to discount insurers’ liabilities. The proposed extrapolation method takes into account information on longer-term market interest rates beyond 20 years for a more natural distribution of interest-rate sensitivities over the curve for liabilities.
It will better align ‘regulatory’ sensitivities over the curve with the true ‘market’ curve than does the current method.
There will be a transition period to the end of 2031 from the existing curve to the new one. While the envisioned transition mechanism will initially have no impact on the curve’s level, it will affect the interest-rate sensitivity of liabilities from day one.
Broadly, the consequence of this change in the RFR curve is that insurers hedging some of their liabilities to contain their SCR will have to adjust their hedging strategy.
2. Amendment relating to interest-rate shocks
The second big change concerns interest-rate shocks. Under the existing Solvency II regulation, such shocks are based on a matrix that provides a relative percentage variation to apply to the interest rate for each maturity between Year 1 and Year 90. The matrix is different depending on whether interest rates move suddenly higher or lower. The percentages also decrease with the maturities.
As this approach creates an asymmetry between the curves relating to upward and downward shocks, the EIOPA and the EC are seeking to better align this SCR module with current market conditions.
The impact of these changes will mainly concern:
- Life insurers with long-duration liabilities and a marked duration mismatch between their assets and liabilities. In particular, lifer insurers with some cash and short-term exposures will have a high capital charge.
- More generally, insurers with a duration mismatch.
3. New approach to calculating the volatility adjustment
The volatility adjustment (VA) aims to mitigate the short-term volatility of insurers’ solvency, taking into account their long-term perspective. It reduces the impact of short-term changes in credit spreads on the valuation of insurance liabilities, thus helping to make capital resources less volatile.
Under the proposals, the way of calculating the VA will change, such that the size of the VA is more dependent on the situation and credit sensitivity of each insurer rather than using a default VA for all insurers (Exhibit 1).
4. Changes to eligibility for long-term equity investments (LTEI)
The EC has reviewed the eligibility criteria for the long-term equity investment (LTEI) module, which was designed to better take into account the long-term nature of insurers’ activity and help the sector to finance the economy.
The complexity of the criteria has inhibited the use of this module. To make LTEI more attractive to insurers, the proposed eligibility conditions will be simplified and help ensure that the equity pocket covers either long-term liabilities or that there will be no forced sale simply to meet liabilities.
5. Adjustment of the correlation matrix
The EIOPA proposes only changing the correlation matrix in cases of downward interest-rate shocks. The change concerns exclusively the correlation between the spread and the interest-rate risks, which has been reduced from 50% to 25%. This will broadly reduce the total market solvency capital requirement for insurers with a large interest-rate and spread SCR.
6. Broadening of the symmetric equity adjustment bandwidth
The symmetric equity adjustment is used to reduce the procyclical character of an insurer’s equity investment. The objective is to make equities less expensive in terms of SCR after a market drop and more expensive after a market rise.
This symmetric adjustment was initially defined at a minimum of -10% and a maximum of +10%, based on the current level of a reference portfolio compared to its average over the last three years. In reviewing Solvency II, this bandwidth will likely be broadened to -17% to +17%.
The main objective is to reduce procyclicality and avoid the insurance industry having to sell equity positions at the worst time, such as after a market drop.
7. Risk margin reduction
The risk margin regulated by Solvency II is designed to cover non-hedgeable risks should an insurer’s activity be transferred to a third party. The proposed revision aims to reduce the size and volatility of the risk margin as the current formula is viewed as being too conservative.
8. Introduction of climate change scenario analysis
The EC will introduce a requirement for insurers to conduct analyses of the impact of climate change on their activities and financial results. The objective is to ensure that the insurance industry better takes into account and manages climate risks and the associated systemic risks.